Thoughts on the Economic Crisis, III

The second part of this series concluded that a source of potential problem in a market economy is the monetary system. There can be too much or too little money, and each can cause problems. In this post, I want to examine the element of time and the financial markets that help cope with problems due to time.

We want to purchase goods and services today, but we also anticipate a similar desire a year from now. Just as trade-offs occur right now--I choose to play golf today rather than to go fishing--so can trade-offs occur over time. I can reduce consumption today, save, and increase my consumption possibilities in the future. Other things equal, current consumption is valued more than future consumption if for no other reason than the future is uncertain. A positive interest rate provides a trade-off between $100 of consumption today for more than $100 of consumption a year from now.

Businesses face problems when their receipts differ in timing from their expenditures. This is most obvious for a new firm. It may take several months of preparation, buying inputs, hiring workers, renting facilities, and so on before the firm has output to sell. The firm's owner must pay for these inputs, facilities, and workers prior to selling any output. The firm owner could have saved the funds to begin the firm, or the owner may be able to borrow some funds. Of course, the borrowed funds have to be repaid later. Even on-going firms often borrow short-term funds to smooth out the flows of receipts and expenditures over time.

Financial markets bring the funds saved by some to the borrowers. Financial institutions include commercial banks, credit unions, insurance companies, investment banks, among others. Another source of funds for businesses are equities, in which firms sell shares of ownership in the firm. Stock markets provide markets for "used shares," increasing the demand for new shares since the owner can sell them later.

Interest rates are the prices that equilibrate supply and demand for funds. If business prospects seem good, the demand for funds increases, which induces interest rates to rise. The higher interest rates provide an incentive for savers to increase how much they are saving. Interest rates reflect preferences of people for current consumption relative to future consumption, the productivity of capital, the relative scarcity of funds, expected inflation rates, and risk. The greater the risk of a borrower, the higher the interest rate the borrower will have to pay for a loan. Prices of financial assets are inversely related to the interest rate. For example, if the price of a bond that pays $1000 in a year is currently $950, the interest rate is (approximately) 5 percent. If the price of the bond increases to $960, the interest rate is now 4 percent.

Since the future is unknown, people have to form expectations about what the economic conditions in the future will be. Probably most people base future expectations upon the past, especially the recent past. Someone wanting to start a new firm must believe that there will be a market for the product in the future or it would be foolish to begin the new enterprise.

Finanacial markets rely on trust. Lenders have to trust that the borrowers will be able to pay them back in the future, and that the borrowers will fulfill their promises. A manufacturer that sells parts to another firm normally doesn't receive payment for a few weeks. The manufacturer trusts that the buyer will ulitmately make the payment. If a check is involved, there has to be trust that the check is good and will not bounce.

What can go wrong? Lots of things. Expectations may change due to new information. Trust can be broken, and if this happens enough, the system can seize up. Expectations may not be met. The demand for a product that an entrepreneur thought would be there when his or her production facilities came on line may not be there because consumer demand has changed, or because other entrepreneurs entered the market sooner. A bank that makes loans anticipates that some loans will not be repaid. If suddenly many more loans default than had been anticipated, the bank's position becomes riskier. It perhaps will reduce loans it is willing to make, making it more difficult for businesses to meet their short-term obligations such as payrolls. If people are laid off, they have a harder time making payments on their loans, which can further impact the bank negatively. If people see the future as riskier than they had previously thought, then interest rates will rise, asset prices fall, and a downward spiral can begin.

In my next post in this series, I will try to tie things together from the previous posts.