The Financial Crisis

I could not help but notice that many of my readers feel somewhat befuddled by the financial crisis that is going on.

You are not alone, of course. Reading other internet blogs, for example, I can sense the rising tide of confusion and anger.

As for myself, before I went into the priesthood I got a degree in international business and finance. I’m often therefore called upon to “translate” economic news and events for my friends into ordinary language.

The origins of this economic problem come from institutions making bad loans. To be honest, this happens all the time - every loan is a bit of a crap shoot, after all - and the economy is normally able to absorb bad debt and deal with it as a matter of course. Imagine a scenario where you are seated in a chair and somebody is tossing small marbles one by one at your head. You feel them as they bounce off, but they don't really hurt you. The person could toss a thousand marbles at you, and it wouldn't make a huge difference.

But what if those marbles were instead tossed at your head all at the same time? Imagine being hit in the head by a bag of a thousand marbles. At the least, it will give you a concussion or knock you unconscious. It might even crush your skull.

My friends, to put this in the simplest possible terms, each of those bad loans was like a marble. The marbles were packaged together in instruments called "asset-backed commercial paper". And now the great big bag is being tossed at the head of Western society. It hasn't hit yet, but nothing can stop its flight - NOTHING. Yes, the origin of this crisis comes from bad loans, but the reason for the severity of this crisis is that all these loans are coming apart at the same time. The sudden collapse of a huge mountain of debt is causing a shrinking of the money supply, otherwise known as a "liquidity crisis". Let me explain this idea of a money supply a bit more.

We live in a money economy, not a barter economy. In other words, we don't trade real goods for real goods. Instead, we use a virtual good, called money, as a medium of exchange. Money, in itself, has no intrinsic value. If you were on a deserted island and had a choice between a dollar and an apple, you'd pick the apple. Money has value only because we, as a society, say it does.

We use money as a medium of exchange because it simplifies transactions. This simplification provides value to the economy, and everyone benefits as a result. Money, however, is subject to a particular danger that real goods are not: the problem of counterfeiting. This is why, for most of human history, we've actually used metals like gold and silver as the basis of our monetary system. Metal coins are hard to counterfeit, especially when you know how much they are supposed to weigh.

The problem with using metal, however, is that the size of the money supply depends on how much metal has literally been dug out of the ground. Sudden discoveries of new deposits can boost the money supply, like what happened in the Gold Rush period, but all that new money injected into the economy is usually accompanied by a sudden rise in inflation. It is great to have all that new money, but the economy can't swallow it all at once, so it starts to choke.

The switch to paper money was the next logical step. At first, paper bills were really just coupons which could be exchanged for metal coins. What happened, however, is that people started exchanging the paper bills with each other instead of the coins, knowing the coins were "backing" the paper in a vault somewhere. Eventually the government mandated that stores and other vendors HAD to accept the paper instead of the precious metals if it was offered - the paper became "legal tender". Thanks to this, the use of precious metals as currency dropped dramatically and basically became limited to certain specialized transactions between the central banks that issued the paper currencies.

We learned a few hard lessons with paper currency, however. Just as too much gold at once can cause a gold rush with its accompanying inflation, too much paper at once can create inflationary scenarios that can ruin an economy. How many times have we heard of countries experiencing hyper-inflation, with people carrying around wheelbarrows full of paper money? Flooding the market with more money should, in theory, encourage people to produce more to earn that money, but if this increase in money supply is exaggerated people will just take the easy way out and raise the price of the goods and services they are already producing anyway. Money, after all, doesn't have any intrinsic value of its own.

The reverse situation is also true: the money supply can shrink, bringing with it the opposite scenario known as deflation. Prices drop, which sounds good, but so do wages. Because of this, as bad as inflation can be for an economy, deflation is far, far worse. Remember these simple equations:

  • A collapse in the money suppley = deflation.
  • Deflation = unemployment.

Why does deflation lead to unemployment? Quite frankly, it is because of human psychology. The same $100 can be used to buy things from any store in the mall: it can be converted to groceries, clothes, video games, whatever. Money has value because it gives us the power to acquire, and so we naturally want more of it. What we forget, however, is that money only has relative value.

In an inflationary scenario, where prices rise (say) 5%, a company can raise wages for every employee by 5% to compensate. No one minds this. Imagine, however, a deflationary scenario, where prices drop 5%. The same company now needs to lower its cost of wages by 5%. It can do so by one of two ways: it could lower wages by 5% across the board, or it can lay off 5% of its workers. Which of the two will it do? Or, more to the point, which of these two scenarios will the workers themselves accept? In theory, the employees should not mind the 5% wage drop, because after all prices also dropped by 5%. In practice, however, companies hardly ever implement across-the-board wage cuts, in large part because employees themselves will not accept them. It is easier to lay people off. Deflation leads to unemployment. The bigger the collapse of the money supply, the worse it gets.

But even worse, deflation is also a phenomenon that feeds on itself. Consider a typical bank deposit: you deposit $100 now, and with a promise to receive (say) $105 a year from now: a 5% return. If inflation suddenly rises, rates of return on new loans have to rise to keep pace, or else people will stop investing: after all, who would invest for a 5% return if inflation is running at 15%? Interest rates therefore match inflation rates, plus a little bit. But now consider interest rates in a deflationary scenario: inflation is actually NEGATIVE, and if it is negative by enough the bank can't offer a positive rate of return at all. If inflation is running at 15% (very high) you might still invest if the promised rate of return was 20%. But if inflation was running at -15% (i.e. deflation), would you still invest in a bank if the promised rate of return was -10%? Of course not. You'd take your money out of the bank and stuff it in your mattress, awaiting the day when interest rates became positive again. In doing so, however, you are taking your money (literally) out of the money supply, thus making the problem worse. That bank now has less money to lend, and with less money circulating in the system due to deflation, the virtuous cycle of borrowing and lending for investment in our future grinds to a halt. Bye bye economy.

What happens in the real world, therefore, is that central banks are constantly monitoring and managing the overall money supply to keep inflation from running away while at the same time avoiding deflation. This has been the money supply goal of the post-Depression, post-World War II bargain of the liberal democracies. Deflationary scenarios, as well as excessive inflationary scenarios, can only really be managed by authoritarian regimes, who avoid civil unrest simply by curtailing people's rights by fiat. It should be no surprise then, too, that people living these scenarios are either ruled by dictators, or tend to turn to dictators for salvation.

The collapse of stocks on Wall Street during the financial crisis is not really the problem, but is instead a symptom is a greater problem. You see, because stocks are traded very freely, their prices can inflate or deflate quickly and easily. But Wall Street acts like a thermometer for the temperature of the economy: a collapse in world stock prices must eventually be followed by a collapse in the prices of other real goods, and eventually a collapse in wages. It is like ripples in a pond. Who exactly will lose their job, and how long it will take to lose it, we cannot say. But we should not imagine it won't happen, and the consequences will affect us all.

This is why the $700-billion bailout package was necessary. The package had the effect of injecting a huge amount of money into the money supply, thereby staving off the deflationary scenario. This extra money will act like "grease" in the "motor" of the economy, giving banks and other financial institutions time to reorganize their portfolios. Again, it is like the marbles. The banks will still get hit in the head by the marbles, but those marbles will at least be spread over time rather than coming in all at once. The financial system will be stung but at least will survive.