The Great Credit Squeeze: How It Happened, How to Prevent Another

Martin Neil Baily, Douglas W. Elmendorf, and Robert E. Litan

Executive Summary

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. In this report, we examine the origins of the current crisis and recommend specific policy responses to address both the immediate and long-term challenges.

The U.S. financial system remains in a perilous state. We share the view of some 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. Estimates suggest that billions of dollars of mortgage-related losses have yet to be declared by U.S. financial institutions, and risk spreads remain elevated. Moreover, an absence of dramatic events does 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. Many banks have raised additional capital to bolster their balance sheets, but much more needs to be raised.

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 may well be in recession. In addition, the ongoing drop in housing construction, further expected declines in house prices, tighter lending standards and terms, and this year’s further rise in oil prices are all exerting further downward pressure on economic activity. To be sure, not 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, we agree with the consensus among economic forecasters that a mild recession is the most likely outcome. But 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. Financial markets will always experience swings between confidence and fear; between optimism and pessimism. However, effective regulation and supervision can reduce the frequency, the magnitude, and the broader consequences of these swings. Our diagnosis of what caused this crisis leads directly to our prescriptions for policy changes. We view our proposals as a measured response—more than a fine-tuning of the regulatory and supervisory system, but less than a complete overhaul.

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