How to Better Prepare for the Next Financial Crisis
Morris Goldstein | Institute for International Economics | March 2010
The financial crisis demonstrated that economic difficulties arise as a result of misguided financial as well as monetary policies. With the crisis a recent memory, the chances are good for tackling the root of the problem and reforming the old system, since both spheres are interconnected and hence need to be reformed in concert. For one, the formation of asset bubbles needs to be avoided and much better regulation is needed for Too-Big-To-Fail financial institutions (TBTF). Furthermore, “beggar-thy-neighbor” exchange rates must not be tolerated.
To begin with, there is no reliable method for identifying asset bubbles in a timely fashion. Hence it is usually cheaper to wait until the bubbles burst by themselves and handle clean-up costs afterwards. In the wake of the financial crisis however, new strategies are called for to preclude the development of excessively large bubbles in the first place. In the United States, one possible approach consists of the formation of a systemic risk oversight council, which would need to include the central bank, the Treasury, and the most important regulatory authorities. Mechanisms need to be developed to prevent financial institutions from growing so large as to become too big to fail. For those TBTF institutions already in existence, procedures need to be developed to allow them to reduce their size or to fail in a manner that does not threaten the system:
- TBTF financial institutions need to develop wind-plans to reduce their complexity.
- Alternative resolution approaches need to be in place in order to preclude recourse to last-minute bailouts in time of crisis.
- Market discipline must be adhered to under all circumstances: Credits should not be repaid at par, and bigger players in the field should not be allowed to buy up insolvent firms.
- The size of financial institutions should be limited in terms of its relationship to a country’s GDP.
In sum, a comprehensive “belts-an-braces” approach should undertake to combine these various policy tools in order to achieve greater effectiveness. In terms of monetary policy, the IMF ought to be consulted wherever a country’s global balance of payments exceeds 4% annually. The IMF could impose penalties on individual countries, such as the publication of the country-relevant data. In the interest of open world markets and stability, the IMF and the World Trade Organization WTO will need to play the role of the referee in the global arena.
The recent economic crisis has clearly shown that a number of issues remain to be dealt with in the spheres of financial and monetary policies. But precisely for this reason, the crisis represents a unique opportunity to reform the existing system and develop new regulatory mechanisms as well as more effective sanctions. The point is not to render life more difficult for certain countries or financial institutions, or to ostracize them based on the difficulties they encounter in the financial or monetary spheres. Rather, they should be encouraged to participate more responsibly in the world financial system and hence in the prevention of future crises.
This summary was prepared by the Atlantic Community Editorial Team from "Confronting Asset Bubbles, Too Big To Fail, and Beggar-Thy-Neighbor Exchange Rate Policies" published here by the Peterson Institute for International Economics.
