What IF the Banking System Failed?

BY Paul Solman  January 11, 2011 at 4:04 PM EST

Name: Paul, El Cerrito, Calif.

Question: I have been a dedicated viewer of your segments on the NewsHour for years. Unfortunately, even with your fine reporting, I am still confused about the ramifications of the financial meltdown in 2008. I understand the causes (credit default swaps, lending practices, etc.), but no one has actually been able to explain what would have happened if the stimulus package had not been approved. With the hysteria about the markets, the impression is that a meltdown would have occurred, but what does this actually mean to main street? The sun wouldn’t stop shining, the atmosphere would not be suddenly blown off the planet, and generally we wouldn’t have a lack of food, energy, etc. Is there a good, solid description of what actually would have occurred?

Paul Solman: The most chilling descriptions we encountered came courtesy of Steve Cecchetti, now with the Bank of International Settlements in Basel, and FOBD Nassim Taleb, whose pre-crisis books, “Fooled by Randomness” and “The Black Swan,” have made him a prophet of Cassandra-like proportions.

“The collapse of the system,” said Cecchetti, “that’s what was at risk here: that we were going to get up one morning and that the financial system would simply not be operating any longer. You would go to the grocery store, you would run your debit card through at the checkout, and the payment wouldn’t go through because your bank wouldn’t be operating.”

Yes, echoed Taleb, the fear is that “a supermarket needing funding will not be able to find a bank solvent enough to lend them money against inventory to make payroll, OK? You may have chain reactions we’ve never imagined before. And these come from the intricate relationships in the system we don’t understand.”

The best explanation as to WHY came, right after the Lehman collapse, from Nobel Laureate Robert Solow, perhaps the most sensible economist I’ve ever encountered.

“What happened in the course of the financial crisis is that banks, insurance companies, and credit unions — all sorts of institutions whose normal business is to finance industry and people who want to buy cars and houses — they’ve been paralyzed. So businesses that would normally be investing in a new computer or a new fleet of trucks or whatever that would need to borrow, can’t borrow. And if they could borrow, they would be paying a very high rate of interest. So they stop.

And then the real economy begins to slow down, and people lose their jobs because their firms can’t sell to consumers, can’t sell to other businesses. A modern economy is a more complicated piece of machinery than a simple barter economy. Production is very complicated. You start with God knows what, and you end up with some extraordinarily complicated piece of equipment or the machinery that appears in my dentist’s office when I sit down. That can’t be directed without a good deal of action which is taken now and can only pay off many stages later. And that’s where the credit mechanism comes in. Industry that depends on it has to slow down, simply because it can’t get the funds that enable each stage in production to pay off the previous stage.”