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Monday, October 6, 2008

Financial Crisis -- What's happening

On my MBA alumni mail lists, a lot of commentary is floating around. As it's a semi-public forum, the people who are angriest are talking a lot more. This is unfortunate, because the most angry seem to be the least knowledgeable about what's going on.

I don't feel like teaching a basic economics class, but suffice it to say that a modern economy is very dependent on credit being extended at a variety of durations. We extend credit to financial institutions by stashing our cash there and getting some interest back. They extend credit it others in much the same way.

For a business, matching cash inflows with outflows is a fundamental act. Now, when you sell something, you're usually not going to be paid until after you deliver it. However, you're going to start incurring costs much sooner than you're paid. Nearly every business has to pay at least some of its bills before it is paid. Those that don't are the subject of much admiration in MBA classes. Aside from that, short term credit is necessary for a functioning economy. We could insist that everyone hold enough cash to cover all their bills before they commit to a sale. That sounds good, but is impractical. We would seriously limit the capacity of the economy and if you think about it, this mode just does not make sense. Let's say a guy convinces everyone on a block to pay him to do their lawns. Wouldn't it be better if he could then go borrow money to buy the equipment? Oh, we could make him wait until he had enough money to buy the equipment outright. Then his boss can keep charging us more to do our lawns and pay the guy so little that he never can go into business for himself. Hopefully, now you're getting the idea.

The short term credit markets right now are frozen. The commercial paper market is basically non-existent right now. Commercial paper are short term notes that large, very stable companies issue. They have generally been considered so safe that you can account for them the same as cash. Companies need to issue commercial paper to finance their day-to-day operations. These are companies that are very solvent, but they use short term debt to enhance their liquidity. Thus, they can extend their decision horizon on how best to deploy their assets. This is a good thing. Here's the thing, no one will lend to them right now and they have their cash tied up in longer term investments. They can get the cash, but not without taking losses on these investments.

Just imagine how tough life would become if credit cards disappeared. This is essentially what is happening right now. Imagine what the fallout would be. We are talking Great Depression-level disruption and shrinking. Hopefully, reasonable people can agree that some ideological purity is a worthy sacrifice if it can avert this crisis.

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