The United States is indisputably undergoing a financial crisis and is perhaps headed for a deep recession. Here we examine three claims about the way the financial crisis is affecting the economy as a whole and argue that all three claims are myths.

We also present three underappreciated facts about how the financial system intermediates funds between households and corporate businesses.Conventional analyses of the financial crisis focus on interest rate spreads.

We argue that such analyses may lead to mistaken inferences about the real costs of borrowing and argue that, during financial crises, variations in the levels of nominal interest rates might lead to better inferences about variations in the real costs of borrowing. Moreover, we argue that even if current increase in spreads indicate increases in the riskiness of the underlying projects, by itself, this increase does not necessarily indicate the need for massive government intervention.

We call for policymakers to articulate the precise nature of the market failure they see, to present hard evidence that differentiates their view of the data from other views which would not require such intervention, and to share with the public the logic and evidence that burnishes the case that the particular intervention they are advocating will fix this market failure.

Download Facts and Myths about the Financial Crisis of 2008

PDF format, 354KB, 41Pages.

V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe
Federal Reserve Bank of Minneapolis
Research Department
Working Paper 666, October 2008.

Visit Federal Reserve Bank of Minneapolis Website

Conclusion
Our analysis has raised questions about the claims made for the mechanism whereby the financial crisis is affecting the overall economy. We emphasize that we do not dispute that the United States is undergoing a financial crisis and that the United States economy may currently be in a recession or may experience one in the near future, perhaps even a very deep one. We do not dispute that spreads between safe securities and risky securities have increased.

Our main point is that policymakers have not done the hard work of convincing the public - or even academic economists - of the precise nature of the market failure they see, of presenting hard evidence, not speculation, that differentiates their view of the data from other views, and the logic by which the particular intervention they are advocating will fix this market failure. We feel that a trillion dollar intervention warrants a bit more serious analysis than we have seen.

Our analysis is based on publicly available data. Policymakers have access to other sources of data as well. Policymakers could well believe that bold action is necessary based on data that are different from that considered here. If so, responsible policymaking requires that they share both the data and the analysis that underlies the need for bold policy with the public.

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