For those who spend too much time reading economics blogs, there was a bit of a stir in the last few days over a paper by three economists at the Minneapolis Fed, which essentially said that bank lending to the real economy had not been affected by the supposed credit crisis. There were articles on the topic by Alex Tabarrok, Free Exchange, Mark Thoma, me, Tyler Cowen, Alex Tabarrok again, Free Exchange again, and Tyler Cowen again, among others. My main issue was that the charts in the paper said nothing about new lending, and my guess was that changes in new lending practices would take time to show up in measures of aggregate lending. (Other people raised more sophisticated issues, for example that companies were racing to draw down lines of credit after September 15 out of fear they might not be around for much longer.)

I want to point out one more source of information that might shed light on this question. Every quarter the Federal Reserve conducts a Senior Loan Officer Opinion Survey which asks how bank lending practices have changed over the past three months. In the July survey, every single measure of either willingness to lend or loan spreads (price of loan, less cost of funding) was at or above the tightest values (least willingness to lend, highest prices) seen in the last twenty years. Granted, these are measures of change in lending practices, but they still show a rapid shift in sentiment at banks. The October survey should be underway now, and it’s hard to see how it won’t look even worse.

The impact of the financial crisis on the real economy can be divided into two periods: before September 15 and after September 15. Before 9/15, it was clear that we were in an economic slowdown, beginning with the construction industry, and that troubled assets on bank balance sheets would probably lead to a long-term decline in lending, which might push the economy into recession. Since Lehman failed on 9/15, this general problem sharpened into a short-term credit crunch, in which various parts of the credit markets have stopped functioning or come close to it. Still, though, people want to know, what does the credit crunch mean for me?

Bloomberg reported that almost 100 corporate treasurers held an emergency conference call yesterday to discuss the challenges they are facing rolling over lines of credit with their banks. In some industries, lines of credit are the lifeblood of even completely healthy companies. They operate like home equity lines of credit: you draw down money when you need it (like to make payroll), and you pay it back when your customers pay you back. (In most business-to-business transactions, money changes hands some time after goods are delivered; hence the pervasive need for short-term credit.)

Now, however, banks are demanding much higher interest rates, lower limits, and stricter terms when lines of credit expire, or are even pouncing on forgotten clauses in contracts to force renegotiations of terms. Lines of credit are priced in basis points (a basis point is 1/100th of a percentage point) over LIBOR, a rate at which banks lend to each other. One company saw the price for its line of credit rise from 90 basis points to 325 basis points over LIBOR, which is itself running at high levels. The banks aren’t doing this because they think their borrowers are in any danger of not paying them back; they’re doing it because they want to hold onto the money because they are afraid of liquidity runs. “These are very different circumstances than many of us have dealt with before,” said one treasurer. “We’re all having to learn every day about provisions that were buried in documents executed 15 years before.”

This is how fear in the banking sector translates very quickly into higher costs and less cash for healthy companies in the real economy. Fortunately there are clear steps that Washington can take to bolster confidence in the banking sector, which will cause the flow of money through the real economy to pick up.

Readers of this blog will already know that we believe that (a) the credit crisis of the past two weeks is serious, (b) there is a real risk of a global recession,  but (c) there are practical steps that governments can take to minimize the damage to the economy. Several of my friends have asked me what this means for them. And I wanted to repeat here what I told them: nothing cataclysmic is going to happen to your money.

First, let’s start with deposit insurance. In general, your checking accounts, savings accounts, and CDs are guaranteed by the FDIC up to $100,000 per account holder per bank, and that is likely to go up to $250,000 shortly. Some people have been pulling money out of banks even though they are below this limit, because they don’t know about the insurance, don’t trust it, or don’t want to deal with the hassle. Now this is something with which I have personal experience. I had a CD (<$100K) at IndyMac Bank when it failed earlier this year. The FDIC took over the bank over the weekend and by Monday everything was exactly the same as on Friday: same web site, same call centers, same CD account, everything. The only change was that the name had changed from IndyMac Bank to IndyMac Federal Bank. I didn’t have to file a claim or even call anyone. My CD is still there, earning interest (at 4.15%, by the way). So if you have an insured account, you shouldn’t worry about it. (Some people have pointed out that the FDIC could run out of money if too many banks fail, but it’s a certainty that the government would put more money in the FDIC in that case.)

Second, you may have investments in stocks or bonds. Individual securities could be wiped out, and some have been already; not only did Lehman shareholders lose their money, but bondholders lost most of their money, too. But stocks are ownership shares in real companies, and most companies are not going to stop operating overnight. They will continue to buy, build, and sell whatever they buy, build, and sell today. Some will go bankrupt, as always happens, and some will lose value, but some will gain value. And it’s not likely that every company in the U.S. will lose all of its value at the same time. So you should be diversified, but you should always be diversified.

Third, there are your debit and credit cards. As long as you have money in your bank account, you will still be able to get at it using your debit card. It is unfathomable that a bank would need cash so desperately that it would block access to deposit accounts (and remember, those accounts are insured). When banks are at risk of failing, they want to preserve as much value as they can to sell to an acquirer. A large part of the value is the base of depositors and the ongoing banking operations. As for credit cards, it is possible that banks will gradually reduce the amount of credit they have extended by offering fewer cards, tightening the terms, reducing credit limits, and even unilaterally canceling some people’s cards. This could affect some people. But again, there is no reason why the credit card system as a whole would fail.

Now, if there is a recession, and that is certainly a possibility, it could have serious consequences for you: you could lose your job, your rate of salary increases could go down, your house could continue to lose value, your investments could lose value, and so on. As we’ve said, there are concrete steps that governments can take to minimize the duration and severity of any recession. In any case, you’re not going to wake up one day and find out that your money is gone. (Unless you keep your money under your mattress, in which case someone might steal it.)

One of the biggest questions about the financial crisis – one heard from Capitol Hill to radio talk shows to casual conversations with friends – is why it matters for ordinary people. One major reason a significant proportion of public opinion is against the rescue plan is the general failure to make the connection between panics in the financial sector and the ordinary lives of everyday people; simply saying that the plan is necessary to prevent (or moderate) a recession smacks too much of “trust me” to be credible.

The connection is that much of the ordinary activity in the real economy relies on credit – think no further than the volume of purchases made using credit cards. (Although banks have been reducing credit limits, there is little risk for now that credit cards will stop working overnight.) And in today’s conditions, when many financial institutions are potential victims of liquidity runs, lending has virtually ground to a halt. The New York Times has an article today about the impact that the current crisis is having on local governments suddenly unable to raise money for ongoing projects such as highway repairs and hospital expansions. Across the country, local governments issued $13 billion in fixed-rate bonds in the first half of September – and $2 billion in the second half. A sudden 87% drop in a major source of municipal funding is a very real impact of the financial crisis, and one that will necessarily result in both fewer services and fewer jobs for taxpayers.