So How Will The Financial Crisis Impact The Wider Economy?

Predictions

from the connecting-the-dots dept

Earlier this week, we received a tremendous response to our post about the financial crisis and how it might impact the tech industry. We received multiple requests for more posts along those lines — and American Express has decided to help foster the discussion. This post is being posted both here and at American Express’ Open Forum blog. Also, more importantly, AmEx is sponsoring a Techdirt Insight Community Case to facilitate a larger conversation about how this impacts small businesses, and what they can do during this crisis. If you’re a small business owner concerned about the crisis, one way to make a little extra money is to take part. Sign up here to provide your own analysis. You can also comment here (or on the AmEx site), but if you want to earn some money, you need to sign up and submit your insights as a member of the Insight Community. So, now let’s kick off a discussion on how the financial crisis might impact the wider economy, with a special look at the small business market.

Getting beyond Wall Street

I discussed some of that in the original post, but many people are still having trouble seeing how this crisis spreads beyond Wall Street financial firms (or, in some cases, their own stock portfolios). There are still plenty of people screaming out that these financial firms need to be punished or done away with completely, without any recognition of how that might flow through the rest of the economy. The New York Times has an excellent writeup, noting that people said the same thing as the Great Depression was happening, as well — again, not realizing that destruction on Wall Street can flow through the rest of the economy.

The basic problem is the fear that the credit markets will simply dry up. If no one will lend money (or it simply becomes ridiculously expensive to borrow money), then some very basic economic functions cease to work. This may start out at a high level with bank to bank loans and bank to business loans, but it can also filter down to things like your mortgage (if you thought things were bad before, wait until adjustable rate mortgages reset with even higher interest rates, contributing to this spiral), car loans and even credit card payments. At the top of the chain, banks are increasingly afraid to lend to each other fearing that whoever they lend to (even for very short term loans) may default before the money can be paid back.

Already, some companies are seeing the direct impact. For example, Caterpillar, the maker of construction equipment is a company you would think would be separate from the financial mess on Wall Street. It has great credit and a long history of being good for paying up any debt. Yet, in a matter of days, the interest that Caterpillar has to pay to borrow has shot up.

Debt isn’t a bad thing

Now, there are those who will say that any “borrowing” or “debt” is somehow bad (we had a few such comments on the first post), but that shows a fundamental (and, somewhat dangerous) misunderstanding of basic economics. Borrowing money and taking on debt is not, by itself, a bad thing. In fact, it’s a very, very good thing. If you can borrow money at one rate, and invest it more profitably, you can contribute to economic growth and provide important goods and services. It’s at the very core of a functioning economy. Money moves around so that it can be invested in more profitable endeavors, and that benefits all of society, by making sure that the money is more efficiently put to work.

Of course, with any amount of debt, there’s always a “risk” involved in whether or not the money (and interest) will get paid back. The amount of interest generally represents the cost of that risk. Higher risk requires more interest. Thus, there are a variety of different ways that you can invest your money with different risk/reward profiles. Lower risk gets a lower return and higher risk, with its higher chance of default, should net you a larger return in the long haul.

However, the fear of various banks defaulting at the top of the pyramid is increasing the risk down the entire chain, even to the point that relatively “safe” investments are suddenly being seen as risky. Part of that is due to uncertainty about how the crisis will impact others (sort of a self-fulfilling fear) and part of it is due to a still murky understanding of the risk involved in the assets at the heart of all of this mess: the various mortgage backed securities you keep hearing about.

So what happens if things get worse?

Well, it won’t be pretty. Credit is such an important part of the entire economy that it’s almost impossible to figure out all of the ramifications of a near total credit crunch. Plenty of companies rely on commercial paper and short-term, low risk loans to finance certain operations, while others use it to get a small, but safe, return themselves. If that were to completely collapse, money would have a lot of trouble moving from where it is to where it would be most efficiently put to work for the economy. Effectively, important projects would get starved of necessary cash and die.

That may happen to some projects all the time — and it’s a natural part of the market — but if it happens across the board, a lot of companies could go bankrupt. A lot of useful investments would go to waste, and (more importantly) the next set of important projects that require investment wouldn’t be able to get the necessary money. It would shrink the economy and harm pretty much everyone.

But won’t that be an opportunity for someone else to lend?

Yes, indeed. And that’s what many free market supporters are betting on. There is still money out there, and it can be put to work. The trillion dollar (plus) question at this point is how much of that money really is out there and how quickly can it flow through the economy (and at what price). Some argue that since so many companies rely on lending out money to make money, that the idea that it would cease is almost impossible to imagine. And that’s true to a certain extent. There will always be some money out there to lend, but the question is how much and at what price. With too little at too high a price, you end up with significant portions of the economy screeching to a halt.

While the markets are normally quite efficient, you do get periods of… irrationality. Mostly, we think about it from the “irrational exuberance” side, which leads to bubbles. But it happens at the other end as well, though usually to a lesser extreme. If almost no one’s lending, the result is a bit of a herd mentality, where very few people want to be the first to step out on that ledge, as they’re afraid that the ledge will get quickly chopped off. Some daring souls may step out, but will it be enough to really keep the economy chugging along?

That sort of “crowdthink” risks severely thinning the amount of capital moving around the economy. Even if certain companies know that they should be lending the money they have sitting idle, they’ll be too afraid to step out on the ledge since no one else is doing it. Those in charge of making lending decisions start thinking: “what do they know that we don’t know?” — and that mentality paralyzes the lending market.

So, what does it all mean for a small business operator?

Well, that really depends on what sort of business you’re in. If you’re a venture-backed startup, it’s probably not as big a problem, immediately. As we originally noted, top tier VCs are pretty secure with the funds they have, and as we saw after the dot com bubble, the big institutional investors still can’t resist allocating a segment of their cash to VC funds. That money is pretty safe. A good venture capitalist should help its portfolio weather the storm. By the way, that doesn’t mean showering them with too much cash. Companies that have raised a ton of cash aren’t necessarily better off, contrary to popular opinion. A lot depends on what business they’re in, how focused they are on an actual business model and how much they’re actually burning. As we saw after the last dot com bubble burst, it was some of the most heavily funded companies that went belly up first — because they had focused too much on raising money and not on building a business.

But, of course, venture backed high growth companies are a tiny, tiny segment of the small business arena. Most small businesses will face a different set of challenges. While they may not rely so heavily on regularly tapping into borrowed money, that doesn’t mean they’re not exposed in many ways. Any sort of expansion capital will be much harder and much more expensive to get. That will make it more difficult for some of those small businesses to make the investments necessary to become big businesses.

More importantly, their own customers may be exposed as well. Many small businesses effectively provide “loans” to their customers, in giving terms of payment, such as net 30 or net 60 (allowing the customer to pay within 30 or 60 days, rather than upfront). Unlike constantly fluctuating interest rates, small businesses generally don’t change those sorts of terms with any regularity. So, many small businesses actually become a lot more exposed: they’re “lending” money at the same rates as before, while the rest of the money flowing around the economy has become more expensive.

With that happening, more customers can be expected to default, putting more pressure on the cash flow of the business. And hiccups in the cash flow will be harder to overcome in the usual way: it will be more difficult and expensive to get a small business loan or a line of credit. Thus, it becomes more difficult to meet payroll and could result in layoffs. Companies may also try to tighten up their payment terms, but that effective “raising” of the interest rate can scare off customers, as well. Already, we’re seeing small businesses being advised to push for early payment and change the terms of payment they offer customers.

Most of this won’t happen immediately for most businesses. It certainly will impact some in the very near future (and a few companies are already experiencing problems). The real worry is the cascade effect of this happening to more and more small businesses, putting even more pressure on the overall economy. More companies having cash flow problems means fewer customers for other companies, as well, accelerating the whole cycle.

So what do you do?

If you’re a small business: focusing on cash becomes king (it should always be, but even more so at this point). Companies won’t be able to rely on lines of credit as much as they have in the past, and should see what can be done to lock in any kind of line of credit or opportunity for a decent loan if they can get it. Basically, companies need to prepare themselves for the possibility of money not flowing, customers not paying and additional economic hardship.

But, beyond that, as with any such situation, new opportunities open up. It really depends on what business you’re in, but if you provide a product that is better/cheaper/more efficient than what others are using, this becomes a sales opportunity. Focus on letting customers know that they can conserve cash by using your product instead. Plus, look for new areas that you can invest in safely and cheaply, recognizing that these sorts of financial messes do pass, and there will be tons of opportunity on the other side if you can grab it.

Filed Under: debt, economy, financial crisis, lending, small business