The Financial Crisis and the Recession: Two Datapoints for the Skeptics

One of the most dramatic features of the financial crisis, for those who were following it obsessively in the autumn of 2008, was the near-freezing up of the commercial paper market. Commercial paper is short-term debt sold in markets rather than advanced by banks. It's mostly very short maturity -- days, weeks or months, not years. It's generally cheaper than other forms of financing, but firms that rely on it need to be able to borrow more or less continuously. Doubts about their financial condition, or even the suspicion that other lenders might have doubts, can quickly push them up against their survival constraint. This is what happened to a number of financial institutions -- most spectacularly Lehman Brothers -- in the third quarter of 2008. The breakdown in the commercial paper market was one of the things that convinced people the financial universe was imploding, and taking the real economy down with it.

The story, implicit or explicit, was that the suddenly reduced or uncertain value of financial assets, and the seizing-up of the interbank markets, left banks unable or unwilling to hold the liabilities of nonfinancial businesses, i.e., to lend. These businesses found themselves unable to finance new investment or even routine operations, leading to the Great Recession. This is essentially the same story that Milton Friedman told (and Peter Temin, among others, criticized), about the Great Depression, but it's also more or less the consensus view of the 2008-09 crisis among New Keynesian economists. For example:

A large decrease in the value of asset holdings of financial institutions resulted in dramatic intensification of the agency problems in those institutions ... Credit spreads widened and credit rationing became widespread. The diminished ability to finance the acquisition of capital goods resulted in huge cutbacks of all types of investment.

The same story was widespread in the business journalism world, with people like Andrew Ross Sorkin writing, "Commercial paper, the workaday stuff that lets companies make payroll, was suddenly viewed as radioactive -- and business activity almost stopped in its tracks." Most importantly, this was the view of the crisis that motivated -- or at least justified -- the choice of both the Bush and Obama administrations to make strengthening bank balance sheets their number one priority in the crisis. But is it right? There are reasons for doubt.

Data from FRED. 

See, here's a funny thing. I haven't seen it discussed anywhere, but it's very interesting. The commercial paper of financial and nonfinancial firms, normally interchangeable, fared quite differently in the crisis. Up til then, both had tracked the federal funds rate closely, except in the early 90s (the last by-general-agreement credit crisis) when both had risen above it. But as the figure above shows, in the fall of 2008, right around the Lehmann failure (the arrow on the graph), an unprecedented gap opened up between the interest lenders demanded on commercial paper from financial versus nonfinancial companies.

The implication: The state of the interbank lending market isn't necessarily informative about the availability of credit to nonfinancial firms. It's perfectly possible that lots of big banks had made lots of stupid bets in the real estate market, and once this became known other banks were unwilling to lend to them. But they remained perfectly willing to lend to everyone else -- perhaps even on more favorable terms, since those funds had to go somewhere. The divergence in commercial paper rates is hardly dispositive, of course, but it at least suggests that the acute phase of the financial crisis was more of a problem for the financial sector specifically than for the economy as a whole

Second. Sorkin calls commercial paper "the workaday stuff that lets companies meet payroll." This kind of language was everywhere for a while -- that the financial crisis threatened to stop the flow of short-term credit from banks, and that without that even the most routine business functions would be impossible.

One of the central political-economic facts of our time is that public discussion of the economy is entirely dominated by finance. The interests of banks differ from those of other businesses on many dimensions; one of them is banks' dependence on short-term financing. Financial firms are defined by the combination of short-term liabilities and long-term assets; they need to borrow every day; that's why they're subject to runs. The fear of not being able to make payroll if you're cut off, even briefly, from financial markets, is perfectly reasonable, if you're a bank.

But if you're not?

In fact, short-term debt is large relative to cashflow only for financial firms. Nonfinancial firms don't finance operating expenses through debt, only investment. (And inventories and goods-in-progress, which are largely financed by credit from customers and suppliers, rather than from banks.) From Compustat:

Short-term debt as a fraction of total debt

Sector	Median	Mean
FIRE	0.56	0.55
Non-FIRE	0.16	0.23

Short-term debt as a fraction of cashflow

Sector	Median	Mean
FIRE	7.53	15.1
Non-FIRE	0.35	0.71

Short-term debt as a fraction of revenue

Sector	Median	Mean
FIRE	0.78	1.64
Non-FIRE	0.04	0.08

(FIRE is finance, insurance and real estate. Short-term here means maturities of less than a year. Cashflow is defined as profits plus depreciation.)
This isn't a secret; but it's striking how different are the financing structures of financial and nonfinancial firms, and how little that difference has penetrated into public debate or much of the economics profession. For the median financial firm, losing access to short-term finance would be equivalent to a 70 percent fall in revenues; few could survive. For the median nonfinancial firm, by contrast, loss of access to short-term finance would be equivalent to a fall in revenues of just 4 percent. Short-term finance is just not that important to nonfinancial firms.
So, the breakdown in short-term credit markets was largely limited to financial firms, and financial firms are anyway the only ones that really depend on short-term credit. I don't claim these two pieces of evidence are in any way definitive -- I've got a long paper on this question in the works, which, well, won't be definitive either -- but they are at least consistent with the story that the financial crisis, on the one hand, and the fall of employment and output, on the other, were more or less independent outcomes of the collapse of the housing bubble, and that the state of the banks was not the major problem for the real economy.



EDIT: For the life of me, I can't get either graphs or tables to look good in Blogger.