Dr. Victoria Salin, Texas A&M University, USA, (vsalin@ag.tamu.edu), March 2009.
2008 was marked by a financial crisis, serious pain from rising costs of energy, and eroding economic fundamentals. Thirty-eight US banks have failed since 2008 began, another 16 in 2009 (FDIC), and “shotgun” acquisitions kept other weak financial institutions from failing. No wonder the American Dialect Society’s 2008 word of the year was “bailout!”
The financial sector is an important generator of economic activity in the USA, employing thousands of highly-skilled professionals, and its troubles contributed to an overall economic slowdown. The slowdown in financial deals, and losses from past deals going bad, have contributed to recent declines in GDP. Financial services accounted for just below 8% of the US gross economic output in 2007 ($2.01 trillion (U.S. Department of Commerce)).
The financial sector’s problems spread to other businesses, via a contraction in credit availability and an escalation in the cost of credit. The cost of corporate borrowing climbed in 2008 (Moody’s), even as the monetary authorities at the Federal Reserve Bank flooded liquidity into the banking system. Worrisome signs abound that the capital market failed to function in allocating funds during the fall 2008. Theorists describe such disequilibrium as credit rationing.
Why is credit rationing such a concern? Economic efficiency is characterized by allocation with the price mechanism—those who most want an item are willing to pay more for it. Plenty of economic theory establishes that the price mechanism operating in a free market allocates resources most efficiently for society. Rationing means that allocations are NOT done by price. Instead, allocations may be on a first-come, first-served basis, by who has the best connections, or according to who is most patient with queuing. By definition, rationing situations are less efficient for society than are allocations by the market mechanism.
Credit markets are subject to rationing more easily than goods markets, according to the Nobel Prize-winning economist Joseph Stiglitz, because the parties to a credit transaction have unequal amounts of information about the risk profile of the borrower and the project being financed. In theory, the result of credit rationing is that only the riskiest borrowers remain in the credit market, leading to an inefficient allocation of financial resources.
The recent evidence is suggestive of credit rationing, although not conclusive. As shown previously, cost of borrowing rose. Supply may have been disrupted as well. Commercial paper outstanding (very short-term working capital for larger firms) decreased markedly starting in summer 2007 (Federal Reserve Bank), and decreased again in September 2008. Bank lending to business customers was stable during the fall 2008 financial crisis, according to the Federal Reserve’s survey, a good sign. However, there was plenty of anecdotal evidence of credit shortages for good customers during September and October 2008. Therefore, both price and quantity evidence is consistent with a disequilibrium in the credit market last year.
Fundamentals
In describing the impact of the financial crisis, Jim Citrin’s 2008 New Years’ Eve blog bid good riddance to the “era of unchecked consumerism and financial excess.” He’s right that financial excess is not needed, but there are connections between finance and economic fundamentals: (1) in making business transactions efficient and (2) in generating consumers’ wealth.
As the policymakers continue to work to restore confidence in the financial sector, it is important to ask, how “fundamental” is finance to food businesses? Business managers choose the leverage position; strategic reasons, access to capital markets, and attitudes toward risk all influence a firm’s dependence on debt financing. But working capital finance is a real cost to most firms, and to their customers, so that the higher cost of business borrowing is a contributor to cost pressures. Companies will need thoughtful plans for controlling spending and streamlining budgets.
To what extent are financial sources of wealth a “fundamental?” In the USA, income derived from financial assets (that is, interest and dividends) was $2.1 trillion last year. Compare that to total disposable personal income in the USA of more than $10 trillion per year, prior to the financial crisis. Income from capital is likely to be more important to older persons, especially retirees, and to wealthier individuals, than it is to the average American.
It will be important to consider carefully the wisdom of the next financial innovation that will be proposed as a solution to the low returns available in a slow-growth market. In the 1980s, it was high-yield “junk bonds”; in the 2000s, the innovation was derivative securities tied to mortgages and other credit-related swaps. Higher expected returns do not come without risk, and in this interconnected global financial system, instability transmits quickly around the world (Lin). Fear, investor psychology, and mistrust are serious issues in financial markets. To the extent that investors have reconsidered their preferences for bearing risk, tangible capital assets may see more investor interest, leading to the potential for equity capital to flow toward manufacturing sectors and the service industries involved in food distribution.
For more information:
- American Dialect Society. “American Dialect Society 2008 Word of the Year is “Bailout”” press release Jan. 9, 2009. Accessed Feb. 15, 2009.
- Citrin, Jim. Posting on Yahoo finance, Dec. 29, 2008.
- FDIC (Federal Deposit Insurance Corp.). Accessed Mar. 3, 2009
- Federal Reserve Bank
- Moody’s Investors Service. Yield on AAA corporate bonds, long-term (30-year), accessed via Federal Reserve Bank of St. Louis.
- Stiglitz, J., & Weiss, A. 1981. Credit Rationing in Markets with Imperfect Information. The American Economic Review. Vol. 71, No. 3, (Jun., 1981), pp 393-410.
- Lin, Justin Yifi. 2008. “Impact of the Financial Crisis on Developing Countries,” paper presented to Korea Development Inst., Oct. 31, 2008.
- Trostle, Ronald. Factors Contributing to the Recent Increases in Food Commodity Prices, presentation by Economic Research Service, US Department of Agriculture. June 10, 2008. Related article available.
- U.S. Department of Commerce, Bureau of Economic Analysis. Dec. 2008.