David Young Blog San Carlos Blog

THE PROBLEM DEFINED

Our financial system is the foundation for operating a sound functioning economy. American business, consumers and international partners rely on loans with financial institutions for daily operations. Businesses typically take out short term loans to manage cash reserve depletion for items like payroll, acquisitions, and emergencies. Consumers use credit cards, home loans, car loans, student loans and various other types which in turn produce income for businesses to grow. The free flow of lending money must occur at four levels or an immediate stop to our economy occurs;

Banks Lend to Banks

Banks Lend To Consumers

Banks Lend to Business

Consumers Buy Business Products and Good

Recently bank to bank loans have frozen. Banks have seen a significant number of depositors shifting funds to treasuries and other government back programs, therefore straining the cash reserves of banks. When this occurs banks ask other banks to free up cash with short term loans to prevent cash depletion and ultimately a bank failure. Since most banks are seeing cash depletion from depositors shifting funds out, they are now refusing to lend to other banks in fear that they too might deplete their cash and also become a victim to financial insolvency. Thereby forcing them to sell, merge or close down (i.e. Wamu, Wachovia, etc.).  The end result is a freezing of bank to bank loans and therefore clogging the system.

A clogged system eventually means banks stop lending to consumers and businesses, or at least reduce their exposure in those areas. Eventually this means consumers will not be buying as much. The final result is that business income start reducing and layoffs take place. Consumers have less money to spend when unemployed, making a further business downturn and even more layoffs. Ultimately a recession or depression takes place.

THE SOLUTION

Government intervention and economic downturn prevention is controlled with two government tools; a. regulation or b. liquidity. Regulation is a good way to solve future problems but it does little to result in immediate relief to the problem. Liquidity is when the federal lending rates are reduced, thus allowing banks to take more cash at nominal rates. Lower rates typically are shared by the bank to its consumers and business when they take a loan out. Unfortunately since banks require more liquidity and are in a state of fear, both consumers and business loans have not resulted in lowered rates. Instead banks are trying to maximize returns and reserve cash. The government liquidity is not helping the consumer or business since banks are unwilling to pass the savings on in the form of a lending rate. Therefore the stimulus is only partly functioning. Banks need more confidence to ensure that the cash crisis can be averted by them. The only way this happens is when they have more confidence in present balance sheet holdings. The bulk of the holdings that are the root cause for bank fear is the mortgage back securities (home loans). Until banks feel comfortable with their financial position and consumers have confidence in placing their savings in banks economic turmoil will continue.  

Thus our Washington leadership is attempting to provide a new temporary relief solution to provide liquidity for banks (in the form of buying their bad mortgages) and therefore free up banks to resume business as usual (i.e. lend to each other, and start free up funds for lending to businesses and consumers possibly with lower rates). 

A bailout appears necessary and critical to allow the flow of money in the banking, private and international sectors. However, what is inside of the bailout is the source of argument. Some argue that if we just wait this will all work its way out. This argument is true however the consequences would likely result in one of the worst recessions ever seen since the Great Depression. Few want to see a prolonged economic crisis. To alleviate and possible reduce the depth of a crisis; the recent 750 billion dollar bailout package was presented to Congress.

Unfortunately approving a package with a group of congressional people where few have economic backgrounds makes the details incomprehensible to most. Voting on such a package, along with influences of a November election, has made our legislature pause. And why not?  How can they know if this will really provide relief to the financial markets without understanding the economics behind the package?  Further crash courses on economics are necessary so that our representatives can make a sound decision for the American public. Or at a minimum it will require trusting those who have the knowledge. Unfortunately little trust exists these days, especially just before an election.

The good news is that this will all eventually shake out. It is only a matter of time. Whether we have a light or heavy handed recession is what lies in the balance. The bailout in its present form certainly is not a cure to solve our economic woes. But it is a start. I for one am glad that this is taking a little longer and hope that the extra time will be used to ensure the best results for the American public.

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