Reducing the Likelihood of Financial Crisis

Douglas W. Elmendorf
Douglas W. Elmendorf Former Brookings Expert, Dean - Harvard Kennedy School

May 14, 2008

Chairman Schumer, Ranking Member Saxton, and Members of the Committee, I appreciate the opportunity to appear before you today.

The current financial crisis in the United States poses two separate challenges for economic policy: one, to resolve the immediate problems; the other, to reduce the likelihood that these problems recur. My testimony will focus on the second of these challenges. The diagnosis and prescriptions I will offer are based on a report I am writing with my Brookings Institution colleagues Martin Baily and Bob Litan, of which a preliminary draft will be released this Friday.

However, I alone am responsible for any errors or inadequacies in my comments. The U.S. financial system remains in a perilous state. I share the view of some other observers that the worst of the credit crisis is probably behind us. But that is by no means certain, and, even if it turns out to be right, the return to normal financial conditions will be a slow and uneven process.

Indeed, we have already seen two false dawns during this crisis. Last October and again this January, financial conditions appeared to be stabilizing—only to be followed by renewed widening of risk spreads, further declines in asset values, and struggles for survival by some financial intermediaries. The Federal Reserve has responded to this turmoil vigorously and, in my view, appropriately by reducing the federal funds rate 3¼ percentage points and by providing significant liquidity as the so-called “lender of last resort.” Through these actions, the Fed has so far prevented what might have been a cascade of defaults and institutional failures. Hopefully, the relative calm since the sale of Bear Stearns in March is a precursor of further stabilization.

Still, estimates suggest that billions of dollars of mortgage-related losses have yet to be declared by U.S. financial institutions. Interbank loan rates remain elevated as banks hoard liquidity and continue to be concerned about the creditworthiness of other institutions. The slowing of the economy is depressing loan repayment rates. Thus, the risk of a large institutional collapse has been reduced but not eliminated. More important, an absence of dramatic events going forward will not imply that financial intermediation is back to normal. The weakened state of banks’ balance sheets will make them less willing to lend to households and businesses for some time to come. For example, the Fed reported recently that a large fraction of banks tightened lending standards and terms across a broad range of loan categories in the first quarter of the year. Many banks have raised additional capital to bolster their balance sheets, but much more needs to be raised. If that does not occur in a timely way, we could face a constriction of lending to households and businesses analogous to the Japanese experience in the 1990s.

The turmoil in the financial system is important primarily because of its impact on the overall economy. The latest data on spending, employment, and production suggest that the economy is very likely in recession, and several forces are exerting further downward pressure on economic activity:

  • Housing construction continues to fall sharply, and the large supply of unoccupied homes offers no comfort that construction will recover soon.
  • House-price futures and analysts’ estimates of sustainable house prices point to further declines, and the resulting loss in household wealth will depress consumption to a growing extent over the next year.
  • The tightening in lending that I just mentioned will further restrain spending, as will the weak level of consumer confidence and the rising trend of home foreclosures.
  • And this year’s further rise in oil prices amounts to a tax on households whose full effect on spending has probably not been apparent yet.

I do not mean to suggest that all of the economic news is bad. Data for the first quarter of the year were more favorable than many had feared, and the decline in the value of the dollar is buoying net exports. Moreover, powerful economic stimulus has been set in motion through the actions of the Federal Reserve and the tax-cut legislation passed by Congress in February. Therefore, I share the consensus view among forecasters that a mild recession is the most likely outcome. But I would caution that a more serious economic downturn is entirely possible. The experience of the U.S. financial system and economy during the past year vividly demonstrate the need for reform of our financial regulation and supervision. Let me offer four principles to guide reform and the specific recommendations that follow from them: