There is no precise definition of “financial crisis,” but a common view is that disruptions in financial markets rise to the level of a crisis when the flow of credit to households and businesses is constrained and the real economy of goods and services is adversely affected. Since mid-2007, central bankers — including the Federal Reserve — have labored to keep the downturn in U.S. subprime housing from developing into such a crisis. While subprime problems were widely anticipated, the subsequent spread of turmoil into many seemingly unrelated parts of the global financial system was not.
Many losses occurring in diverse firms and markets — often quite severe — have features in common: the use of complex, hard-to-value financial instruments; large speculative positions underwritten by borrowed funds, or leverage; and the use of off-the-books entities to remove risky trading activities from the balance sheets of major financial institutions. It is not yet clear whether financial market problems will significantly slow the economy: many believe that the current episode is simply the downside of a normal credit cycle, that is, a natural corrective to several years of unusually easy credit conditions. On the other hand, some analysts identify market dynamics that may amplify the effects of financial shocks and have the potential to generate self-reinforcing, downward financial and economic spirals. The Federal Reserve has used its traditional tools to avert such an outcome: it has lowered short-term interest rates dramatically and injected billions of dollars into the banking system to support market liquidity and keep credit flowing. In addition, the Fed has expanded its sphere by making funds available to securities firms, which it does not regulate, and has provided funding to underwrite the rescue-through-acquisition of Bear Stearns, a leading investment bank.
The duration of the current instability is in marked
contrast to financial shocks of recent decades — stock market crashes, bond market disruptions, the 9/11 attacks — when the central bank was able to contain market problems quickly with little or no interruption of U.S. economic growth. Depending on how soon normal market conditions are restored, and at what cost, policy makers may consider whether regulators have access to adequate information about market conditions, and whether currently unregulated market participants should be subjected to disclosure and reporting requirements.
In addition, the social costs of failed financial speculation may be judged great enough to warrant new restrictions designed to lower the incidence of losses that have system-wide impacts or to put the markets and the economy in a better position to weather such shocks.