What's the big deal about banks refusing to lend?

Philip Brewer — Tue, 30 Sep 2008 21:15:16 +0000

Anybody--but especially frugal people--can be excused for thinking that the whole credit crisis thing is being overblown. After all, we get along without debt. In fact, we strongly recommend that others do so as well. If getting along without debt is the way to go, why make such a big deal over a credit crunch?

For an individual, there's a reasonable debt-free path to some sort of prosperity. You earn money, you spend less than you earn and save the difference. Over time you accumulate durable items that raise your standard of living for years to come; your income rises (as you become more skilled and prove yourself a reliable worker); you earn a return on your savings and investments.

So, what's the big deal? If everybody did that, we'd hardly need credit at all, and could just ignore credit squeezes. Right?

Consumer debt

That intuitive analysis really just covers consumer debt, which is not at the heart of the matter.

Consumer debt is a factor in the crisis, in that it has let people live beyond their means. That has produced an illusory boost to the economy, even as it has produced a shortage of savings. But a cut-off in consumer credit is not what people are worried about when they say that banks have quit lending (even thought it's enough all by itself to produce a recession, simply because consumers who had been borrowers will have to become net savers, if only because their access to credit has been cut off).

Productive debt

The shortage of credit that has everyone in a tizzy is credit used to buy productive assets. When a farmer borrows money to buy seed, that's productive debt. When a baker borrows money to buy a second oven, that's productive debt. When a huge utility borrows money to build a power plant or a water treatment facility, that's productive debt.

It's possible for farmers, businessmen, and giant corporations to get by without debt--but only as much smaller operations. So, there are two issues: the size of the enterprise, and the transition to being that size.

Enterprise size

WIthout access to debt, business size is limited by the amount of invested capital:

The farmer can't plant more seed than he can afford to pay cash for (after budgeting for fertilizer, fuel, and so on).
The baker finds himself turning away good customers because his one oven can only produce so much (until he saves up enough money to buy a second oven--something that might take years).
The utility can't expend to serve a growing population (except by retaining a decade's worth of profits).

This is not necessarily a bad deal for the business, if the enterprise is sized correctly. The baker with just one oven can only produce so much bread or pizza, so he only has to work so hard. Since demand is strong but supply is limited, it's possible to earn a good profit. You often see this sort of result in highly skilled crafts--a well-thought-of luthier might have an order book that extends out for months or even years.

When credit is available, this sort of situation doesn't develop, except for things like skilled crafts. Credit makes it possible for the business to expand. And if the business doesn't expand, competitors will move in to meet the demand.

When credit is tight, this sort of situation can persist for years (which can be very frustrating for customers, who can't buy what they want--because the guy who makes it is selling all he can produce to long-time customers).

Transition

Before we get to the tolerable (if sometimes frustrating) situation of businesses staying small even when there's strong demand, we have to get the businesses sized correctly. That can be terribly painful.

Many businesses are utterly dependent on ready access to credit. This is especially true of businesses with large capital demands, such as farms (where huge amounts of money are tied up in land and equipment) and utilities (where the capital takes the form of power plants, telephone switches, well fields, pumping stations, water towers, etc.), but it can be true of any business.

With much or all of their capital tied up in plant and equipment, the business uses credit to buy supplies and to meet payroll. If access to credit is lost, even for a couple of weeks, the business is no longer a going concern--invoices go unpaid and the payroll can't be met.

That's even true of a business that's not really operating on the edge. A successful farmer, for example, might have enough cash to finance his whole operation--buy seed, fertilizer, fuel, pay for maintenance, and so on--for a year. But suppose a poor crop this year leaves him with less cash next year. Unless he has access to credit, he can't make full use of his land and his equipment. If he's only able to plant and fertilize half his fields, he can easily enter a death spiral, never making enough money one year to make full productive use of his capital the next. In theory he could downsize the farm--selling some land, selling a big combine and buying a smaller one, etc.--but that sort of transformation is hard at the best of times and can easily be impossible in any particular year, especially if his neighbors are in much the same situation.

Other businesses face exactly the same sorts of issues--needing to sell equipment that they can't put to productive use because they lack the cash to buy raw materials, pay their employees and so on. But they too can't actually do so, because nobody else has the cash or the access to credit to buy the equipment.

Current situation

I mention all this because we're dangerously close to this situation now. Many businesses are unable to borrow. If this continues, they'll be forced to try to shrink--and many of those efforts will fail. Even where they succeed, the new business will be smaller--with fewer employees, less output, and lower profits. They (and their customers, and their suppliers) will all be buying less, meaning that other businesses--even ones that don't depend on credit--will have to shrink as well.

That's what a recession is, and this is shaping up to be just that.

For an individual, getting along without debt is a great idea--now more than ever. But for the economy as a whole, a credit crunch is hard on everybody.

What to do

Well, staying out of debt is a good start. Beyond that, it depends on how you make a living. Last year I wrote about preparing for a recession. That advice still holds, and it's not too late to prepare, even with recession staring us in the face.

If you're an employee, you're largely dependent on the success of your employer, and your employer's success will depend on its need for credit. If you have any visibility into that side of your employers operations, you can get a good sense as to how much risk a credit crunch poses. Note that being a great employee won't necessarily help in a situation like this. Many firms that lose access to credit will have to shrink by half or more, so plenty of highly productive employees will have to be let go.

As a special case of being an employee, if you work for something other than a business--federal, state or local government, a school or university, a charity, foundation, or similar non-profit--you may be in much better shape. Those sorts of institutions tend not to be dependent on debt to fund their day-to-day operations. They may see their income drop as charitable contributions and tax receipts drop--and they may well have to let employees go--but the aren't in the position of having to shrink their business instantly down to what can be funded on a cash basis. They're probably already there.

If you're a business owner, move as quickly as you can to get things on a cash basis. (I realize that this advice is coming rather late in the cycle.) If you've been using credit to bridge the gap between paying your suppliers and getting paid by your customers, this will admittedly require shrinking your business. There may not be time to wind things down gradually--you're probably better off immediately cutting whatever you can't afford without credit. A small business with one or a few employees is better than a medium-sized one with many employees, if the medium-sized one is in receivership.

If you're retired, the future is especially murky. The collapse of credit is hugely deflationary, and if that's all that happens, your cash and government bonds will do very well, and you'll come out of this in fine shape (unless you have too much of your retirement money in stocks). The bailout efforts, though, are largely inflationary. To the extent that they succeed, those stock investments may do okay, while the cash and bonds lose purchasing power to inflation. Worst case, we get enough inflation to destroy your dollar-denomonated investments without preventing the deflationary recession that wrecks your stocks, and then drives the economy down to the point where you can't get a job either. In that situation you have little choice but to opt out of the money economy all together. Let's hope it doesn't come to that.

No matter where you're starting from, though, recognize that these financial events affect production, but they don't affect productive capacity: The land is still there, the factories are still there, the equipment and workers are still there. Over time, things will work themselves out to put the productive capacity back into production.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: