Wednesday, September 24, 2008

Why credit matters

As the dimensions of Treasury's plan to buy bad debt become clear, I'm seeing lots of rumblings along the lines of "So what if credit gets tight? Lax credit standards got us into this mess! Maybe we should live within our means for a change!"

Which is true, as far as it goes. Certainly giving no down payment mortgages to anyone with a pulse turned out to be a remarkably bad idea.

But last week's problems weren't about mortgages, they were about commercial paper. Commercial paper is the short term loans that companies like Intel and Toyota use to finance their businesses. It's about the safest non-government debt there is, and it usually pays an interest rate only a hair above short term Treasury bills. Last week, the interest rate on short term Treasuries went to almost zero, and the rate on Intel's commercial paper went to six percent. (Why? Because the money market funds who invest in commercial paper started hoarding cash to meet a flood of redemptions.)

Well, okay, so what does that mean?

Suppose I decide to go to a conference. It's related to a particular project, so either a client has agreed to reimburse my travel or I'll pay for the conference from the project fee. The hotel and the airline want their money upfront, though, while the project fee won't come in for a month or so. My credit is good, so I just use a credit card, paying the card company a nominal fee to use their money for a month or two.

But what if the card company suddenly doubled or tripled my interest rate? Or refused to authorize the transaction? I might have the money socked away, in which case paying for the conference displaces whatever I was planning to buy instead. Or I might decide to stay home. Staying home cuts that amount of revenue from the hotel and airline, and it might even mean that I'd have to cancel the relevant project altogether. The credit environment changed for reasons that have nothing to do with me, but the way I run my business still has to change.

Companies like Intel are in the same position. When Intel builds a fab, it has to make substantial investments long before chips start rolling off the line. It has to buy equipment (and the equipment suppliers have to pay their vendors), it has to facilitize the building, it has to pay the designers and all the overhead they incur. Some of that money comes from existing operations, but some of it comes from credit. If the cost or availability of credit changes radically--as it did last week--suddenly the whole economic model for the project changes. Again, the economic model changed for reasons that have nothing to do with Intel: their business remains fundamentally healthy. Still, Intel might have to rethink their investment in the project.

Repeat that experience across the entire economy, and you have big big problems. If companies don't invest, they can't grow, and if they aren't growing they aren't creating jobs. People who scoff at the implications of a credit freeze just don't know what they're talking about.

Which is not to say that the Treasury plan is without flaws. As originally proposed, it gives way too much power to an unelected political appointee whose term expires in four months. It offers way too little upside to taxpayers who are, for the most part, completely blameless. And it's not at all clear that it will even fix the underlying problems. Congress needs to address all of these issues.

But Congress can't sit on its hands, either. The partial solutions we've been seeing for the last several months seem to be making things worse, not better.

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