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Klock: So, what's the problem?

Klock: So, what's the problem?


By Derek Klock

Klock is a professor of practice of finance in the Virginia Tech Pamplin College of Business.

Cash! Cash is the problem. This disaster, much like a nation-wide natural disaster is showing the short-comings of a credit-driven business model. The genesis of the problem is obviously an extreme drop-off in discretionary spending due to attempts to control the spread of the virus. This creates a cash-flow shortfall for businesses that now have to access lines of credit and other forms of borrowing to meet payroll, overhead, or other fixed expenses. Normally, in event-driven downturns like natural disasters, this drawdown on sources of credit isn’t wide-spread in terms of geography or business sector, but this pandemic is affecting the entire nation and nearly every business all at once. This creates strain on the financial system to meet the credit needs of a huge number of businesses. This strain unbalances the balance sheet. There are so many businesses needing cash that banks must convert tremendous amounts of financial assets into cash. But where are the buyers for these assets? This is the real problem — a pending credit crunch.

So, what’s the answer?

It is two-fold. First is to backstop the financial system. To mitigate the potential for a credit crisis the Federal Reserve banks, the United States and others, must stand ready to purchase assets and provide cash. Reducing rates, while helping with the cost of borrowing, doesn’t really address the core problem. Quantitative Easing (QE), the purchasing of financial assets by the Fed to assist with longer-term liquidity, is an answer. Freeing up bank balance sheet assets by reducing the reserve requirement, the amount of collateral assets that banks must hold on deposit with the Fed, is another answer. The expansion of the overnight borrowing (repo) operations, to help with near-term liquidity, is yet another answer. These responses will help the entire financial system weather the storm.

The second is to backstop the economy. Fiscal stimulus aimed at households and small businesses is meant to alleviate near-term financial strain of covering spending needs in light of an income reduction. Programs to assist with small business lending, programs to suspend interest on student loan debt, potential changes to payroll tax are all meant to provide businesses and households with extra money. However, the risk to the economy possibly isn’t as bad as many think. The additional savings and reduction in debt usage at the household level in response to the Great Recession of 2008 should act as a buffer to near-term financial distress to some degree and will allow for many to financially weather the storm better than they did. This of course assumes that unemployment doesn’t increase too much or for too long.

Once the immediate concern of viral contagion passes, so long as we haven’t had financial contagion, the markets will be on solid footing to repair the damage done. In fact with so much monetary and fiscal stimulus this could set-up a very robust recovery in the longer term.

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