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RENEE MONTAGNE, host:

And what Adam Davidson just told us about the troubled credit markets is at the heart of what's being called the liquidity crisis. We've heard that word, liquidity, a lot lately. The nation's leaders have been struggling to restore liquidity to the financial system.

Chairman BEN BERNANKE (Federal Reserve): This morning, the Federal Reserve announced a new facility that will help provide liquidity to…

Secretary HENRY PAULSON (Treasury): Confidence, capital, systemic risk and liquidity…

President GEORGE W. BUSH (United States of America): Just this morning, the Federal Reserve announced action to provide additional liquidity to credit markets.

MONTAGNE: NPR's Chris Arnold helps explain just exactly what that means and why it is so important to the economy.

CHRIS ARNOLD: When we talk about liquidity, basically we're talking about movement. You open a faucet, water flows out to where it's needed and the seizing up of the credit markets has basically dropped the water pressure for the whole economy. And there are a lot of companies opening their faucets and nothing's coming out.

Mr. PETE KYLE (Economist, University of Maryland): Yeah. Money is like the tap water in the economy, and normally you have two different pumphouses that supply it.

ARNOLD: Pete Kyle is an economist at the University of Maryland. He says that traditional lending by banks is one pumphouse; the other is what's called the commercial paper market. Companies use that to go straight to investors and borrow money outside the banking system.

Dr. KYLE: Today, you're seeing that that commercial paper market, that extra supply of liquidity, is just not available.

ARNOLD: So with that pump house down, banks are in a tough spot. And that's not good for the economy.

Dr. KYLE: I'm predicting a pretty severe recession.

ARNOLD: OK. Here's how all this fits together. Take Marriott, the hotel company. It's a good solid business. We reached Arne Sorenson, Marriott's CFO, at an airport yesterday and he explained that in a normal month, the firm would be borrowing about $900 million through that commercial paper market.

Mr. ARNE SORENSON (Chief Financial Officer, Marriott): You could think about that as being, you know, $30 to $45 million a day that would come due. And we'd go into the markets and we would in effect renew that - we'd roll it over.

ARNOLD: Marriott uses that money to pay employees, pay contractors who are building new hotels. But then, three weeks ago, Lehman Brothers failed. That spooked investors in money market funds. Those funds have several trillion dollars to invest, and they usually buy a ton of that commercial paper, in effect lending money to big companies like Marriott. But they stopped doing that.

Mr. SORENSON: During that week, the commercial paper markets seized up.

ARNOLD: Losing that source of liquidity has already taken a toll.

Mr. SORENSON: So in at least two hotels under construction and getting near opening in 2009, construction has stopped.

ARNOLD: Sorenson says plans for other hotels have been scrapped in recent months because of the situation in the credit markets, including a 2,000-room hotel in San Diego which now won't get built.

Mr. SORENSON: There are probably already tens of thousands of those jobs that would have been created that probably have been lost.

ARNOLD: Sorenson says it's not a life-threatening problem for Marriott. The firm had a backup line of credit with a bank, so it can keep making payroll, and he says the company's in good shape. The biggest corporations usually have more options. But back to the tap-water analogy. Companies like Marriott suddenly need billions of dollars in extra liquidity from regular banks. And many of those banks are already short of cash because of losses in the housing bust, so they're getting a lot less willing to loan out money to everybody else. Pete Kyle.

Dr. KYLE: The banks are hoarding water because they are afraid people are going to come and demand water from them. So they keep as much in supply as they can.

ARNOLD: And in an environment like this.

Dr. BOB FROEHLICH (Vice Chairman, Mutual Fund Arm of Deutsche Bank): The people that need the money the most will get it the least.

ARNOLD: That's Bob Froehlich, vice chairman of the mutual fund arm of Deutsche Bank. He says that liquidity is so scarce right now that things could get much worse very quickly. He thinks many small- and medium-sized companies could start falling apart and laying off lots of people.

Dr. FROEHLICH: Companies that are solid companies do not have the cash flow to be able to meet payroll - that's the magnitude of the crisis we're facing. There has never ever, ever been anything like this in the 33 years I've been in the business.

ARNOLD: That's why Treasury Secretary Paulson has been looking like he hasn't slept in weeks. The government is scrambling to fix this liquidity crisis before the fallout gets worse. It's been loaning to banks, loaning directly now to all kinds of companies, to meet that demand for liquidity. Economist Pete Kyle has been watching all this closely.

Dr. KYLE: So the Fed is saying, we're going to be the firemen here and we're going to come and put our hoses into the system and we're going to start pumping water essentially out of our trucks, or out of our reserve system.

ARNOLD: Kyle says the Great Depression happened in part because the government didn't respond quickly enough to a credit and liquidity crisis. But he says he just can't see that happening again. He thinks the credit markets will soon get back under control. He thinks we're headed for a tough recession, with unemployment rising above eight percent, but nothing really cataclysmic. Chris Arnold, NPR News.

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