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 longterm
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 mortgagerelated
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.