The economic challenges facing the global economy are increasing in depth and intensity. Major developed economies are now in recession, and growth in developing countries is slowing, as world trade declines and capital flows plunge. November export reports from Korea (-18%), India (-12%) and China (-2%) were particularly startling.

In the United States, recent indicators suggest a decline in economic activity even greater than our prior pessimistic forecasts. Recent data on employment, trade and sales imply an annualized decline in fourth-quarter gross domestic product (GDP) exceeding 6%.

The major underlying cause of this severe global slowdown is the availability, price and terms of credit. Banks are still hoarding cash, deleveraging their balance sheets and tightening lending standards. Credit markets — despite some notable exceptions like conventional mortgages and commercial paper — remain impaired and many risk spreads are near record highs. The credit freeze, in other words, appears to be far from thawing.

The key question for investors is, What is necessary for positive economic growth to resume and financial markets to recover? Two things, in our view, are essential:

* Credit needs to begin flowing again, and

* Spending by households, businesses, foreigners and governments — key constituents of any country's GDP — in aggregate, needs to increase. Lack of demand from three of these constituents (households, businesses and foreigners) is causing the current contraction in economic activity.

For credit to flow and spending to increase, the following conditions must be met:

* The banking system must be working — i.e., lending — and credit markets must be functioning, and

* Growing resources (incomes, profits or tax revenues) and a return of confidence must be occurring among economic entities.

The severity of credit problems and declining economic activity indicate that these conditions will now occur only through aggressive monetary and fiscal policies. At the moment, households are spending less as income growth slows and wealth declines. Businesses, facing increasing margin pressures, are reducing inventories, capital spending and payrolls. And export demand, reflecting the slowdown abroad, is diminishing.

This leaves central banks and governments as the spenders of last resort. Fortunately, these institutions are adapting to this role and demonstrating a willingness to aggressively spend and experiment with policy initiatives, hopefully where appropriate. Recent moves by the Federal Reserve are the epitome of such reactions.

The Fed has declared a willingness to use all available tools to improve credit flow and promote the resumption of sustainable growth. The Bank's list of measures — undertaken, under review or options for future consideration — is impressive and includes:

* Slashing the Fed Funds rate from 1% to virtually zero,

* Committing to keep the Fed Funds rate low for some time,

* Purchasing even more securities issued by Fannie Mae and Freddie Mac,

* Expanding its facility to backstop asset-backed securities, and ensuring the flow of funds for car loans, credit cards and student loans,

* Evaluating the benefits of purchasing long-term government securities,

* Possibly purchasing any private asset, at any price and in any quantity the bank chooses,

* Buying any foreign currency asset,

* Financing the government on any scale, and

* Issuing its own debt, enhancing its ability to increase lending and asset purchases while maintaining control of interest rates.

The focus of Fed policy is shifting from interest rates to its balance sheet operations. The Fed clearly still wants low Treasury yields. They're the benchmark to which risk spreads for other loans are added. But the Fed's expanding balance sheet — which could soon exceed a record $3 trillion — is now the key policy tool. The Fed's balance sheet will continue to grow as the bank lends and purchases assets, in effect printing vast quantities of money.

The Fed is working closely with the Treasury Department, which is likely to soon announce a new effort to lower mortgage rates. In addition, massive new stimulus programs are coming with the new administration. For example, President-elect Obama has pledged to revive the economy and create jobs by making the single largest new investment in infrastructure since the Eisenhower administration. The total new spending programs could approach $1 trillion during the next two years. Policymakers have acknowledged that a major risk in the current environment is a lack of boldness.

Stocks rallied strongly after the Fed moved into uncharted waters by dropping the Fed Funds rate to near zero and focusing on expanding its balance sheet going forward. Riskier asset prices, while still highly volatile, had already been exhibiting encouraging underlying resilience, despite the outpouring of negative economic news.

This performance, in our judgment, was attributable to many of the silver linings we have previously noted. High on that list were attractive valuations, lowered expectations, and the anticipation of meaningful new monetary and fiscal policies. The market's response to the Fed's actions and the intentions of the new administration seem to confirm the importance of new policy initiatives.

It's still too early to call an end to the current bear market. More unsettling economic, financial and corporate news is coming. But government policy responses will increasingly counter these unfavorable circumstances as 2009 unfolds, and should therefore significantly contribute to eventual recovery in the global economy and financial markets.