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
broader economy.
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.