GD Brief: Responding to the Financial Crisis

 

This Great Decisions Brief is derived from FPA's Great Decisions 2011 materials. For a deeper exploration of this topic order Great Decisions 2011 and join our community discussion programs in your area.

Current Situation

The U.S. is slowly recovering from the largest financial crisis since the Great Depression. The 2008 economic meltdown reverberated across the globe, causing governments to take drastic measures to save their teetering financial institutions and prevent devastating long-term effects on their populations. After a $700 billion government bailout of banks, insurance agencies, and auto industries in the U.S., Washington may have averted a complete disaster. But unemployment rates remain higher than they have in decades, small business are having increasing trouble making ends meet, while big banks have largely returned to pre-crisis profit levels and beyond. To ensure a more secure future, how extensive should financial regulation be, and what is the best way to enforce it? Is economic growth more important than stability? Can there be efficient international regulation, and if so is the U.S. in a position to lead this effort?

History

Most experts attribute the recent meltdown to decades of poorly enforced, or non-existent, financial regulation. 2007-2008 was the apex of a massive credit crisis, largely initiated by an immense increase in sub-prime mortgages in the early 2000s. Initial warning signs regarding deregulation were ignored by key financial advisors, the Treasury, and Congress, who all cited the rise in housing sales as a positive sign of a growing economy. With no oversight, banks increased risky investments. Yet the bubble soon imploded- borrowers across the country defaulted on their loans and lenders were left with no security. The government takeover of Fannie Mae and Freddie Mac, the subsequent collapse of investment bank giants Lehman Brothers and Merrill Lynch, and AIG’s sudden bankruptcy shook stock markets across the globe. The complexities of the crisis aside, growing popular discontent centered on the greed of Wall Street. Though begrudgingly, few could ignore the necessity of government intervention to prevent a depression.

Challenges

The crisis proved the need for increased transparency in financial intuitions. Yet key players, from heads of investment banks to prominent economists and financial advisors in the White House, disagree over how to proceed. It is doubtful that the culture of big risk-big gains will ever change on Wall Street. Many argue that increased regulation by governments only hinders economic growth, which is at this moment more important than financial stability. Moreover, banks are resistant to accept governmental oversight, especially since many have paid back their bailouts to be rid of contingency clauses. Some challenges are more concrete: as one expert notes, rating agencies played a huge role in the crisis, yet they continue to operate under a conflict of interest. Because issuers pay rating agencies for their grades, agencies have an incentive to give better ratings, thus masking risky financial packages. Ratings agencies also present a challenge since most are based in the U.S., to the chagrin of many European players in the financial system. As the crisis showed, banks and governments are connected across borders. Yet how can regulation be enforced on an international scale?

Opportunities

The economy remarkably seems to be on an upward hilt. Agreements at Basel III to increase bank capital requirements and the 2010 G-20 Summit are examples of positive international cooperation to address problems in the global financial system. While debates over financial oversight will continue, some economists argue that crises are an inevitable part of modern economies, and government interference only disrupts natural shifts in the free market. However, most people remain concerned about the future of financial institutions and their reluctance to change. If anything, the economic crisis did dispel all myths of “too big to fail,” and prompted worldwide scrutiny of Wall Street’s actions.

Policy Options

Domestic

  1. The U.S. government should take a more direct role in administering financial oversight in order to prevent future crises
  2. The U.S. government should lobby for increased financial regulation, but leave key decisions to the banking community
  3. The U.S. government should not get involved in the free market, as it hinders economic growth

International

  1. The U.S. should lead a global effort to create certain universal regulations on financial intuitions and play a key role in ensuring their enforcement
  2. The U.S. should engage in international dialogue regarding regulation, but as the key cause of the crisis is not in a position to propose solutions
  3. Governments should not attempt to find mutual agreement regarding financial oversight, and should leave market decisions to the free market

Glossary

Basel Committee on Banking Supervision- Established in 1974, followed by most national financial regulators around the world; among other things, it makes bank lending to government “risk free”, and cheaper than loans to private firms.

Basel III – The most recent of the Basel Accords, created in response to the global financial crisis. Notably, it increases bank capital requirements.

Dodd-Frank Wall Street Reform and Consumer Protection Act – Singed into law by President Barack Obama in July 2010 to address key problems that led to the crisis- an act to “promote the financial stability of the United States by improving accountability and transparency in the financial system.”

Federal Reserve – Central bank of the United States, in charge of overseeing all financial institutions, currently led by Chairman Ben Bernanke

G-20 Summit, Toronto 2010 – Summit meeting of G-20 leaders to address financial markets and the world economy, held in June 2010. In attendance were finance representatives from 19 countries and the European Union, as well as six invited nations and world leaders.

International Monetary Fund- An international organization created in 1945, currently represented by 187 countries. Aims to ensure global financial stability, promote international trade and sustainable economic growth.

Subprime lending – Loans made to previously undesirable candidates, i.e. youth or those with bad credit histories, who might not be able to make repayments.

U.S. Department of the Treasury – Key responsibilities include printing all currency and collecting taxes for the United States government.

 

This Great Decisoins 2011 Brief was written by Sarah Marion Shore


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