September 16, 2020
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Let’s Focus on Margins

Let’s Focus on Margins

Economics is the study of scarcity. In economics a major focus is on margins. Specifically, our decision making with regard to scarcity has to do with such things as trade-offs and opportunity cost. Embedded in those concepts is risk. 

What I mean by that on a very personal note, when we go shopping, we have limited amounts of money in which to spend. We make choices based on price, preferences, needs, etc. Again, subsumed in those choices are opportunity cost – if we buy that loaf of artisan bread, is the cost too much (price too high)? The trade-off comes into the conversation when we say – yes, we need bread, but perhaps it might serve us better to purchase the less expensive bread. 

Underlying all of this decision making is marginal analysis; decisions occur on the margins, in fact. What this means is that all of us are subject to scarcity to one degree or another. Focusing on financial resources, we might have enough cash reserves or balances in our checking/savings accounts to have a 10-day buffer, a 10-week buffer, etc., to cover our expenses. The point is that we are always subject to this marginal analysis. If we have too much of a buffer, we surrender potential loss of interest, or our money might be devalued and depreciated, thereby subject to inflation. Nonetheless, we are all faced with marginal analysis in terms of determining how much cash, for example, that we should keep on hand.   

In our normal course of business, we have a pretty good idea how much we need to have on hand and that will typically suffice. However, when shocks occur in the system – exogenous (from outside of the economy) or endogenous (internal to the economy), this causes disruptions. Those shocks can be on the supply or demand side. On an individual note, you might not be able to find toilet paper – supply, or you might not be able to pay for toilet paper because you are laid-off – demand. Let’s take it to the next level. 

The economy is made up of four basic sectors: household; business (firms); government; and international. We’ve already covered the household and as for government and international, we will set that aside. Let’s now focus on the business sector. What most people fail to realize is that businesses are subject to the same decision-making on the margins as individuals and households. In order to sustain itself, a business is dependent on sales to customers – very simple. When an economy is hit with such an enormous exogenous shock, as occurred with the Corona virus (Covid 19), it causes massive disruptions. As is the case with the individual, a business has a limited amount of cash (cash, checking account, or line of credit) available to it. With no firm idea of how long the shock will last, the entrepreneurs or managers at the firm has to make decisions very quickly. The last thing they want to do is to lay off massive numbers of workers, but without the cashflow from sales, it’s often the only reasonable choice. Beyond that, management might turn to their bank to see if they can secure loans to get them through the turmoil. 

Now, the bank of course must consider the risk associated with extending credit to businesses (and individuals for that matter). At the front of the line in terms of risk is credit or default risk, where the borrower is unable to pay the interest or the principle. This would certainly be considered a supply side issue for the businesses trying to access the aforementioned credit. The bank is in a very difficult position because by extending credit, the bank is actually creating credit – yes, money (not printing money) where there was none before.  

Again, an example of this, is where a bank extends a $100 million loan to a business for them to meet its payroll obligations (without it, the business would have to lay off its workers). With a 10% reserve requirement, the bank would be required to have $10 million on reserve in terms of cash-in-the-vault, or on deposit at the Federal Reserve. If the business could not pay the loan off, the bank would be on the hook for the entire $100 million (less the $10 million in reserve). In short, the businesses need to borrow, at least enough to get them through the market turmoil, and the banks need some assurance that they will be repaid those loans. This speaks directly to the current liquidity problem. While there might be businesses that are flush with cash, and could certainly weather the storm, they would also be subject to the fall off in demand for their products, especially if they are producing durable goods (autos, appliances, new homes, etc.). The point is that while some businesses will certainly be impacted more severely than others, there is a ripple effect (more like a tsunami in this case) that will roil the entire economy.   

The critical piece to this, beyond addressing the health crisis and basic needs, is to get the financial markets in order, to get depositories (commercial banks, credit unions, savings banks, savings and loans) lending, infusing liquidity into the economy. The key there is to reassure the depositories that while borrowers might be late in making payments, for example, there is some assurance that there will be a rebound (hopefully quickly) and the economic ship will be righted. Firms have to also be reassured that any fall-off in the demand for their products will be addressed as well (payroll tax holiday — social security 6.2% for employee and 6.2% for employer). So, in essence, that is what behind the FED’s 0.0% Fed Funds Rate and moving to 0.0% reserve requirement across-the-board for depositories, is to help encourage those depositories to lend, lend, lend.

So, channeling the very wise cable guy: let’s get ‘er done!

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Written by
Edward Derbin