If the Bailout is the Solution, What's the Problem?

The problem isn't that consumer spending is down. The problem isn't that the stock market is down. The problem is the TED spread.

Huh? The TED spread is an obscure difference between two obscure interest rates. So let's explain what it is and why you should care. The TED spread is the difference between the three-month LIBOR interest rate and the three-month T-bill rate. The LIBOR rate is a market-determined interest rate on bank-to-bank loans. It's the answer to the question of "What interest rate will I get if I'm a bank and I loan money (for 3 months) to another bank?" The three-month T-bill rate is the answer to the question of "What interest rate will I get if I loan money (for 3 months) to the US Federal Government?"

The TED spread is the difference between these interest rates. Money lent to the US government is safe (historically). Money lent to banks might not be --- the bank could fail. The difference in these rates tells you about market perceptions of the risks of lending to a bank.

The TED spread is usually less than half a percent. Banks are seen as safe, so banks can easily borrow money. This is a good thing, because the role of banks in our economy is to get money from lenders to borrowers. It's unusual that the TED spread gets much above 1.5%. As I type this, the TED spread is 3.34%. That's really high, and it means people are afraid to lend money to banks. People are thinking "Gee, even though the LIBOR rate is a lot higher than the T-bill rate, I'm better off going with the safe option."

You can see what the TED spread is by clicking here.

If lenders are afraid to give money to banks, then banks have a harder time lending money to everyday people. This could make it harder to get a mortgage, harder to get a student loan, harder to get a credit card, harder for entrepreneurs to keep small businesses going. How much harder? It's hard to say. But this is the risk we face unless we can get the TED spread down.

It's been rightly pointed out that regular people are still able to get credit. So why all the alarm bells? The reason is that short-term disruptions in the supply of a good usually aren't noticed by consumers. Firms usually keep enough inventory on hand to be able to cover short-term supply issues. As an example, consider what happens when one of the North Salt Lake oil refineries has a technical problem (say, a pipe explodes). This reduces the supply of gasoline available, but we consumers hardly notice. The reason is that refiners keep a stock of inventory on hand just in case. During a refinery disruption, refiners draw down inventory, keep the supply out there, and motorists aren't greatly affected.

Same for the supply of money available to be lent by banks. Banks keep extra cash around just in case they have some short-run supply issues. So, a short-run TED spike is probably as bad for borrowers as a short-run refinery closure is for drivers.

But now suppose the refinery is going to stay closed for a year. Or two refineries close. Or three. Inventory isn't big enough to compensate, and we'd see gas prices rise. Same with financial markets. If the supply disruption lasts for too long, then we probably will see a larger impact on main-street lending.

This is not to say that Monday's package was a panacea. It wasn't clear exactly how much that was going to help. But you'll know when this crisis is over when the TED spread comes down.

It's also important to note that the TED spread isn't our only economic problem. Whoever wins this election will have a lot of hard decisions to make. The current Congressional negotiations aren't intended to solve all problems; they are just intended to get money flowing to banks again.

So, keep an eye on the TED spread.