In order to evaluate yesterday’s Federal Reserve decision to lower short-term interest rates by a quarter of a percentage point, Americans need to know the magnitude of the current “credit crisis.” Is it indeed a threat to the economy? Or has the “crisis” been exaggerated?

The Fed’s decision, its third cut in four months, shows its concern that the credit crisis in subprime mortgages poses serious economic risks beyond the housing sector. The president of the Boston Federal Reserve Bank, Eric Rosengren, dissented because he thought rates should be cut more, by half a percentage point.

The new plan of Treasury Secretary Paulson, to which several lenders agreed, seeks to contain the crisis by letting some holders of adjustable-rate mortgages keep their low “teaser” rates.

Although perhaps a short-term solution, the government-sponsored rewriting of existing contracts is unprecedented. It’s likely to harm future borrowers, since lenders will be less willing to lend at favorable rates if they believe the government can step in and pressure them to change terms of contracts.

Finance professor of Columbia Business School Charles Calomiris thinks we’re not yet in a crisis. Next Monday, at the American Enterprise Institute in Washington, D.C., he’ll argue that the economy is not in such bad shape, and that the economic consequences of the present credit crunch will be more modest than many have thought.

Taking the opposing side will be the former managing director and chief emerging market economic strategist at Salomon Smith Barney, Desmond Lachman. His view is that credit markets are in as much turmoil now as when the crisis first erupted in August, and that the ongoing housing market bust runs the risk of aggravating that turmoil.

Mr. Calomiris says that it’s too early to conclude that our banking system will be unable to cope with the wave of defaults and will have to curtail lending. Rather, he believes that the financial system will be able to absorb mortgage and securitization shocks in an orderly fashion.

The Columbia professor portrays the housing finance shock as small relative to the total economy. Although losses will probably range between $300 billion and $400 billion, housing prices are slipping but not collapsing. The most precise measure of changes is from the Office of Federal Housing Enterprise Oversight’s index that compares sales prices of the same houses over time. The prices declined by only 0.4% in the third quarter of 2007, the first quarterly decline in 13 years. Prices of the same houses were 1.8% higher a year ago.

Prices declined in 21 states and in just over half of the metropolitan areas tracked by OFHEO. New York State’s prices declined by less than 1%, 0.82% to be precise, which is the second quarter of decline for the state.

The shock to the economy of the problems with subprime loans has been magnified because of the new and widespread way that institutional home loans are bundled and sold to institutional investors. It’s all but impossible to know which mortgages in which bundle are sound. Asset values have declined because some loans within a bundle might go into default and foreclosure. The fraction may be small, or not, but the uncertainty rattles markets.

Mr. Calomiris recommends reforming the ratings agencies, such as Moody’s and Standard and Poor’s, which have failed at the crucial task of measuring the risk of mortgage-backed securities. The government has essentially transferred regulatory power to ratings agencies, which have incentives to grade securities favorably because investors want to be able to buy a wide range of top-rated securities.

Grade inflation affects credit rating agencies as well as schools. Rather than assign letter grades to bundles of securities, the agencies should make clear the default probabilities and risk of investment. Rating agencies sell investors the tools to calculate this for themselves but don’t publish the information.

In contrast, Mr. Lachman sees a much larger crisis in the making. “House prices have started to decline and could very well decrease by 5-10 percent a year over the next few years, which will erode the underlying collateral of bank mortgage lending,” he said over the phone.

He argues that lending standards were relaxed imprudently and credit spreads between risky and less risky assets were reduced to historic lows. Markets were clearly mispricing risk, with sub-prime mortgage lending the clearest case of poor lending decisions. However, bad lending decisions were also made with respect to credit card, auto, and home equity lending.

So, who is right? It’s clear that prior to this summer credit risk was underpriced. In July, the spread between the three-month London interbank rate, or LIBOR rate and the three-month Treasury bill rate was 0.54%, meaning that investors demanded .5% more in returns on risky non-government bonds.

But credit moves in jumps. In August the spread rose to 1.28%, and in November it was 1.69%, meaning that last month investors demanded almost two percentage points more to put their money in banks rather than safe government investments. That doesn’t mean markets aren’t working. They’re working, but at a different set of prices.

Some well-capitalized banks, such as HSBC, are originating new deals every day. There’s plenty of credit for good borrowers at the right price. However, with other investors backing away from any security that they don’t immediately understand, and securities issuers not yet prepared to pay the additional risk premium these investors require to cover their structuring risk, the mortgage-backed and asset-backed securities markets are drying up.

It may be years until there’s a final, retrospective verdict on whether or not America is in a credit crisis this winter. The Fed, though, isn’t waiting for that verdict. They are playing it safe.