Publisher Council on Foreign Relations Press
Release Date March 2009
Council Special Report No. 45
A new report from the Council on Foreign Relations (CFR), Lessons of the Financial Crisis, calls for major economic reforms, both to avoid fueling excessive corporate and individual borrowing in the future and to make the financial system much more resilient in the face of falling asset prices. "The crisis offers a sobering lesson about the dangers of policies that fuel the rapid buildup of debt across the economy," says the report. "Excessive leverage in the economy needs to be prevented because credit does not return to normal once asset prices stop rising and start falling. It becomes dangerously scarce."
Although many are arguing that the crisis is a direct result of lax regulation, "U.S. monetary policy, taxation policy, and home ownership promotion policy were so conducive to credit expansion that the idea, understandably popular in Washington and Brussels, that preventing future such crises can be accomplished simply by waking up regulators ‘asleep at the switch' is dangerously simplistic," says Benn Steil, senior fellow and director of international economics at CFR. "The United States in particular, given that it effectively sets monetary and credit conditions for a significant portion of the global economy, needs to put in place policies that can better discourage, recognize, and curtail a credit boom, and ensure that systemically important financial institutions can withstand its unwinding." Steil lays out specific recommendations for reforming the international financial architecture, bank capital standards, borrower screening and monitoring, corporate and individual taxation regimes, over-the-counter (OTC) derivatives markets infrastructure, corporate governance, and monetary policy.
The report's recommendations include the following:
- Corporation finance: "U.S. corporations face an astounding 42 percentage-point effective tax rate penalty for equity-financed investments. ...It is imperative that this disparity be addressed as part of wider efforts to make the tax system less distortionary in its effects on economic activity generally."
- Mortgage finance: "[M]ortgage interest deductibility...does nothing to assist low-income families, as few of them pay federal income tax. ...It should, together with home equity loan interest deductibility, be dramatically scaled down once the housing market has revived."
- Capital standards: "Capital requirements should be made countercyclical, rather than procyclical, by raising them in line with growth in a bank's assets--that is, banks should be obliged to build up their capital faster when credit is expanding."
- Credit ratings agencies (CRAs): "The second flaw in the [bank capital] regime is the role of officially sanctioned credit ratings agencies in assigning the risk ratings that determine capital requirements. ...But other, sounder metrics are available for this purpose; for example, the size of the asset's yield spread over Treasurys. CRAs...are rife with conflicts of interest that cannot be regulated away...and should not have any formal role in the regulatory process."
- OTC markets infrastructure: "[T]he over-the-counter (OTC) derivatives markets, particularly credit default swaps...involve no central clearinghouse to track exposures, net trades, novate trades, collect margin, and absorb default risk. The result was an unmonitored and unchecked build-up of exposures that threatened to bring down other significant market participants, and ultimately forced the U.S. government to bail out AIG at massive, and still growing, cost. ...U.S. and European regulators (whose institutions account for the vast bulk of OTC trading) should therefore oblige regulated central clearing, whether trading is on- or off-exchange, once volume barriers in a given contract are breached."
- International financial architecture: "[One] option is for countries, particularly smaller ones, to self-insure against currency crises by replacing their national currencies with one of the two globally accepted means of international payment, the dollar or the euro. ...Countries that are dollarized...and euroized have in the current crisis been spared the devastation of mass capital flight. Countries on the periphery of the eurozone...have suffered far more from the global financial upheaval than their euroized neighbors."