“Neither a borrower nor a lender be,” prattled Polonius to Laertes in Shakespeare’s “Hamlet.” Well, maybe. Last month, the European Central Bank, the European Commission and the International Monetary Fund decided that Cyprus needed a fast 17 billion euro bailout. They proposed to offer the tiny island 10 billion euros and demanded that depositors in Cypriot banks fork over the remaining 7 billion.
Specifically, they proposed taxing bank deposits. Depositors with more than 100,000 euros in their account would be faced with a 9.9 percent tax while those with less would see a 6.75 percent levy.
As you can imagine, depositors rushed to withdraw funds from Cypriot banks before the measure went into effect. So the authorities shut down the banks for several weeks and instituted capital controls. This had to be unsettling for retirees and the working class, as well as small businesses that need to make payroll using their bank accounts.
Setting aside for now how the crisis was averted and whether something similar could happen here, in the real world few businesses of any size can operate without access to short-term credit to smooth out mismatches in their normal cash flows.
Suppose your family’s widget factory pays its employees every Friday. That means a weekly cash outflow. But most of your prime customers are wholesale distributors who pay for purchases from firms like yours on the last day of the month following widget deliveries. So you have four payroll outflows for each injection of cash from sales.
Like the overwhelming majority of businesses, you cover these cash flow mismatches by drawing down a credit line from your local bank each week to make payroll and repay the drawdowns as soon as payment is received.
But one Friday morning when you get on your PC to access your firm’s bank accounts and transfer enough cash from your credit line to cover payroll checks, you see a chilling message on your screen: “All credit lines are frozen until further notice.”
You scrounge around among your firm’s bank accounts and come up with enough cash to cover this week’s payroll, leaving you pretty well tapped out until a big group of customer payments is due to arrive in three weeks. But what about your next three payrolls?
One option is to simply close the factory and lay off your employees until the payments arrive. But a closed factory doesn’t produce widgets, so you can’t deliver to your customers, who may tum to other suppliers. In any case, your future cash inflows will be lower, which means smaller profits.
Another option is to close the factory and lay off your employees for just a week, when you try to find enough emergency cash somewhere to cover the next two weeks of payroll. Losing only one week of production will reduce your loss, but what if you can’t find the money?
The widget company’s experience isn’t just limited to Cyprus. It was repeated a few million times in the United States during the fall of 2008. The results were massive layoffs, lost wages (which meant less consumer spending) and lost company profits. All of which made a disastrous recession even worse.
Why did this happen in the U.S.?
Because too many banks woke up one morning to find that some of the dicey unregulated derivative securities they held in their portfolios had lost most of their value. In a panic, they tried to conserve as much available cash as they could by freezing lending to businesses and individuals alike.
Back in Cyprus, the banks became a tax haven for overseas depositors. They then invested the money in Greek bonds to generate big returns. When the bonds tanked, the banks were on the verge of bankruptcy and needed a bailout.
But there’s no need to be alarmed. It can’t happen here. The American economy has been strong for months now, the stock market is rising, and your 401(k) is going through the roof. Right?
originally posted: April 6, 2013