Credit Crunch and Federal Reserve Bank Policy

Credit can generally be defined as the transaction amidst two parties in which, one party, such as the creditor or the lender supplies goods or money or other services or securities in return for a promised future payment by the other party, the borrower or the debtor. Payment of interest is the general norm of such transactions. Any large business house, consumer expenditures, or governmental schemes may also borrow public money in the form of selling shares.1

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It is the function of large financial institutions, such as banks, to issue or generate credit transactions. A smooth inflow of credit between the borrower and the lender is what establishes ideal market conditions. A credit crunch occurs when there occurs a lack of obtainable credit in the market and the borrowers cannot find adequate finance. Usually, such a phenomenon happens when the creditors are unwilling to invest more money or hike up their interest rates to such exorbitant levels that it becomes virtually impossible for the lender to borrow.2

The central question, then, is why do the creditors suddenly refuse to invest more money? Actually, far from being an isolated fact, it is a part of a complex chain reaction. The lenders reel under deficit money supply when they fail to realize the interest or even the actual capital they had invested in companies or institutions, which accrued a disastrous amount of losses. Such loss incurring companies cannot return the money they had borrowed from the creditors and have to default payment. In the case of such defaults, the banks try to mortgage or sell the properties of defaulters.

However, when the prices begin to fall, even the bank has to sell out at considerably lower prices and suffer huge losses. Consequently, their ability to lend money is severely crippled. In certain cases, the banks are required to raise the level of capital reserves and to comply with this have to restrict lending. Even when banks perceive a risky market, interest rates may shoot up to discourage lending leading to a credit crunch.3

The nation has seen such a crisis in the past and incorporated different methods as bail-out plans. The 1932-53 crisis called for the reconstruction of finance corporations and the trigger was a Great depression. The 1989-95 crisis needed Resolution Trust Corporation and the trigger was the savings and loan crisis. Here 747 small companies were affected and the cost was $300 billion where the initial cost estimation was $50 billion. In other countries too, like Sweden (1992-96) and Japan (1996), the resolution was in form of a Bank Support Authority in Sweden and Resolution and Collection Corporation in Japan, and in both cases, the trigger was fallout from a real estate bubble.4

Back in the US, on December 12, 2007, five of the leading banks of the world, including the Federal Reserve Bank of USA came together to invest huge amounts of fresh money into the global market to combat the international credit crunch failing economy.5 This move was largely stimulated by the concern of leading economists who were predicting a recession in US markets as a slowing down or decline of US and British housing markets.

In an emergency set of solution-seeking procedures, the Federal Reserve Bank drastically diminished interest rates, splurged out innovative lending programs, sought to modify the poor condition of Bear Stearns, and provide loans to boost the nearly crippled mortgage agencies of Fannie Mae and Freddie Mac. It was, however, not as if, the Federal Reserve Bank was taking over every financial proposition in the US, but had to do so because it was big enough to stem the crisis.6

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To avert a crisis, the Federal Reserve Bank is lending out money to small and big borrowers on an unprecedented level and as such has been thoroughly criticized by politicians for interfering with the fiscal policy.7 At present, the Federal Reserve Bank has already provided money for AIG and Bear Stearns amounting to $217 billion. It has also agreed to gear up the amount to $277 billion as a bailout plan.8 Marsh states that the bailout plan includes Ford and M recovery of $25 billion and indicates that the bailout plan is actually an “infusion of credit versus direct cash payment”.9

As it is, the income and expenditure balance of the US is at a deficit of $407 billion as of 30 September 2008. At the same time, the offshore deals help foreigners to avoid at least a tax amount of $100 billion each year.10 Thus, it is obvious that steps are necessary and should be taken soon.

However, in the event of magnifying unemployment and inflation, the Federal Bank cannot afford to sit still. It has to fight for a stable equilibrium in prices and combat unemployment. The most innovative plan to diminish the credit crunch has been to increase lending with the motivation to restore liquidity to troubled markets and look after the demands of the inter-bank loaning facilities.11 The current crisis made the Federal Bank decrease the interest rates on lent amounts and lengthen the time limit for the repayment of the loan. “Term Auction Facility” was adapted as a scheme for slow banks through which loans at a cheaper rate could be made available from discounts windows and the deals were guaranteed anonymity.12

The Federal Bank also took the drastic measure of investing $200 of its capital to bail out investment banks with securities, which were difficult to trade, such as mortgages. It also provided $30 billion to Bear Stearns to help it tide over its economic crisis. The Federal Bank also undertook to support “AAA-rated” securities and loans made by students as collateral to soften the crisis for the common person. The present credit crunch has a similar instance when a similar crisis hit the global market post 911 and all the global banks joined forces to stabilize the global economy.13 There is a similar pattern about the great depression of 1929.

The decade leading up to the stock market crash of 1929 and the following Great Depression is typically remembered as one of great prosperity; everybody, it seemed, was getting wealthier. While the rich added to their riches, even the working class was beginning to earn a little bit of money to put away. The middle class was inching closer to luxury with the money it had made in investment markets. All signs were pointing up.

It was precisely this shared spirit of unbridled optimism, however, that led to the crash and the subsequent depression; the Thirties were particularly horrific specifically because few, in their boom-era delirium, had foreseen that the wave, so long cresting, must eventually break. When, on that Black Monday, the stock market did actually crash, and when bankruptcies and layoffs followed on its heels, the country was unprepared—due to ideology as well as limited governmental infrastructure—to deal with the economic repercussions.14 A similar pattern has shown up presently.

Thus, this paper would look into the different aspects of the Credit crunch. It would look into the parameters of the policies formulated and implemented by the Federal Reserve Bank. It would also evaluate the probable development in the near future and would draw attention to similar problems in the near past and the measure taken. Throughout, I will adhere to the following table of contents:

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  1. Introduction: General View on the Credit crunch
  2. Credit Crunch: United States’ Economic Parameters
    1. Gross Domestic Product
    2. Fiscal Situation
    3. Demographics and the Job Market
    4. Capital Flows
    5. Negative Balance of Payment
  3. Reserve Bank Policies: Damage Control
    1. Policies
    2. Actions
    3. Assumptions
  4. Past Financial Crisis
    1. Incidents
    2. Measures
    3. Results
  5. Comparison with Present Crisis
  6. Recommendation
  7. Conclusion: Bailout plans

Works Cited

Berkowitz, L; Banking and Economy. (New Haven and London: Yale University Press. 2006) pp. 189.

Border, S; Banking: Fire of the Mind (Wellington: National Book Trust; 2006) pp. 227-228.

Cecchetti, Stephen. Federal Reserve Policy Actions in August 2007: Answers to More Questions. Brandeis University; Eurointelligence Advisers Limited. Web.

Deb, J; Introduction to US Finance (Dunedin: ABP Ltd. 2005) pp. 323.

Dell, S; Evaluation of IMF (Dunedin: ABP Ltd. 2006) pp. 78-81.

Dos, M; Future of Thought Process in Financial History (Christchurch: Alliance Publications; 2005) pp. 441-442.

Dollard, John; Modern Fiscal Policies: A look into Tomorrow. (New Haven and London: Yale University Press. 2006) pp. 89-92.

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Fletcher, R; Credit Industry: Beliefs and Knowledge; Believing and Knowing. (Mangalore: Howard & Price. 2008) pp. 188.

FT Research; NY Times; 2008.

Galbraith, John Kenneth. The Great Crash. New York: Houghton Mifflin, 1954.

Grynbaum, Michael M. Persistent Anxiety Over Tight Credit Sends Stocks Plunging. NYTimes. 2008. Web.

Kar, P; History of Consumer Market Applications (Kolkata: Dasgupta & Chatterjee 2005) pp. 145.

King, H; Fiscal Fitness Today (Dunedin: HBT & Brooks Ltd. 2005) pp. 126.

Lamb, Davis; Cult to Culture: The Development of Civilization on the Strategic Strata. (Wellington: National Book Trust. 2004) pp. 243-245.

Macey, Jonathan R, Geoffrey P. Miller, Richard Scott Carnell, Banking Law and Regulation 2007, Aspen Pub, 2008.

Marsh, Bill; A Tally of Federal Rescues; The New York Times; 2008.

Meltzer, Allen H; Congressional Budget office (Spending); Office of Management and Budget; 2008; pp. 41.

Meltzer, Milton. Brother, Can You Spare a Dime?. New York: Facts on File, 1991.

Robert & Utan; Where in Federal Budget This year….; NY Times; 2008.

Singleton, Jeff. The American Dole: Unemployment Relief and the Welfare State in the Great Depression. Westport: Greenwood Press, 2000.

Wolfson, Martin H; Financial Crises: Understanding the Postwar U.S. Experience; M.E. Sharpe; 2007.

Whybrow, Martin. International Banking Systems Market Report. IBS Publishing Ltd, 2007.

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