Why so much fear about a credit crisis? And why so much effort to keep financial companies afloat? The financial sector got itself into this mess. Why not just let the Wall Street bigwigs go bankrupt? After all, the financial sector is not all that big; we worry far less about the automobile or computer sectors. The answer is simple: We worry about the financial sector not because of its size, but because all the other sectors rely on it to function. The failures of other big sectors would be painful, but, unlike a financial sector collapse, they would not bring all other sectors crashing down with them. That’s why one of the roles of a central bank is to be a lender of last resort.
Think about what would happen if your credit dried up. Say even though you’re every bit as trustworthy as before, you suddenly find you can no longer borrow money, which means no credit cards. Some things might still work just fine: You could just use cash at the local grocery store. Some things would be harder: If you didn’t have credit, you’d have to pay all your bills in advance. And to do this by check you’d still need a well-functioning financial system. Some things would be downright impossible: Forget about buying anything on the Internet. Paying for college? No problem… as long as you’ve saved enough to pay up front and in full.
The situation is even worse for companies. While they might not use credit cards, they use lines of credit to buy the raw materials for production and to pay their workers. If that credit line disappears, many—perhaps most—companies would essentially be forced to close, leaving their workers out of a job. That’s why a severe financial crisis can bring the entire real economy to a halt.
So when credit freezes up, the real economy can quickly freeze up. It’s not slow like the effect of a contractionary demand shock. It is fast, like a heart attack. Think of credit as financial oil. If the economy were an automobile engine, the financial system would be the motor oil. While oil is a relatively minor part of a working engine, it is absolutely essential. Try driving your car without oil for 10 miles. I can tell you from experience, the engine seizes up and is ruined. It cannot be salvaged. The fear in October 2008 was that the entire credit system would stop. If that happened, what had started as a financial crisis on Wall Street would spread from Wall Street (the financial sector) to Main Street (the real sector), creating not a recession but a depression.
First Published: 08/11/2012