The credit crisis has spread out to the entire US economy, as seen in the previous blog, and has caused more than enough damage. So what did the US government and the Fed do in order to improve and try to rescue the situation?

Well first of all, the Federal Reserve Bank has taken several steps to work on the crisis, along with central banks around the world. Their main actions are, as Ben Bernanke said, „efforts to support market liquidity and functioning and the pursuit of our ecnomic ojectives through monetary policy.“
Between September 2007 and March 2008 , the Fed decreased the interest rates from 5.25% down to 2.25%, one of the open market operations used by the Fed to regulate the supply of money in the US economy. By doing so, they allow people and companies to borrow more in order to keep invesment active, one of the main components for economic growth, and as well stimulate consumption in this close-to recession situation.
Secondly, the Fed and other central banks have increased their loans to member banks to make sure they have sufficient liquidity. These are basically short-term loans collaterised by government securities. These mortgage backed securities are the CDO’s that were the main problem of the crisis and as a result, these securities were seen as illiquid assets. So, by accepting the securities (by the government) in exchange for loans, the banks benefit by being liquid again and regain trust from borrowers and investors, which in the end helps stimulate the economy again.
Furthermore, on March the 4th, Bernanke delivered a speech called „Reducing Preventable Mortgage Foreclosures“. He proposed some solutions about the trouble with foreclosures. These keep increasing, meaning that people lose their collateral (house) and thus spending power. As a result, a negative cycle develops in which there is less purchasing power, leading to less consumption, leading to decreased company revenues and thus decreased investment and salaries and so on and so forth. In order to avoid this, Bernanke proposed a reduction in loan principal amounts. Compared to interest only loans and standard loans, fixed principal loans generate the lowest total interest charge over the term of the loan, meaning that it’d be easier for people to repay their loans and thus have a greater chance to keep their houses as collateral.

Many companies and banks have suffered from this crisis and billions of dollars have ben lost. The Fed thus helped some of them and one of the most recent „actions“ is the Bear and Stearns case, which is one of the largest global investments banks, securities trading and brokerage firms in the world. In March 2008, the Fed provided funds to enable J.P Morgan Chase to purchase and „save“ Bear Stearns. This company had important mortgage-backed securities (MBS) investments that had recently strongly decreased in value, which could then have led to further devaluation in similar securities in the vulnerable banking system.


Then, the US government also had a say in this whole crisis. The „booster package“ mostly comprised of tax reductions, which would then leave more disposable income and thus allow more consumption as well, hopefully stimulating the economy enough to avoid a recession.
Furthermore, Bush introduced several programs, in order to ¨freeze¨ the mortgages of a certain number of mortgage debtors holding ARM´s. Bush also created a refinancing facility called FHA-Secure, which is part of a collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance.

During February 2008, a program called "Project Lifeline" was also announced, whereby six of the largest U.S. lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days to 90 days or more. This program was to encourage more loan adjustments, to avoid foreclosures, which are a thread to the economy right now.
The government is also considering action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling and qualifications of lenders. These regulations or guidelines could influence the nature and the transparency required for the very complex legal entities and securities involved in these transactions.

All in all, the Fed and the government basically use Keynes’ and Milton’s theories, whereby the government counteracts the economic cycle through monetary and fiscal policies. They
hope to create a positive multiplier in the Circular Flow of Income through these interventions, however, this might lead to the opposite. Indeed, by pumping more money into the economy, there will eventually be inflation, which combined with unemployment during this crisis, could lead to stagflation, one of the worst case scenarios.
So, let’s just wait and see.