Back in September, V.V. Chari, an economist at the University of Minnesota and an adviser to the Federal Reserve Bank of Minneapolis, got a call from a Congressman. Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke were arguing that they needed $700 billion to save the nation's financial system, and the Congressman wanted to know what to make of it all. Chari said he didn't know he hadn't looked at the data. Policymakers kept talking about how banks weren't lending to businesses or to individuals or even to each other, so Chari pulled numbers to see just how badly the credit markets were frozen. He was surprised: he didn't see much of anything wrong.
Is there a credit crunch? Was there ever? Those questions may seem absurd. Throughout the autumn, the interest rate banks charge each other broke one record after another as trust between institutions evaporated, investors stashed so much cash in super-safe Treasuries that yields approached zero, and the private securitization market for mortgages, which keeps capital flowing for more home loans, disappeared. Lehman Brothers collapsed when no one would loan it money, and any number of other firms AIG, Citigroup, GM went hat in hand to the U.S. government, lender of last resort. (Read TIME's Top 10 Financial Collapses of 2008.)
But during all of that, there was also persistent anecdotal evidence that lending to credit-worthy borrowers was doing just fine it seemed every other day some community bank CEO was on CNBC talking about how many loans his institution was making to small businesses and people who wanted to buy cars or houses. As the story of Chari, his surprise realization, and the academic dialogue that followed make clear, understanding what is happening in the economy let alone how to fix it is an incredibly difficult task, even for people who have built their entire careers around doing just that.
In October, Chari teamed up with two other economists, Lawrence Christiano and Patrick Kehoe, and wrote a paper called "Facts and Myths and the Financial Crisis of 2008." In it the economists wrote that the United States was "indisputably undergoing a financial crisis and is perhaps headed for a deep recession," but the nature of the problem, they said, had been completely misrepresented. "Policymakers had made three very specific claims," says Chari. "That banks were not lending to non-financial businesses and households, that banks were not lending to each other, and that the ability of non-financial businesses to access the commercial paper market had declined very sharply." When he and his colleagues plotted Federal Reserve data through mid-October, they found no dramatic decline in any of those categories. Most measures of lending were holding steady; some were even increasing.
Meanwhile, a group of economists at the Federal Reserve Bank of Boston had been noticing the same thing. "We were trying to understand why these numbers looked the way they did," says Burcu Duygan-Bump. Partly because of conversations the economists had with Fed staffers in the banking supervision division, the group came to believe the aggregate data was obscuring the underlying dynamics of the financial system. "If you say New England has a snowstorm with an average snowfall of two inches, that might not reflect the fact that Boston got ten inches and northern Maine got none," says Ethan Cohen-Cole, another of the economists.
In November, Duygan-Bump, Cohen-Cole and two other colleagues Jose Fillat and Judit Montoriol-Garriga put out a paper called "Looking Behind the Aggregates: A Reply to Facts and Myths About the Financial Crisis of 2008.'" In it, they argued that even though overall lending seemed to be robust, that could very well be the result of companies drawing down existing credit lines agreements banks had made in better times and now couldn't renegotiate. In fact, there was plenty of anecdotal evidence in the business press to suggest that was exactly what was happening, that companies were locking in funding not to invest, but to hoard cash for worse times ahead. It wouldn't be hard to imagine regular people doing the same thing with home equity lines of credit. When it came to lending between banks and the commercial paper market, the economists pointed to a shift toward shorter-term lending. Even if overall volumes were holding steady, a reliance on overnight loans would nonetheless indicate that lending wasn't working as usual, they argued.
At about the same time as the Boston Fed piece came out, two finance professors at Harvard Business School, David Scharfstein and Victoria Ivashina, wrote a paper called "Bank Lending During the Financial Crisis of 2008." Scharfstein and Ivashina focused in on a database of new loans made to large corporations and documented a 36% drop during August-October 2008, as compared with the three months prior. They, too, argued that drawn-downs were artificially inflating overall lending figures. Yes, there was lending, but it was involuntary, and often to struggling companies like GM and Tribune that banks might not otherwise give money to. "If credit lines get drawn down by the most vulnerable individuals and companies, that's potentially destabilizing," says Scharfstein.
But did that sort of involuntary lending mean that other potential borrowers were getting crowded out? In a rebuttal to the Scharfstein paper, Chari and his co-authors wrote that they hadn't seen any data showing that banks weren't lending to credit-worthy companies asking for loans simply because certain firms were tapping pre-existing credit lines. "The argument is if you're a new customer walking into a bank, it's impossible for you to get a loan," says Chari. "That story may be true, but there's no convincing evidence that's what's going on."
The back-and-forth can feel esoteric, but, in fact, it goes to the heart of solving the problem. "If losing firms are sucking up all the credit, then isn't the [correct] policy response to let banks cancel lines of credit?" asks Octavio Marenzi, CEO of the banking consultancy Celent, who joined the debate in December with his own paper, called "Flawed Assumptions about the Credit Crisis." After going through a reckoning of the aggregate data including the fact that consumer credit hit a record high in September 2008 Marenzi put forth a couple of possible explanations, including "that policymakers are reacting to the situation of a particular set of businesses and financial institutions and are incorrectly generalizing these to the economy as a whole."
Chari is more cautious. "Our position throughout has been that policymakers likely have access to information that is better than the information we have and that it would be good for them to share that information," he says. "They've been remarkably unforthcoming about the rationale for their interventions." That seems to be a common sentiment. "The one thing they emphasize that we really agree with is they want policymakers to share more data that underlie their decisions," says the Boston Fed's Duygan-Bump. As a new Administration takes office and the process of spending hundreds of billions of dollars to fix the economy continues, it will be as important as ever to question whether the policy responses we come up with are the right ones to make sure not only that they work, but also that they're pointed at the real problem.