The sub-prime crisis that began in August 2007 has been called the worst financial crisis since the Great Depression by George Soros, Joseph Stiglitz, the International Monetary Fund, and other commentators.2 Furthermore, Soros thinks that the crisis may be affecting the real economy, though the extent of the effect is not yet fully known. In this paper, we study how the subprime crisis may spill over from the financial sector to the real economy.
If there is a spillover, does it manifest itself primarily through reducing consumer demand and consumer confidence? Is there also a supply-side channel through tightened liquidity constraints faced by non-financial firms? Understanding these channels should help the design of an appropriate policy response. The view that the real economy may suffer from a credit crunch as a result of the subprime meltdown is far from self-evident. As Bates, Kahle, and Stulz (2007) carefully document, non-financial firms' held an abundance of cash prior to the crisis.
According to them, “the net debt ratio (debt minus cash, divided by assets) exhibits a sharp secular decrease and most of this decrease in net debt is explained by the increase in cash holdings. The fall in net debt is so dramatic that average net debt for U.S. firms is negative in 2004. In other words, on average, firms could have paid off their debt with their cash holdings.” Given the apparent secular downward trend in cash holdings, the net debt ratio was likely even more in the negative territory by mid-2007, right before the start of the full-blown subprime crisis in August 2007.
This at least suggests the possibility of no serious liquidity tightening outside the financial sector. Probably out of this belief, Federal Reserve Chairman Ben S. Bernanke called strong corporate balance sheets “a bright spot in the ...