Financial Market Turmoil and U.S. Macroeconomic Performance
Prepared for Members and Committees of Congress
A large and relatively unimpeded flow of credit through healthy financial markets is a salient
attribute of the U.S. economy and any well functioning modern economy. Banks and other
financial institutions channel the economy’s savings toward a variety of current productive uses.
By borrowing short-term and lending long-term, these institutions create a flow of credit that
passes liquidity from savers to investors, and transforms liquid short-run assets into less liquid
long-term assets. These long-term assets are created by credit-financed, current spending by
households on housing, consumer durables, and education, and by, current spending by
businesses on new plant and equipment. But lending in credit markets requires confidence in the
borrowers’ ability to repay the debt (principal and interest) in full and on schedule. The current
turmoil in U.S. financial markets is the result of a breakdown in that necessary confidence. In an
environment of distrust, financial institutions are far less willing and able to lend long-term. The
move toward short-term lending diminishes the flow of long-term credit to the non-financial
economy and dampens the economic activities of households and businesses that are dependent
on borrowing. Economic policy may be needed to get credit flowing smoothly again and to
mitigate the damage incurred by households and non-financial businesses. A number of indicators
have pointed to a substantial rise in the cost of credit and a decrease in the flow of credit to the
A reduced flow of credit will likely dampen economic activity that is dependent on such
borrowing as residential investment spending (purchasing new homes) by households, business
investment spending (purchasing new plant and equipment) and consumer spending (purchasing
autos, appliances, and higher education) by households. Residential investment spending has
fallen over 40% between the fourth quarter of 2005 and the third quarter of 2008, and has on
average subtracted about 1.0 percentage point from real GDP growth in each of those six quarters.
Non-residential investment spending continued to increase in 2007 and the first half of 2008, but
the pace fell steadily, and in the third quarter of 2008 it declined 0.1%. Consumption expenditures
had been increasing, but at a decelerating rate in 2007 and the first half of 2008. However, in the
third quarter of 2008 consumer spending fell 3.1%. A recent study estimates that the decrement to
the U.S. economy’s supply of credit is about $1 trillion, leading to a potential drag on real GDP of
about 1.8 percentage points for two years.
There are three types of policy response, applied separately or in combination as the severity of
the problem warrants. The first type is the conventional macroeconomic policy tools of monetary
and fiscal policy, used with the aim of broadly supporting bank liquidity and aggregate spending.
Monetary policy, having greater flexibility than fiscal policy, will usually play the prominent role.
The second type of policy for responding to a credit crisis is the Fed’s traditional role of “lender
of last resort,” typically involving some expanded use of the Fed’s discount window, the facility
the Fed uses to make short term loans to banks that need to bridge a short-run shortage of
liquidity. These policies will be more narrowly focused on the needs of troubled institutions. The
third type of policy response is the use of “extraordinary measures” involving direct interventions
by the federal government to restore confidence in financial markets, forcing credit to flow
broadly and at greater volume.
Introduc tion ..................................................................................................................................... 1
Evidence of Tighter Credit Conditions............................................................................................2
The Effect of Tighter Credit Conditions on Macroeconomic Activity............................................3
Impact of Tight Credit on Residential Investment....................................................................4
Impact of Tight Credit on Business Investment........................................................................5
Impact of Tight Credit on Consumer Spending........................................................................5
The Effect on Consumer Spending of Falling Asset Values Reducing Household
We al th .............................................................................................................................. 6
The Double-Edged Influence of the International Sector on GDP...........................................7
International Flows of Goods..............................................................................................7
International Flows of Capital (Assets)..............................................................................8
An Estimate of the Potential Drag on Real GDP Growth from a Diminished Flow of
Credit ......................................................................................................................... ................... 8
A Simulation of the Effect of a Diminished Credit Flow on Real GDP....................................9
Economic Policy Responses to the Credit Crisis...........................................................................10
Conventional Macroeconomic Policy.....................................................................................10
The Fed as “Lender of Last Resort”........................................................................................14
Extraordinary Measures (Large Scale Intervention)...............................................................15
How Will TARP Work?.....................................................................................................16
Will TARP Solve the Problem?.........................................................................................16
Forecasting the U.S. Economy’s Path Through the Financial Crisis.............................................17
Author Contact Information..........................................................................................................18
A large and relatively unimpeded flow of credit through healthy financial markets is a salient
attribute of the U.S. economy and any well functioning modern economy. Banks and other
financial institutions channel the economy’s savings toward a variety of current productive uses.
By borrowing short-term and lending long-term, financial institutions create a flow of credit that
passes liquidity from savers to investors and which transforms liquid short-run assets into less
liquid long-term assets.
These long-term assets are created by credit financed current spending by households on housing,
consumer durables, and education; and current spending by businesses on new plants and
equipment. In a highly developed financial system, this flow of credit will not only be to
households and non-financial businesses, but also to other financial institutions to meet
occasional short-term needs for liquidity that serves to minimize disruptions in the flow of credit
to the non-financial economy.
This act of borrowing short-term and lending long-term, however, makes financial institutions
less liquid and therefore inherently vulnerable to crisis. It is a sustainable situation, however, so
long as there is widespread confidence, particularly among lending institutions themselves, in the
quality of the assets being created. Specifically, it requires confidence in the ability of those assets
to sustain a flow of earnings sufficient, at a minimum, to meet the lending institutions’ short-term
borrowing costs (liabilities).
The current turmoil in U.S. financial markets is the result of a breakdown in that necessary
confidence. In an environment of distrust, financial institutions are less willing or able to lend
long-term. While still willing to borrow short-term, in the face of great uncertainty they will tend
to also lend short-term in an attempt to enhance their own liquidity. They prefer to hold riskless
Treasury securities that offer almost no return rather than lend to a business or consumer who
presents even moderate risk. The move toward short-term lending diminishes the flow of long-
term credit to the non-financial economy and dampens the economic activities of households and
businesses that are dependent on borrowing.
The breakdown of confidence in U.S. financial markets is an outgrowth of the end of the housing
boom in 2006 and the subsequent fall of home prices. As home prices fell sharply in many areas
of the country, a surge in delinquencies and foreclosures on mortgage loans occurred, reducing
the flow of earnings to lenders who held these nonperforming mortgages. As the fall in earnings
grew larger, it became increasingly evident by the late summer of 2007 that an unusually high
percentage of the mortgages and mortgage backed securities (MBSs) created during the housing
boom were of lower quality then originally estimated. The initial overvaluing of these assets has
been attributed to an adverse interaction between lax underwriting practices by the originators of
the loans and deficient evaluations by credit rating companies of the MBSs created with those
loans. These shortcomings were easily overlooked so long as home prices were rising, but
became evident once home prices fell.
The fall in the value of these mortgages and mortgage related assets translated into growing
losses for the financial institutions who held them. As their balance sheets deteriorated, so did
their ability to lend to each other and to lend to the non-financial economy. The financial market
disruptions escalated during 2008. Because of the wide distribution and complex structure of
many MBSs it became very difficult for a potential lender to confidently appraise the quality of
assets on the balance sheet of potential borrowers and the risk of the borrower defaulting on the
loan. Thus even well capitalized banks became reluctant to lend. As research by psychologists has
shown, fear of loss is often a stronger motivator than the prospect of gain, explaining why in a
crisis, financial institutions’ concern for preserving wealth overrides the desire to increase wealth.
The rational choice for any one burdened financial institution is to reduce its debt by selling
assets. But, as many similarly burdened institutions attempt to reduce debt by simultaneously
selling assets, the price of assets is driven sharply down, deteriorating their balance sheets further
rather than improving them. The constriction of the flow of credit is accordingly magnified and
that, in turn, increases the drag on economic activity in the credit dependent non-financial sectors.
Left to market forces alone, this systemic failure would arguably only resolve it self slowly and at
great cost to the wider economy. The Great Depression is seen by many economists as an
example of the perils of leaving the resolution of a major financial crisis to the markets
themselves. Recent research shows that “fire sales” driven by a sharp increase in investors
preference for liquidity can push asset prices below their fair market value and be very costly to
the financial system by forcing the inefficient liquidation of long-term investments and to the 1
wider economy by reducing the availability of credit for productive endeavors.
Therefore, mainstream economists today argue that economic policy measures are needed to get
credit flowing smoothly again and to mitigate the damage incurred by households and non-
financial businesses. The form and scope of such policy initiatives can, nevertheless, vary.
Further, because of the substantial interdependence of the global financial system, a coordinated 2
policy response by the affected countries could be needed.
A number of indicators have pointed to a substantial rise in the cost of credit and a decrease in the
flow of credit to the non-financial sectors of the U.S. economy. These include
• Despite the Fed’s lowering the federal funds rate by 4.25 percentage points
between September 2007 and October 2008, the added liquidity did not cause
most mortgage interest rates to ease. The rates on non-conforming jumbo loans
have risen substantially.
• Despite the Fed’s efforts to bolster the inter-bank loan market, the growing
turmoil has caused the so-called TED spread, the difference between what banks
and the Treasury pay to borrow money to rise to exceptional heights. Usually this
spread would be 50-70 basis points, by October 2008 it soared to 464 basis 3
points. Such a large spread suggests a huge increase in perceived risk and a great
reluctance of banks to make short-term loans to each other.
1 Franklin Allen and Douglas Gale, Understanding Financial Crises, (Oxford: Oxford University Press, 2007).
2 For background on financial instability and its implications see, Irving Fisher, “The Debt-Deflation Theory of Great
Depressions”, Econometrica 1: 1933, pp 337-357, Charles Kindleberger, Manias, Crashes, and Panics, (New York:
Basic Books, 1978), and Hyman Minsky, Stabilizing an Unstable Economy (New Haven: Yale University Press, 1986).
3 Data for the TED spread came from http://www.bloomberg.com/quote?ticker=.TEDSP%3AIND.
• According to the Fed’s July and September 2008 surveys of senior loan officers
for a sample of banks, most banks are tightening lending standards for residential
mortgages, consumer loans, and business loans. The change of standards were
decreased loan size, decreased loan term, increased level of collateral required,
and an increased spread of the loan rate above the banks’ cost of funds.
• New issues of speculative grade bonds have fallen and the interest rate on lower
grade corporate bonds has increased.
• Credit extended by banks has fallen from about $1.1 trillion in the fourth quarter 4
of 2007 to only $211 billion in the second quarter of 2008.
Credit flows will reflect the interaction of supply and demand in financial markets. All of the
above indicators of tighter credit conditions have emerged at a time when economic activity, for
reasons separate from events in financial markets, has been slowing, an event that would weaken
the demand for credit and otherwise tend to loosen credit conditions. This configuration of
economic forces suggests that it is a diminished supply of credit that is causing the tightening of
credit conditions in U.S. financial markets.
Financial markets exert their influence on real economic activity by affecting both the price and
the quantity of credit supplied to borrowers in the non-financial sectors of the economy. It is
expected that a higher price of credit (higher interest rates) will dampen credit supported spending
by households and businesses. It is perhaps less obvious that changes in the quantity of credit
offered (credit rationing) to non-financial borrowers can have an effect on their spending apart
from the effect of increased price. In a financial crisis, banks and other lending institutions can
become so illiquid or risk averse that even at higher interest rates, little credit will be made
available to long-term borrowers—and a true credit crunch emerges.
A reduced flow of credit will tend to dampen economic activity highly dependent on borrowing,
such as residential investment spending (purchasing new homes) by households, business
investment spending (purchasing new plant and equipment) and consumer spending (purchases of
autos, appliances, and higher education) by households.
In a situation where the prices of assets owned by households are falling, there are likely to be
two primary channels of negative effect on consumer spending: the direct dampening effect of
tighter credit conditions, and the indirect dampening effect on spending caused by a decrease in
household wealth due to declining prices of homes and of financial assets held by consumers.
Slower spending by households and businesses slows the growth of real GDP, the most general
measure of overall economic well-being and a possible precursor of rising unemployment.
4 Credit flow data came from the Federal Reserve Board, Flow of Funds Account of the United States, Statistical
Release Z.1, September 18, 2008, Table F.1, at http://www.federalreserve.gov/releases/z1/current/z1.pdf.
U.S. aggregate economic activity has been slowing for some time. In 2006, real GDP increased
2.8%, a pace generally considered close to the economy’s sustainable long-term rate of growth. In
2007, the pace of real growth slowed to 2.0%, as the weakness of the housing sector became a
significant drag on economic activity. More deceleration has occurred during 2008, with an
outright decline of real GDP of 0.5% in the third quarter. (The third quarter GDP number is a
preliminary estimate and subject to revision.)
Much of the economic weakening in 2008 is attributable to a sizable loss in real purchasing
power caused by sharply higher energy and food prices, which has slowed several categories of
aggregate spending. But it is also possible that the further weakening of economic activity in the
third quarter of 2008 reflects the added dampening effects of the turmoil in financial markets
beginning to spread to the broader economy. If so, such negative effects would likely be evident
in the most credit-sensitive categories of aggregate spending.
So far, the effect of progressively tighter credit conditions in 2007 and 2008 has been most
evident on real residential spending, which is highly sensitive to changes in the price and quantity
of mortgage lending. The inventory of unsold homes was reported to be around 4.5 million units 5
or equivalent to about an eleven month supply. Similarly, housing starts have fallen precipitously
from over 2 million units in 2006 to an annual rate of about 800 thousand units through 6
September 2008, or a total decline in housing starts of about 60%.
In terms of GDP growth, real residential investment spending has fallen over 40% between the
fourth quarter of 2005 and the third quarter of 2008, and on average has subtracted about 1.0
percentage points from real GDP growth in each of those six quarters. Because residential
investment spending typically accounts for only about 5% to 6% of GDP in normal
circumstances, economic weakness in the housing sector by it self may slow the economy but is 7
unlikely to cause it to stall if other spending categories remain strong.
A significant factor in the sizable decrease of residential investment has likely been a sharp
slowing of the flow of mortgage credit from lenders. As recently as the fourth quarter of 2007,
mortgage lending to households occurred at an annual rate of $635 billion, but that flow had 8
diminished to $81 billion by July 2008.
The recovery of residential investment spending will likely require a recovery of the flow of
mortgage credit. However, even if there is a relatively quick improvement in credit conditions,
the large inventory of unsold homes suggests that residential investment will continue to be a
drag on the economy well into 2009.
5 National Association of Realtors, “Existing Home Sales,” http://www.realtor.org/research/research/ehsdata.
6 Housing start data reported by U.S. Department of Commerce, Bureau of the Census, New Residential Construction
Statistics, November 19, 2008, http://www.census.gov/const/newconstruction.pdf.
7 The source for GDP data is the U.S. Department of Commerce, Bureau of Economic Analysis (BEA),U.S Economic
8 See Federal Reserve Z.1 data.
Real non-residential investment spending continued to increase in 2007 and the first half of 2008
despite the growing turmoil in U.S. financial markets. Since then, the rate of increase has been
slowing. After advancing 7.5% in 2006, the pace of spending by businesses on new plant and
equipment slowed to 5.0% in 2007, and through the second quarter of 2008 that pace had slowed
to about 2.3%. In the third quarter of 2008, however, real nonresidential investment declined 9
It is likely that a recent history of substantial profits reduced the need for corporations to use
external sources of funds to finance investment spending. That insulation has so far allowed this
category of spending to largely avoid the dampening effect of deteriorating credit conditions.
However, over the four quarters ending in June 2008, non-financial corporate profits advanced
only 0.8%. In a slowing economy, a further weakening of profit performance can be expected.
This prospect makes it unlikely that businesses can continue to use internal funds to finance such
a large share of investment spending. The fall of real nonresidential investment in the third
quarter of 2008, although small, suggests to some that for many businesses a point as been
reached where a dwindling flow of credit becomes a significant constraint on non-residential
investment spending. For most corporations the primary credit constraint is not likely to be a lack
of bank credit but the inability to issue bonds on affordable terms.
Beyond the cost of borrowing, businesses’ willingness to undertake investment spending will be
strongly influenced by their expectation of the future demand for their products. In anticipation of
meeting strong demand in the future, businesses increase current investment spending to add
production capacity needed to meet future demand. If, on the other hand, there is an anticipation
of weak demand, businesses are likely to reduce their current investment spending. That
expectation will be contingent on the expected spending by consumers. A sizable slowing of
consumer spending is likely to deteriorate businesses’ expectations of future consumer spending,
inducing a slowing of non-residential business investment.
Consumer spending is the largest component of GDP, accounting for about 70% of total
aggregate spending. In addition, consumer spending tends to be relatively stable, generally free of
wide swings and decreasing in only the most severe economic downturns. Nevertheless, given its
great size, even modest swings in consumption spending will have a strong influence on the
growth of GDP through both its direct effect and its indirect effect on business investment
spending. As discussed above, business investment spending will slow if the expectation for the
growth of demand for their products is downgraded following signs of slower consumer
Real consumption expenditures had been increasing, but steadily decelerating their rate of
advance in 2007 and the first half of 2008. After increasing about 3.0% in 2006, that pace slowed
to 2% in 2007, and through the first half of 2008 slowed further to about a 1% annual rate.
9 See BEA U.S. Economic Accounts.
However, in the third quarter of 2008, real consumer spending fell sharply, down 3.1%.10 That’s
large enough to subtract 2.25 percentage points from the growth rate of real GDP in the third
quarter and could indicate that the economy is in the midst of a sizable down turn. The
deceleration of consumer spending over the past year is substantially the result of lost purchasing
power due to the sharp rise in energy and food prices. Only in the third quarter of 2008 has there
been mounting evidence of tight credit conditions dampening consumer spending.
Until recently, the flow of credit to households (other than mortgage lending) was not greatly
diminished. As recently as the fourth quarter of 2007, bank loans to households increased at an
annual rate of nearly $63 billion. By the second quarter of 2008, however, bank loans to
households decreased at a $52 billion annual rate. This diminished flow of bank credit could
constrain many types of consumer purchases such as autos, major appliances and higher
In contrast, the flow of consumer credit (largely credit cards) has remained relatively strong
through the second quarter of 2008, down from an annual pace of $136 billion in 2007 but still
increasing at a $114 billion annual rate in the second quarter of 2008. This pattern of borrowing
probably indicates that households have been running up their credit card balances to sustain their
spending. If so, consumer spending may weaken further, since such a pattern of spending cannot
be sustained indefinitely.
The effect of tighter credit on consumer spending is likely to be more evident in the sub-category
of consumer durable goods. These are expenditures that are typically financed by borrowing and
are also purchases that can be postponed until economic conditions improve. Real consumer
durable spending began to decline in late 2007, decreasing 4.3% and 2.8% in the first two
quarters of 2008 respectively. The third quarter spending drop was much greater, down 14.1%,
resulting in a 1 percentage point decrement from the third quarter’s real GDP growth rate.
The biggest contributor to the decline of consumer durable goods purchases is a sharp fall in
automobile sales in 2008, down from about 16 million units in 2007 to an annual rate of less than
13 million units over nine months of 2008. In addition to tighter credit conditions, record high
gasoline prices likely contributed to the weak automobile sales over the whole period, as has the
steady fall in household wealth caused by falling home prices (see next section’s discussion of
this effect). Nevertheless, the sharpness of the third quarter fall is also probably a manifestation of
the abrupt further deterioration of credit conditions that occurred around mid-year.
In addition to the direct dampening effect of tighter credit conditions on consumer spending, there
is likely to be an indirect dampening effect caused by falling asset prices reducing household
wealth. Falling prices for stocks and bonds decreases the value of households’ retirement and
investment portfolios, inducing consumers to spend less and save more in an attempt to replenish
lost wealth. In addition, falling home prices erase accumulated equity, decreasing a ready source
of liquidity for households to finance current expenditures. Also tighter credit conditions and
10 See BEA, U.S. Economic Accounts.
tougher loan terms may make it more difficult to convert any remaining wealth (equity) into
Economic research indicates that for every $100 billion decrease in household wealth, consumer
spending tends to fall $4 billion to $10 billion, with the change emerging over a one- to two-year 11
period. Over the last year, household net worth declined nearly $3 trillion. If past relationships
continue to hold, that decrease in wealth could cause a cumulative decrease in consumer spending
of between $120 billion and $300 billion. A spending change of that size would translate into a
drag on economic growth equivalent to 1.0% to 2.5% of GDP. That spending reduction could
grow larger if home and other asset prices continue to fall, causing household wealth to continue
In addition to relatively steady consumer spending, the U.S. economy’s ability to maintain
moderate real GDP growth over the last two years, despite the sharp fall of the housing sector and
unprecedented disruptions in financial markets, is largely explained by the strong growth of real
net exports since mid-2006.
The strength of net exports has been a consequence of relatively stronger economic growth
among major U.S. trading partners and of more competitively priced American goods resulting
from the over 30% decline in the dollar’s real (trade-weighted) exchange rate from 2002 through
In 2007, real export sales increased 8.4% while import purchases increased only 2.2%. Through
the first half of 2008, export sales have remained strong and import purchases have actually
decreased. This pattern was strongly evident in the second quarter of 2008, when net exports
generated nearly all of that quarter’s annualized GDP growth rate of 2.8%. In the third quarter,
real export sales fell off their second quarter pace, but were still strong, and imports continued to
decline. Overall, net exports contributed 1.1 percentage points to the third quarter’s real GNP
growth, continuing as a source of economic strength, but not strong enough to offset the quarter’s 12
sharp fall in consumer spending.
Whether this pattern of strong net export growth can continue is open to question. The pace of
economic growth in foreign economies is slowing due to a combination of reduced purchasing
power caused by high energy and food prices, credit constraints as a result of the spread of the
negative effects of the U.S. credit crisis to many industrial economies with closely linked
financial markets, and less accommodative policy responses by foreign governments. The
prospect of slower economic growth abroad is likely to weaken the demand for U.S. exports and
reduce their positive impulse on real growth in the United States over the near term.
11 See Christopher D. Carol, Misuzu Otsuka, and Jirka Slacalek, “How Large is the Housing Wealth Effect? A New
Approach,” NBER Working Paper No. 12746 (Cambridge, MA: National Bureau of Economic Research, December
12 See BEA, U.S. Economic Accounts.
The depreciation of the dollar since 2002 has been animated by a slow but steady weakening of
the demand for dollar-denominated assets on the part of foreign investors, reducing the inflow of
foreign capital. This gradual ebbing of the foreign inflow of capital is equivalent to a reduction in
the inflow of foreign credit (lending), but it has not over this period been disruptive or caused any
abrupt increase in U.S. interest rates. Nevertheless, capital outflows are likely to have a
heightened significance in the current state of financial turmoil and diminished credit flows to the
The negative effect on domestic credit conditions would be more substantial if the inflow of
capital slows sharply. That could happen if foreign investors, faced with the financial turmoil in
the United States, suddenly decide that dollar assets are too risky. An abrupt fall in capital inflows
would be an added decrement to the supply of credit, exerting stronger upward pressure on U.S.
interest rates, exacerbating the negative effects already affecting the credit and interest rate
sensitive sectors of the economy.
For the 12 months through June 2008, the U.S. Treasury reports that the U.S. economy received a
net foreign inflow of foreign capital of $270 billion, down from $879 billion during the preceding
twelve months. This overall inflow was largely sustained by official purchases (inflows of capital
from foreign central banks), more than offsetting net outflows of capital by foreign private
investors. However, in July 2008 there was a net capital outflow of $75 billion, reflecting the joint
effect of a net outflow of $92 billion by private investors and a net inflow of $18 billion from 13
other foreign central banks.
If this pattern of large reductions of foreign capital inflows continues along with a weakening
demand for U.S. exports, the near-term negative effects of this capital outflow on credit sensitive
economic activity risk offsetting any concurrent positive effects from net exports.
If, however, economic conditions abroad deteriorate greatly, a “flight to quality” towards dollar
assets, particularly low-risk Treasury securities, may have a positive effect on credit conditions in
the United States. The recent strength of the dollar suggests that this move into highly liquid
dollar assets is occurring, but it is an open question whether it will be sustained.
Although the GDP data indicate that the economy has weakened in 2008, it is difficult to say how
much of the slowdown evident so far is attributable to the ebbing of credit flows to the non-
financial sectors. The sharp surge in energy and other commodity prices are thought to have had a
significant dampening effect on economic activity in 2008, and there were clear signs that the
economy was already slowing prior to the recent escalation of financial turmoil, in part due to the
weakness of residential investment since 2006, and in part due to the erosion of real purchasing
power caused by increased energy prices. It is likely that the negative effects of 2008’s financial
13 U.S. Department of the Treasury, Office of International Affairs, Treasury International Capital (TIC) data for
August 2008, released October 16, 2008, http://www.treas.gov/press/releases/hp1215.htm.
market turmoil on the real economy will be partially evident in the second half of 2008 and more
fully evident in 2009. How big an economic blow might be coming?
A recent study contains an estimate of the potential overall effect of reduced credit flows on real 14
GDP. It examines the linkage running from home prices falling, to mortgage credit losses and
reduced capitalization of leveraged financial institutions, to a reduced supply of credit flowing to
households and non-financial business. This study is not presented as the last word on this
subject, but it is carefully constructed and presents plausible estimates of gross magnitudes of
effect and has the added advantage of being timely.
The study focuses on the supply of credit provided by three sets of financial institutions: (1) on
balance-sheet lending by banks (and other leveraged financial institutions), (2) off-balance sheet
lending by the asset backed securities (ABS) market, and (3) lending by government-sponsored
enterprises (GSEs). The study estimates the dampening effect of the reduced flow of credit from
these three sources on the rate of growth of real GDP.
The central projection of the study is based on the assumption that home prices fall 10% from
their mid-2008 level. Mortgage credit losses are projected to accumulate to $636 billion through
2012. Given a series of assumptions about tax rates, recapitalization rates, and leverage ratios, a
credit loss of that size is projected to cause a decrement to the U.S. economy’s supply of credit of
about $1 trillion, and lead to a drag on real GDP of about 1.8 percentage points for two years. For
an economy that is likely already growing significantly below its trend rate of near 3%, this
degree of drag from deteriorating credit flows has the potential to halt real economic growth over
the next two years.
A particularly critical assumption for this outcome is that Fannie Mae and Freddie Mac (the main
GSEs) continue to expand credit growth at their recent pace. Over the past year, despite a decline
in the market value of their equity capital, the GSEs have accelerated their contribution to credit
growth, adding almost $620 billion of lending over the year ending in June 2008. The study’s
central projection of credit growth has the GSEs continuing to expand their lending at a $750
billion annual rate. (This outcome is more plausible now that the GSEs are controlled by the
However, if the GSEs should stop expanding their lending, the study estimates that the decrement
to total credit growth would increase to $1.7 trillion, and the estimated drag on real GDP would
increase to 3.2 percentage points over the next two years. That would be a substantial blow to
overall economic activity and probably, other factors constant, has the potential to generate a deep
These estimates do not include other negative effects of the housing downturn on overall
economic activity, such as the wealth related dampening of consumer spending, nor does it reflect
14 Jan Hatzius, “Beyond Leveraged Losses: The Balance Sheet Effects of the Home Price Downturn,” Brookings
Papers on Economic Activity, fall 2008, http://www.brookings.edu/economics/bpea/~/media/Files/Programs/ES/BPEA/
the sizable real income losses stemming from higher energy prices. Nevertheless, the study
suggests that a substantial credit crunch by itself has the potential to deliver a major negative
blow to the economy, potentially inflicting significant economic damage well beyond the housing
sector and the financial markets.
How can economic policy contain or mitigate the potentially large negative economy-wide effects
of a major credit crisis? In general, there are three types of policy response to be applied
separately or in combination as the severity of the problem warrants. The first type comprises the
conventional macroeconomic policy tools of monetary and fiscal policy, used with the aim of
broadly supporting bank liquidity and aggregate spending. Monetary policy, having greater
flexibility and precision than fiscal policy, will usually cause it to play the prominent role.
The second type of policy for responding to a credit crisis is greater use of the Fed’s traditional
role of “lender of last resort.” This policy will typically involve expanded use of the Fed’s
discount window, the facility the Fed uses to make short term loans to banks that need to bridge a
short-run shortage of liquidity. Theses policies will be more narrowly focused on the needs of
troubled institutions and deal more directly with un-blocking the flow of credit than would
conventional macroeconomic policy.
The third type of policy response is the use of “extraordinary measures” involving direct
interventions by the federal government to restore confidence in financial markets and the remove
impediments to credit to flowing broadly and at greater volume. This “extraordinary intervention”
may involve a restructuring of the debt of troubled financial institutions and significant changes
in the regulation of financial markets. It is also argued that, to be effective, a government most
often will need to apply “extraordinary measures” quickly and decisively so that the actions
clearly remove all uncertainty about profit and loss in the financial sector.
The U.S. government, to date, has employed all three types of policy responses to the current
credit market crisis.
Monetary policy is the Fed’s standard and most frequently used tool to exert broad-based
influence on credit conditions and economic activity so as to achieve full employment and price
stability. U.S. monetary policy is implemented by targeting (raising or lowering) the short-term
federal funds rate, a market-determined interest rate that banks charge each other for short-term
loans. The targeting of the federal funds rate is accomplished with open market operations
whereby the Fed buys or sells Treasury securities for cash to increase or decrease liquidity in the
financial markets, increase or decrease real borrowing costs, and thereby increase or decrease 15
investment (and other credit sensitive) spending.
15 See CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte.
From the standpoint of financial institutions, open market operations affect the prices of assets
and the cost of carrying debt. Through both of those changes, the Fed may be able to influence
banks’ willingness and ability to lend.
In response to a financial crisis, the Fed would apply a stimulative monetary policy. A stimulative
monetary policy is initiated with the Fed entering the federal funds market, making open-market
purchases of Treasury securities from banks in exchange for cash. The infusion of cash increases
the reserves (liquidity) of the banking system, exerting downward pressure on interest rates. The
effect on interest rates is likely to be reflected quickly and most fully on short-term interest rates
and then, hopefully, spread to longer-term interest rates. Beginning in September 2007, in
response to continuing evidence that “disruptions in financial markets” could have adverse effects
on the wider economy, the Fed aggressively applied successive injections of monetary stimulus,
as it added reserves and pushed down the federal funds rate from 5.25% to its current level of 16
However, the stimulative effects of a much lower federal funds rate to the wider economy seem to
be substantially muted as evidenced by the failure of long-term interest rates to fall. This lack of a
stimulative effect is occurring because banks, still lacking the needed degree of “confidence”
have been content to increase reserves and liquidity, but not increase their lending activity. They
are still not willing to borrow short-term and lend long-term, the behavior needed to keep an
adequate flow of credit (liquidity) moving to the non-financial sectors.
The phrase often used to describe this lack of effect on real economic activity is that monetary
policy can not get “traction.” In the economic literature, the extreme form of this phenomenon is
called a “liquidity trap,” a situation where the financial system’s seemingly limitless appetite for
short-term liquidity keeps the economy stuck in a sub-optimal equilibrium of slow economic
growth that monetary policy (alone) cannot push it out of. At this extreme, monetary policy’s
attempt to move the economy is likened to “pushing on a string.”
In the current situation, the economy may not have fallen into a “liquidity trap,” and getting the
economy back to its trend rate of growth may only be a matter of applying more monetary
stimulus. But there may be some restrictions on the Fed’s ability to apply more stimulus. For one,
the federal funds rate is approaching the “zero bound.” When the short-term policy rate is at or
near zero, the conventional approach for conducting a stimulative monetary policy is not possible.
However, there are alternative means that the Fed could employ to provide stimulus in this
situation. First, the Fed could try to change financial market’s interest rate expectations. The
current interest rate on long-term assets depends on the entire expected future path of short-term
interest rates, including the zero rate for the federal funds rate. If the central bank can persuade
the public that it will hold the short-term rate at zero for longer than had been expected, interest
rates across the whole term-structure should also fall, stimulating spending. Such an outcome
would hinge on whether the Fed’s policy commitments are taken as credible by the public.
Second, the Fed could alter the composition of its balance sheet. The Fed’s asset holdings are
primarily of Treasury securities of different maturities ranging from one month to 30 years, but
because its targeted interest rate for the conduct of monetary policy has been the short-term
16 See the minutes of The Fed’s Open Market Committee from September 2007 through October 2008 at
federal funds rate it has relatively large holdings of short-term securities. (The average maturity
of its assets is typically around one year.) If the Fed were to shift the composition of its balance
sheet toward long-term assets by selling short-term treasuries and buying long-term treasuries, it 17
could possibly lower long-term yields to provide stimulus to economic activity.
A third option for implementing monetary policy at the “zero bound” is to expand the size of the
Fed’s balance sheet. This, of course, is the conventional means of conducting a stimulative
monetary policy of buying securities to increase the supply of reserves in the banking system. The
policy focus, however, is shifted from the price of reserves (interest rates) to the quantity of
reserves. This process of increasing reserves above the level consistent with keeping the policy
interest rate at zero was used by Japan during its financial crisis of the 1990s and is often called 18
Stimulative monetary policy at the zero bound was the major part of Japan’s initial response to its
financial crisis in the 1990s. That policy, for the reasons just discussed, had a very difficult time
getting “traction” and was not by itself able to push the Japanese economy out of crisis.
Nevertheless, operation of monetary policy at the zero bound for the federal funds rate would be a
passage through uncharted waters for U.S. monetary policy. There remains substantial uncertainty
about how well the alternative operating procedures might work, particularly given the important
role often volatile investor expectations would play in the alternative procedure’s ability to
stimulate economic activity.
Another important constraint on the Fed’s ability to conduct a stimulative monetary policy is the
risk of inflation. After 2006, inflation began to accelerate. The Consumer Price Index (CPI)
increased 2.5% in 2006, but through July 2008 the CPI was rising at about a 5.4% rate. Much of
the upward pressure on the price level was the consequence was a sharp rise in energy and other
commodity prices. In addition, the falling dollar had increased the domestic price of many
In August and September of 2008, inflation slowed substantially, perhaps indicating that
economic growth has slowed enough to remove much of the upward pressure on energy and food
prices. If so, this apparent abatement of supply-side generated inflation may allow the Fed to
worry less about near term inflation effects of a large scale monetary stimulus to counter the
dampening effect on economic activity of the current financial market crisis.
17 For this process to work, however, investors must treat Treasury securities of different maturities as imperfect
substitutes, otherwise an increase in the supply of short-term securities coupled with a like-size decrease in the supply
of long-term in public hands would not cause a significant decrease in long-term interest rates. The evidence is limited,
but it would tend to indicate that the public sees only a small degree of imperfect substitutability between short-term
and long-term Treasury securities, raising doubt about the efficacy of altering the composition of the Fed’s balance
sheet to generate a stimulative monetary policy.
18 Quantitative easing is thought to affect real economic activity through three channels. First, it induces a shift in
investor portfolios away from cash and toward other financial assets, so it would tend to push up asset prices and push
down yields. Second, by altering investor expectations about the future path of the federal funds rate by demonstrating
a willingness to keep reserves high, it could (as already discussed above) induce a decrease in interest rates. Third,
quantitative easing could generate a stimulative fiscal effect as the swapping of non-interest bearing currency and
reserves for interest bearing Treasury debt leads to a reduction of the current and future interest cost of the federal
government and a lowering of the associated tax burden on the public.
There is still the issue of long-term inflation effects of current monetary stimulus. The Fed has
injected large amounts of liquidity into the economy that could pose an inflation problem once
the economy returns to a normal rate of growth. However, measures of inflation expectations 19
have fallen since June 2008.
Nevertheless, policies in addition to monetary stimulus were thought to be needed to get credit
flowing and support aggregate spending.
Fiscal policy can support economic growth through an increase in the budget deficit via lower
taxes and increased government spending (including both changes in discretionary spending and
changes in the automatic stabilizers). A policy of fiscal stimulus would involve tax cuts or
spending increases (or some combination of the two). Unlike monetary policy, which must
transmit its stimulative impact to economic activity indirectly through financial markets, fiscal
policy has a relatively direct impact on economic activity. Increased government spending is a
direct addition to aggregate spending. A tax cut is less direct because it must first pass through
household income before it boosts spending, and there is always the possibility that all or part of
the tax cut is saved rather than spent by households. In addition to its effect on aggregate
spending, fiscal stimulus may have an indirect positive effect on the condition of financial
institutions’ balance sheets as the salutary effect on economic activity also exerts upward pressure 20
on asset prices. To be most effective, fiscal policy initiatives would occur in conjunction with a
stimulative monetary policy.
The Economic Stimulus Act of 200821 provided tax rebates to households and accelerated
depreciation rules for business that amounted to an increase in private sector income of about 22
$120 billion in 2008. Taking potential multiplier effects into consideration, the rebate could 23
generate an even larger stimulus to total economic activity. History and economic theory,
however, indicate that one-time tax cuts often do not stimulate consumer spending. Nevertheless,
evidence from the 2001 federal tax rebate showed that households eventually spent about 2/3 of
that rebate. The Bureau of Economic Analysis’s estimate of personal saving increased
substantially in the second and third quarters of 2008, suggesting that a substantial portion of the 24
In addition, the “automatic stabilizers,” which are policies or programs designed to provide an
offset to current economic trends without additional legislation, have been enhanced by extending
19 University of Michigan Inflation Expectation, Survey Research Center: University of Michigan, data available at
20 For further discussion see, CRS Report RS21136, Government Spending or Tax Reduction: Which Might Add More
Stimulus to the Economy?, by Marc Labonte.
21 P.L. 110-185, 122 Stat. 613-622.
22 For further discussion see, CRS Report RS22850, Tax Provisions of the Economic Stimulus Package, by Jane G.
23 Multiplier effects are the additional increases in aggregate spending that occur when an expansionary fiscal policy
increases consumer spending.
24 See BEA, U.S. Economic Accounts.
the term of unemployment benefits from 20 weeks to 40 weeks. Because unemployment benefits 25
tend to get spent quickly, they usually give a timely and direct stimulus to economic activity.
Total real federal spending over the four quarters ending mid-2008 has increased about 5%, and 26
contributed an estimated 0.4% to the growth of real GDP over this period. However, to correctly
gauge government’s effect on aggregate spending, its revenue and spending actions need to be
evaluated. The generally accepted way of determining whether the influence of the government
budget on aggregate spending and real GDP is positive or negative is the direction of change of
the “standardized budget measure.”
The standardized measure excludes the effect of cyclical fluctuations and factors that are short-
lived and unlikely to affect aggregate spending in the shortrun. The Congressional Budget Office
(CBO) projected in October that the standardized budget deficit increased from 1.1% of potential
GDP in 2007 to 2.8% of potential GDP in 2008, which suggests that government fiscal actions are
expected to provide a stimulative impulse to the economy equal to 1.7% of potential GDP. In
2009, however, the standard budget deficit is projected to fall to 1.6% of potential GDP, which
signals a reduction of the government budget’s stimulative effect on aggregate spending. (This
estimate pre-dates legislation that is discussed below that provides a major increase in 27
government expenditures for rescue of the financial system.)
In the role of “lender of last resort,” the Fed offers credit to solvent but temporarily illiquid
financial institutions. These are financial institutions that are solvent because the value of their
assets exceed the value of their liabilities, but because their debts tend to be short-term and liquid
while their assets are long-term and illiquid, they are in need of short-term funds to meet short-
term debt obligations. The expectation is that with improved access to short-term liquidity,
financial institutions will be more willing and able to lend to each other and to the non-financial
sectors of the economy, and thereby remove excess volatility in financial markets.
The Fed’s “discount window” is its facility for making loans to financial institutions with short-28
term liquidity problems and the “discount rate” is the interest rate charged for these loans.
Financial institutions are often reluctant to use the discount window out of concern that financial
market participants will draw a negative inference about their financial condition if their
borrowing from the Fed becomes known. In conjunction with conventional monetary stimulus
(discussed above), the Fed, beginning in August 2007, has taken a number of steps to make use of
the discount window more attractive. It has broadened the group of eligible participants, it has
extended the term of loans, and it has lowered the discount rate.
Enhancements to the Fed’s lender of last resort function have included the creation of the Primary
Dealer Credit Facility which opened the discount window to non-member financial institutions,
the Term Auction Facility to make loans to member banks based on a broader range of collateral,
25 For further discussion see, CRS Report 92-939, Countercyclical Job Creation Programs, by Linda Levine.
26 See BEA, U.S. Economic Accounts.
27 Congressional Budget Office, The Cyclically Adjusted and Standardized Budget Measures, October 2008,
28 For further discussion of Fed policy see, CRS Report RL34427, Financial Turmoil: Federal Reserve Policy
Responses, by Marc Labonte.
and the Term Securities Lending Facility to lend Treasury securities in exchange for some asset
backed securities. The Fed has also entered into asset swaps with the European Central Bank and
several other foreign central banks to increase dollar liquidity in foreign financial markets. (These
direct loans to the financial sector are typically “sterilized” by the Fed through the purchase of
Treasury securities so as to keep the total value of its asset holdings steady and avoid generating
any inflationary pressure.)
Maintaining market confidence in the financial sector also involves ensuring that any exit of firms
from the sector occurs in an orderly way. To this end, the Fed in March 2008 facilitated with
loans the purchase of a troubled investment bank, Bear Stearns, by J.P. Morgan. The Fed judged
that, given the severe illiquidity of the financial system at that time, a bankruptcy filing by Bear
Stearns would have led to much broader liquidity problems. The Fed argued that lending support
for the sale of Bear Stearns was necessary to avoid the systemic risk of a disorderly exit.
The Fed’s enhanced discount window initiatives have pumped a large volume of liquidity into the
U.S. financial system. For the two month period ending October 1, 2008, the Fed increased
system-wide reserve funds by over $800 billion, increasing total reserve funds to over $1.5
trillion. For comparison, reserve funds increased only about $27 billion over the twelve months 29
ending June 2008.
Despite their size, the Fed’s lender-of-last-resort initiatives (along with conventional monetary
stimulus) have not yet resulted in renewed credit flows at pre-crisis levels, as financial institutions
have accumulated reserves, but remained reluctant to generate new long-term lending. This lack
of effect has suggested to some that the problem goes beyond a matter of short-run illiquidity, and
involves long-term solvency issues. (Long-term insolvency means that the “true” market value of
some financial institutions’ assets is not sufficient cover their liabilities.)
The Fed’s ability to continue pursuing large “lender-of- last-resort” activities may eventually be
constrained by the changing risk profile of the central bank’s balance-sheet. Its recent “lender of
last resort” initiatives have meant that the Fed has exchanged a sizeable portion of its holdings of
low-risk Treasury securities for high-risk collateral. Although the Fed is able to hedge some of
this risk, the average level of risk carried in the Fed’s total asset holdings has increased. More
lending by the Fed could potentially increase the level of risk in its asset holdings to a point
beyond which it is not willing to go.
The Fed has implemented extensive “lender of last resort” measures to help the financial sector
bridge temporary liquidity problems of turning assets into cash and avoiding selling at “fire-sale”
prices. The Fed has also continued to apply a stimulative monetary policy that has provided
liquidity, lowered market interest rates at the short end of the yield curve, and increased the
demand for financial assets. The objective of both policy initiatives is to reduce the risk of
insolvency and assuage banks’ reluctance to lend long-term.
29 Data on reserve growth comes from the Board of Governors of the Federal Reserve System, “Factors Affecting
Reserve Balances of Depository Institutions”, H.4.1 release, September 25, 2008, http://www.federalreserve.gov/
The “conventional initiatives” alone were not seen to be enough, however. In two bold steps
beyond the conventional, the government, to forestall bankruptcies that could be particularly
devastating to the whole financial system, took control of the mortgage giants Fannie Mae and
Freddie Mac and the insurance giant AIG.
Nevertheless, despite these efforts, the financial turmoil persisted, credit flows remained anemic,
risk spreads remained at record size, and the threat of more widespread bankruptcies of financial
institutions increased. The prospect of a collapse of the entire financial system, with large
negative repercussions on the wider economy, prompted the federal government to initiate a
massive intervention into the financial system to restore confidence and resume the flow of credit.
Hence, the Troubled Asset Relief Program (TARP) was initiated with a variety of features, but the
heart of the program is that it gives the Secretary of the Treasury up to $700 billion to either buy 30
mortgages and other troubled assets or directly recapitalize selected financial institutions.
The details of how the program will be fully implemented are still being developed. A central
objective, however, is to increase demand relative to supply for risky assets in order to stabilize
their price. Arguably, the government will now target, as it does the federal funds rate, the price of
risk in the economy. Stabilizing the price of risk may reduce the incentive of financial institutions
to hoard liquidity and induce them to return to their conventional role of borrowing short-term
and lending long-term, and begin to pass a larger flow of liquidity to the non-financial sectors to
support credit dependent spending.
In general, there are at least two ways for TARP to stop the price of risky assets from falling.
First, the Treasury can reduce the supply of risky assets by buying them or guaranteeing them (a
guarantee reduces the supply because it transforms a risky asset into a not risky asset). Second,
the Treasury can recapitalize the financial system either through inducing it to capitalize itself or
through the government taking some level of equity position in troubled financial institutions.
With recapitalization, the demand for risky assets is expected to recover, exerting upward
pressure on asset prices. (The initial spending of TARP funds has been for recapitalization.)
Within this general framework, critical decisions, therefore, must be made about what assets to
buy or guarantee: whole mortgages and mortgage pools; mortgage backed securities; or “other
assets” deemed important to promote financial market stability. In addition, decisions will be
made about what price to pay for the troubled assets. The Treasury could either buy at “market
price,” to protect taxpayers, or it could buy at “above market price,” to provide recapitalization of
the assisted institution, conferring a significant benefit to that institution but none to many others.
TARP takes the U.S. economy into uncharted waters and it is uniquely difficult to predict what
the outcome of the program will be. Many economists argue that some initiative broadly like this
was probably needed to stave off an economic catastrophe that would have extended far beyond
the housing sector and Wall Street. One lesson that some have drawn from Japan’s banking
30 For further discussion, see CRS Report RS22963, Financial Market Intervention, by Edward V. Murphy and Baird
troubles in the 1990s was the Japanese government’s failure to act quickly and decisively in
restructuring financial sector debt was an important reason why Japan emerged from its financial
crisis so slowly, enduring a decade of lost economic growth.
If such a large and extraordinary intervention into U.S. financial markets is needed to assure their
smooth functioning, it raises the longer term question of whether the management of risk can
largely be left to financial markets themselves. Some argue that permanent public guarantee of
risk could be necessary to avoid overly volatile asset markets, to ensure the ability to issue debt,
and to preserve an adequate flow of credit to the non-financial economy.
Sceptics counter that large scale government support and guarantee of risk may induce “moral
hazard”; that is, if financial markets come to believe that government will come to the rescue any
time problems occur, then those markets will have less incentive to prudently manage risk and
more incentive to take on imprudent risk. To resolve the moral hazard problem posed by TARP,
more extensive prudential supervision and regulation of financial markets may be required.
Economic forecasts are different from simulation studies such as the one above. A forecast of the
rate of growth of real GDP attempts to incorporate all of the significant forces, positive and
negative, that are likely to influence economic growth. Among these forces are the expected
effects of current and anticipated economic policy initiatives to counter the negative effects of the
financial crisis. Nevertheless, some perspective on the expected magnitude of the repercussions
on economic activity can be gained from how economic forecasts have changed over the year as
the financial turmoil has unfolded.
Most forecasts at the beginning of 2008 projected some slowing of economic growth due to the
effects of the housing crisis, rising energy prices, and conventional cyclical forces. The degree of
the financial market melt-down that emerged in the spring was not anticipated in those early
forecasts, however, and would force sizable revisions of most forecasts by the fall. Focusing on
2009, the first full year when the economic repercussions on economic growth would be most
evident, the following revisions have occurred:
• The IMF’s October 2008 forecast for U.S. real GDP growth for 2009 has 31
decreased from 1.8% in January 2008 to 0.1%.
• The Congressional Budget Office forecast for growth of real GDP in 2009 has 32
fallen from 2.8% in January 2008 to 1.1% in September 2008.
• The Blue Chip Indicators consensus forecast of U.S. real GDP growth in 2009 33
has moved down from 2.9% in January 2008 to 2.1% in September 2008.
31 International Monetary Fund, World Economic Outlook, October 2008, p. 2, http://www.imf.org/external/pubs/ft/
32 Congressional Budget Office, “CBO’s Economic Projections for Calendar Years 2009-2011”, http://www.cbo.gov/
33 Blue Chip forecast can be found in CRS Report RL30329, Current Economic Conditions and Selected Forecasts, by
These forecasts, reflecting the stabilizing and stimulative economic policies in place through
September 2008, show the U.S. economy slowing substantially more in the coming year then had
been expected before the intensification of the turmoil in financial markets that emerged as 2008
Economic forecasts carry a high degree of uncertainty, and most of the risks in the current
economic situation are judged to be on the down-side. One important risk is that the constraint on
credit flows from the de-leveraging of financial institutions could be deeper and more protracted
than expected. A second substantial risk is that the housing prices do not stabilize, and instead
deteriorate further. In addition, the global dimension of the crisis broadens the problems beyond
the U.S. market and adds the risk of destabilizing shifts in international capital flows.
On the up-side, U.S. economic policy has shown the ability to change quickly and substantially in
response to the financial market turmoil, and the United States has a strong record of successfully
managing recoveries from business cycle downturns.
Craig K. Elwell
Specialist in Macroeconomic Policy
Gail E. Makinen, pp. 9-10.