Credit squeeze (formerly know as a panic)

By Philip Brewer on 9 August 2007 (Updated 18 August 2007) 6 comments

There used to be a particular financial event called a panic. There were two famous ones around the turn of the last century: the panic of 1893 and the panic of 1907.

A panic worked like this: Everything would be going along fine until something produced a lack of confidence, at which point people would take their paper money to the bank to exchange for gold. The banks, after paying out large amounts of gold, would be unable to make ordinary loans. With credit restricted, business began to grind to a halt--manufacturers couldn't borrow to buy raw materials, retailers couldn't borrow to take delivery of goods for sale, farmers couldn't borrow to buy seed, etc.

If someone who had both lots of gold and faith in the economy stepped in, lending gold to the banks so that they could resume normal lending, then the panic could be ended quickly and with little harm to the economy. If there was nobody able and willing to do that, the result was usually a depression. Multiple businesses would fail, unable to carry on without access to credit. Their banks would have to write off the loans, people would be thrown out of work, etc.

The main purpose of the Federal Reserve was to prevent this scenario. The Fed was intended to be the "someone with gold and faith in the economy," able and willing to lend unlimited amounts to sound banks, so that they could carry on with normal lending. And, although the Fed has created its own set of problems, it has succeeded at that goal: there hasn't been a classic financial panic since the Fed was created in 1913.

I mention this today, because we're just about as close to a financial panic as we've gotten since then. It isn't a panic, because "ordinary" lending hasn't been affected. There's been quite an impact on "weird" lending, though. The subprime mortgage market has collapsed, and at the same time the market for leveraged buyouts has collapsed.

Personally, I'm not sorry to see either of those go. Leveraged buyouts have generally turned out to be a way for very rich people to become incredibly wealthy, largely at the expense of ordinary workers, their communities, and small investors. If you can't qualify for an ordinary mortgage, you probably can't really afford a house--and getting fooled into thinking you could afford one by teaser rates on an option-ARM is a lot more likely to ruin your finances than turn you into a homeowner.

I don't think a classic financial panic is at all likely. Much more likely is what we've had: the Fed goes beyond being "able and willing" to lend to sound banks and lends excess money. (And, in fact, today the Fed needed to provide $24 billion of liquidity to keep short term lending rates stable. The European Central Bank provided $130 billion in overnight lending.)

These sorts of events can cause the whole economy to lurch unexpectedly in one direction or another (or first in one direction and then in the other). Interest rates may spike or fall (or go first one way and then the other.) The stock market may do the same. Very rich and very smart people try hard to predict the lurches and can make a lot of money if they guess right. My own inclination, though, is simply to try not to get squashed whichever way things go. The two keys for that are:

  1. Avoid debt, especially floating-rate debt. At times like these, rates can easily spike up at just the same time that some otherwise minor problem in either the job market or the banking system can interfere with your ability to make timely payments. That can take what would otherwise be a temporary economic glitch and turn it into a bankruptcy or foreclosure.
  2. Stay liquid--have an emergency cash reserve. Some people prefer to have all their money invested in the stock market for maximum long-term returns, and rely on credit cards to cover them in case of an emergency. That works fine when the system is going along smoothly, but can fail badly during a credit squeeze. Your bank could just cancel your credit card right at the same time the value of your investments was plummeting. The cost of some idle cash is very small compared to your possible exposure otherwise.

I don't want to sensationalize things--I think the risks are small. But there is a real risk that the current situation could get messy, and these are modest steps that I think are worth taking in the face of what will probably turn out to be a modest problem.

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Guest's picture
George

This advice is what is in ever financial book I've read and most of the advice I've received has been this: Stay out of debt, have savings. Not only the way to weather the economy, it's also a way to just be stable in life.

Before this "squeeze" I was feeling about as unamerican as fidel castro but now that the subprime mortgage industry is effectively drying up, my friends who bought houses right out of college are starting to see the light.

Philip Brewer's picture

Glad to hear that you're doing well.

Staying out of debt is always a safe choice. It's not always the winning choice, though. In a resource-rich environment, the people who are willing to go out on a limb (and aren't so unlucky as to get caught short by a crunch like this), come out ahead.

Of course, coming out ahead isn't the important thing.

It would be best if you could see the future. Even though you can't it's often possible to see far enough ahead to know that there won't be a crunch in the next few years, and feel confident enough to take on a safe amount of debt. (Now is not that time.)

Guest's picture

I've also heard a few "experts" recommend the purchase of small amounts of silver and gold. What do you think about that?

The scariest thing in my mind is that given the challenges you've mentioned above we've yet to see what the baby-boomer effect is going to do to the landscape.

I'm under the impression that, with-in the next few years, the number of people turning 70 1/2 who will be forced to start withdrawing their money from the IRAs will increase by over 33% in a single year. That is bound to put a huge strain on things.

Philip Brewer's picture

Gold and silver aren't really producing assets--they don't pay interest or dividends, and they don't really go up in value. (They may go up in price when market fluctuations let you buy them at an unusually low price and as inflation makes the money worth less, but that's just the value remaining stable.)

That stability makes gold and silver good stores of value, as long as you don't buy them at historically high prices. If you bought gold six or eight years ago you're sitting pretty right now. It's not so clear that buying gold at today's prices will turn out to be a win.

Besides a store of value, they may also be good in times of great emergency, if things get bad enough that people lose their confidence in cash. In practice, though, the dollar has turned out to be a lot more useful than gold or silver so far, at least in developed countries, even during emergencies, for as long as I've been paying attention.

Having said all that, I've got some gold and silver in my safe deposit box at the bank. I figure it's a hedge against worse emergencies than we've faced so far. Plus, it's pretty.

Guest's picture
Guest

The mystery is where the Fed and European Central Banks get these billions they "pump" into the economy. How much "reserve" is in the Reserve? Is this just printing money? If "pumping" money into the economy is a good thing, why isn't it done all the time? Isn't this the "pump" that causes inflation?

Philip Brewer's picture

Modern central banking is an empirical system--they do what seems to work. If inflation rises, then they must have been creating too much money. If deflation threatens, then they must not have been creating enough.

The billions that they're creating now are targeted at keeping short-term interest rates stable. When inter-bank rates (such as the Fed funds rate) move above the target, the ECB, the Fed, and other central banks inject enough money to bring the rate back down to the target. If interest rates fall below the target, they'll drain those reserves back out again to keep rates stable.

So, the reason they don't do it all the time is that they don't want to force rates below their target (which is their current best guess as to what rate will keep inflation low but stable).

The actual mechanism of the "pumping" is to lend money to banks against collateral. The collateral used to be either treasury securities, or else loans the bank had made. Over the past few days, though, the collateral has been mortgage-backed securities. I'd be really interested to know how careful the Fed is being to ensure that these securities are not the exact same (potentially worthless) ones that triggered the whole situation.