What’s a Credit Crunch and Why Should We Care?

The U.S. stock market has been nothing if not volatile this year, especially over the course of the past few weeks. As the current credit crisis tightened and the world watched in horror, what most people saw was the stock market spiking and plummeting, often on mere rumor and speculation, and sometimes on the strength of what seemed like nothing at all. We’ve gotten used to this show, and for many people, it has become a source of rage and disgust.

The 777 point plunge in the Dow Jones Industrial Average after the defeat of the House $700 billion rescue package was dramatic and scary. By most accounts, about $1 trillion was lost in a single afternoon. I personally lost a quarter of my 401(k). The very next day, however, more than half of that loss was recouped on the mere hope that some kind of bill would in fact pass by the end of the week, even though it was impossible to know what kind of bill that might be.

Meanwhile, radio talk shows were busy interviewing everyone who had ever held any kind of opinion about anything related to finance, and some of it was not just misleading, it was nuts.

For instance, at one point I heard the crisis described as something that would “…make it harder for people to get car loans and would also cause small businesses to have to use their credit cards instead of lines of credit with their banks.” At the other end of the spectrum was a semi-hysterical comment by a cable news pundit who said, “People want to know if they will be able to use their ATMs by the end of the week!”

Both of these remarks are misleading.

First of all, the ATM issue is not an issue. Sometimes ATMs don’t work even when there isn’t a credit crisis. The things actually run out of money sometimes, often on Sundays, and on top of that they are subject to computer software glitches, mechanical breakdowns, and all sorts of other gremlins that are just part of life. Stuff happens with ATMs, and the credit crisis is not the kind of “stuff” that happens to them. It’s not related at all. You have no more reason to worry about your favorite ATM now, this week, than you ever have.

So calm down.

The other remark is just as misleading though. If auto loans are harder to get and business trips are put off, that’s bad for the economy, certainly. But explaining the credit crunch this way gives the impression that it is something that will just make people tighten their belts a bit, and tightening our belts is something that the overwhelming majority of us feel is long overdue and probably a good thing. I have noticed a real effort on the part of the media not to scare people. Fine. But let’s be honest at least.

The real scare with a credit crunch has nothing to do with your purchasing habits and everything to do with the fact that so many businesses, including big banks, run on short term credit. By short term I mean a day, a week, sometimes a month. A business needs this credit to even out cash flow so it can function properly. So, for instance, the garden center where you work as a clerk probably makes about 80% of its money in May and June. The rest of the year, your paycheck is likely written on a line of credit from the bank. This is true of many businesses, especially retail and construction. Profit is not spread evenly over twelve months.

Free flowing credit is good for business because, over the course of a year, if a business still makes lots of money during that May and June flower frenzy, they will turn a profit and stay current on their short term lines. The bank stays happy, the business stays happy, and you stay employed and get paid in checks that don’t bounce. You take those good checks to your bank and spend the money on stuff, and the world goes round and round like it should.

When credit gets too tight, it’s like throwing a wrench into the gears of that whole system, and commerce grinds to a halt. When commerce grinds to a halt we get a recession, or worse.

That is the fear that is behind the current attempt to “rescue” the U.S. financial system fast, but it is just abstract enough to be a non-issue for the average person. We all see that DJIA looping up and down like an out-of-control hang glider, and we think, that’s nuts. Those guys deserve to fail.

What is harder to understand is that, if those guys fail, they will retire to their homes in Martha’s Vineyard and Connecticut and Vale, and we will lose our jobs and wait in line to buy milk because, if you don’t buy it on the day it comes in, you don’t get any.

I believe that the truth is that that might happen anyway, no matter what Congress does or doesn’t do. But I also think part of the problem right now is the complexity of the situation and opaque nature of the mess our economy is currently in. The stock market is only the thermometer, and it seems to be a broken thermometer at that: One that works sometimes and other times seems completely, psychotically detached from any day-to-day reality.

The excesses of the financial world and the real estate bubble have left us with a loss of trust in our leaders and our business, and they in turn have all lost trust in each other. Nothing good happens financially in an environment in which there is no trust, and once lost, trust is a very hard commodity to lay one’s hands on.

So it’s no wonder that the American people are overwhelmingly against any government intervention in this historic economic mess. What is frightening is that by the time people do realize that this mess is going to hit them personally, and hit them hard, it may well be too late.

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