October 6, 2008

October 6, 2008 | Commentary on Economy

Pain of credit crunch is likely to continue

Financial markets are under enormous strain now, enduring an old-fashioned credit crunch the likes of which we haven't seen in decades.

The first clear sign of the crunch appeared Wednesday, when data revealed that U.S. auto sales had plummeted 27 percent in September from already-depressed levels.

The Treasury Department and the Federal Reserve have tried to stem the tide of financial contagion, beginning with the managed collapse of Bear Stearns on through the de facto bankruptcy of AIG, previously the world's largest insurance firm. These on-off efforts were stunning and controversial. They also proved too little, too late.

A huge problem that began in the housing sector in 2006 spread to mortgage-backed securities and then to more exotic financial instruments. Weakness now infects the core elements of our financial system, including commercial paper, commercial bank deposits and such simple matters as inter-bank lending.

The credit crunch means that even prospective borrowers with good credit ratings are often unable to borrow. Worse, businesses and individuals are seeing their lines of credit contract so that even healthy businesses may suddenly disappear.

The housing sector remains in trouble, and many major financial firms remain severely undercapitalized, problems that will take many months to resolve. Yet the immediate problems we face are something else entirely.

First, the contagion threatens to spread to sound commercial banks. Depositors are afraid their bank will fail and they'll lose their deposits. Of course, deposits up to $100,000 are FDIC insured, and retirement accounts are insured up to $250,000. But most businesses maintain cash accounts with balances far larger. Losing access to their cash balances could bankrupt a healthy company.

According to one report, about $2.5 trillion in bank deposits are currently uninsured. To assure all depositors their money is safe, the FDIC announced it has effectively extended deposit insurance to all deposits.

Our second problem is that the financial markets are seizing up. Normal inter-firm borrowing has dried up, and normal business sales, when they occur, do so at fire-sale prices.

As markets began to seize up, Treasury Secretary Henry Paulson announced a program to deal with the markets on a systematic, focused basis. Its centerpiece is the controversial $700 billion Troubled Asset Relief Program. If it works - and there are no guarantees - this rescue plan will reassure markets that when an institution or investor needs to sell a financial asset, the federal government will step up to buy it at a deep discount relative to normal market value but above the fire-sale price.

The rescue plan will help the seller, of course. But it will also help everyone else in the market by establishing a more normal asset price. And it will help the broader markets by improving confidence that the markets will continue to function. Contrary to popular perception, the focus of the rescue plan is restoring markets, not bailing out weak companies.

After years of false dour forecasts, the recession is real, and it threatens to be a doozy. Steps taken in Washington so far will help soften the blow. After passage in the Senate, if the measure had failed in the House of Representatives, then Wall Street would have gotten more of its just desserts, but the economy would have shared in the consequences. With its passage, then the pain of the recession will be lessened for workers and families on Main Street.

Politics is about choices.

Peter Brookes is the Norman B. Ture Senior Fellow in the Economics of Fiscal Policy at The Heritage Foundation.

About the Author

J.D. Foster, Ph.D. Norman B. Ture Senior Fellow in the Economics of Fiscal Policy
Thomas A. Roe Institute for Economic Policy Studies

First appeared in the Des Moines Register