A Numbskull's Guide To The Financial Crisis

First in a series of posts.

I play the numbskull and Megan McCardle patiently answers my questions.

First question to Megan:

The government says that the credit markets are "locked." What does that mean?

Megan responds:

The reason markets are locked is that everyone is scared.  When financial markets turn scary, the first thing people want to do is get their hands on as much cash as possible.  Ordinary investors want cash.  Unsurprisingly, the institutions who invest their assets also want cash, in case any of those folks ask for their money back.  And the money managers who institutions invest with, like big money market and mutual funds, also want cash, to give to the institutions when they pull out.

One or two people wanting to liquidate their investments and turn them into cash is not a problem; in ordinary times, the inflow of investors makes up for the outflow.  These are not ordinary times.  When everyone wants to liquidate their investments, no one can.  Money managers are sitting on big piles of perfectly sound securities that they cannot sell simply because everyone's trying to hoard their supply of cash and treasury bills (which the market regards as functionally equivalent to cash in the short term).  Government debt is in such high demand from institutions that are required to invest in ultra-safe securities that at one point, investors seemed willing to pay the government to take their money.  Everything else, no matter how likely it is to pay off, is just so much paper.

This feeds on itself:  people won't buy because they don't know whether they can sell in an emergency.  So they're waiting for other people to come back in the market and start buying again.  Of course, all the other people are waiting for the same thing.  Everyone wants to go to heaven, but nobody wants to die.

It's hard to see a way out of this without some form of intervention, because it's a problem of collective action.  If everyone wasn't trying to hoard cash, no one would need to.  Either private enterprise or the government need to find some way to cut through the gordian knot and open up the markets again.