A reader asks: Where's the evidence that a market collapse could cause a systemic meltdown inflicting widespread misery on millions of Americans? The answer lies in understanding exactly why investors are so nervous. Two words: credit risk.
On Wednesday morning, a metric lovingly referred to as "the TED spread" by financial whiz kids spiked dangerously high. The TED spread is the difference between the interest rate on three-month U.S. Treasury bills and three-month "LIBOR" -- the interest rate that commercial banks charge each other for lending money in Europe. I can't improve on Paul Krugman's pithy explanation from March.
It's a measure of financial jitters. If banks believe that their peers are solid, they should be willing to lend each other money on almost the same terms as money lent to Uncle Sam. When they start demanding a big interest rate premium, that's a sign of fear.
So when the TED spread rises, the market fears banks are about to start failing. Last week the TED spread hit its highest mark since the stock market crash of October 1987. It subsided a bit after the news of the Paulson plan hit the markets, but it's rising again now, as investors wait for new information on the prospects of the bailout.
So why should we all be worried? Well, for one thing, if banks start failing, and credit markets freeze up, then any business that depends on rolling over short-term debt to fund daily activities is in danger. Remember Enron? Enron imploded in a matter of days because its lenders suddenly refused to roll over its short-term debt. But it's not just Wall Street investment banks and out-of-control Houston energy companies that depend on debt markets -- a vast number of large corporations engage in the same practices. And if a significant percentage of large corporations can no longer borrow money the implications for the "real economy" will be substantial. Higher unemployment, slower or negative economic growth, etc.
And, of course, tight credit doesn't just affect giant corporations that borrow a lot -- it affects any small business or individual who needs a loan. Credit is the grease that keeps the modern economy going. Think about what happens to a car engine that runs out of oil. Hint: It doesn't work anymore, and it costs an awful lot to fix.
The core truth of the modern economy is that all the big corporations, banks, hedge funds, insurance companies and countless other institutions are laced together by a web of debt, transmogrified in endlessly complicated ways by inscrutable financial derivatives. If one piece goes down, the ripple effects are expected to be dire. A credit freeze sets the stage for failures to begin. All of the Fed and Treasury interventions since last August 2007, when the credit markets first went haywire -- and the TED spread started surging -- can be seen as an effort to grease the economy, unfreeze credit markets, and increase liquidity. Because without liquidity, the whole system breaks down. There's some pretty good evidence, assembled cogently by Megan McArdle right here, that suggests we came awfully close to such a breakdown last week.
Is the Paulson plan the best way to infuse liquidity back into financial markets and ensure that credit is readily available to everyone? I have no idea. Was the original plan an outrageous grab for power? Absolutely. Should Congress demand concessions that directly help homeowners and ensure taxpayers get a piece of the companies they are helping? I sure think so, although I also think I understand the counterargument. (Paul Krugman, incidentally, disagrees with me on that last point, although in a blog post today he called my argument "an interesting theory.")
But the idea that there is a serious problem that must be addressed is not some kind of flim-flam attempt by the Bush administration to pull wool over our eyes. The TED spread doesn't lie. Fear rules the financial markets today. And the longer nothing is done to address that fear, the worse it will get.
Ironically, the fact that President Bush is going to address the nation at 9 p.m. EST tonight to push for the bailout fills me with even more foreboding. Is there anyone this country trusts less than the current president? Let's wait and see how his sage words move the TED spread.