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The Global Financial Crisis: Analysis and Policy Implications

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The Global Financial Crisis: Analysis and Policy Implications The Global Financial Crisis: Analysis and Policy Implications Dick K. Nanto, Coordinator Specialist in Industry and Trade July 2, 2009 Congressional Research Service 7-5700 www.crs.gov RL34742 CRS Report for Congress Prepared for Members and Committees of Congress The Global Financial Crisis: Analysis and Policy Implications Summary The world has entered a global recession that is causing widespread business contraction, increases in unemployment, and shrinking government revenues. Some of the largest and most venerable banks, investment houses, and insurance companies have either declared bankruptcy or have had to be rescued financially. Nearly all industrialized countries and many emerging and developing nations have announced economic stimulus and/or financial sector rescue packages, such as the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). Several countries have resorted to borrowing from the International Monetary Fund as a last resort. The crisis has exposed fundamental weaknesses in financial systems worldwide, demonstrated how interconnected and interdependent economies are today, and has posed vexing policy dilemmas. The process for coping with the crisis by countries across the globe has been manifest in four basic phases. The first has been intervention to contain the contagion and restore confidence in the system. This has required extraordinary measures both in scope, cost, and extent of government reach. The second has been coping with the secondary effects of the crisis, particularly the global recession and flight of capital from countries in emerging markets and elsewhere that have been affected by the crisis. The third phase of this process is to make changes in the financial system to reduce risk and prevent future crises. In order to give these proposals political backing, world leaders have called for international meetings to address changes in policy, regulations, oversight, and enforcement. On April 2, 2009, heads of the G-20 nations met in the Leaders’ London Summit and announced measures to bolster international financial institutions, stabilize the world economy, and reform and improve the financial regulatory system. The fourth phase of the process is dealing with political, social, and security effects of the financial turmoil. One such effect is the strengthened role of China in financial markets. The role for Congress in this financial crisis is multifaceted. While the recent focus has been on combating the recession, the ultimate issue perhaps is how to ensure the smooth and efficient functioning of financial markets to promote the general well-being of the country while protecting taxpayer interests and facilitating business operations without creating a moral hazard. In addition to preventing future crises through legislative, oversight, and domestic regulatory functions, Congress plays a key role in generating policy options and informing the public. On the regulatory side, the largest questions seem to be how U.S. regulations should be changed and, if changed, how closely those changes are to be harmonized with international recommendations. Congress also plays a role in measures to reform and recapitalize the International Monetary Fund, the World Bank, and regional development banks. On June 17, 2009, the Department of the Treasury presented the Obama Administration proposal for financial regulatory reform. The proposal focuses on five areas and includes establishing the Federal Reserve as a systemic risk regulator, creating a Council of Regulators, regulating all financial derivatives, creating a Consumer Financial Protection Agency, improving coordination and oversight of international financial markets, and other provisions. Legislation in Congress also addresses these issues. Congressional Research Service The Global Financial Crisis: Analysis and Policy Implications Contents Recent Developments and Analysis.............................................................................................1 The Global Financial Crisis and U.S. Interests.............................................................................2 Policy ...................................................................................................................................4 Four Phases of the Global Financial Crisis ............................................................................8 Contain the Contagion and Strengthen Financial Sectors .................................................8 Coping with Macroeconomic Effects.............................................................................10 Regulatory and Financial Market Reform......................................................................12 Dealing with Political, Social, and Security Effects .......................................................15 New Challenges and Policy in Managing Financial Risk ...........................................................20 The Challenges ...................................................................................................................20 Origins, Contagion, and Risk ....................................................................................................28 Risk ....................................................................................................................................31 The Downward Slide ..........................................................................................................32 Effects on Emerging Markets ....................................................................................................37 Latin America .....................................................................................................................44 Mexico .........................................................................................................................46 Brazil............................................................................................................................48 Argentina......................................................................................................................49 Russia and the Financial Crisis............................................................................................51 Effects on Europe and The European Response .........................................................................52 The “European Framework for Action” ...............................................................................55 The British Rescue Plan ......................................................................................................58 Collapse of Iceland’s Banking Sector ..................................................................................59 Impact on Asia and the Asian Response.....................................................................................61 Asian Reserves and Their Impact ........................................................................................64 National Responses.............................................................................................................65 Japan ............................................................................................................................65 China ............................................................................................................................66 South Korea..................................................................................................................71 Pakistan ........................................................................................................................71 Other Countries’ Moves ................................................................................................73 International Policy Issues.........................................................................................................74 Bretton Woods II...........................................................................................................75 G-20 Meetings ..............................................................................................................75 The International Monetary Fund ..................................................................................77 Changes in U.S. Regulations and Regulatory Structure..................................................80 Legislation................................................................................................................................81 Figures Figure 1. Quarterly (Annualized) Economic Growth Rates for Selected Countries ..................... 11 Figure 2. Origins of the Financial Crisis: The Rise and Fall of Risky Mortgage and Other Debt.......................................................................................................................................29 Congressional Research Service The Global Financial Crisis: Analysis and Policy Implications Figure 3. Selected Stock Market Indices for the United States, U.K., Japan, and Russia............33 Figure 4. Exchange Rate Values for Selected Currencies Relative to the U.S. Dollar..................35 Figure 5. Current Account Balances (as a percentage of GDP)...................................................39 Figure 6. Global Foreign Exchange Reserves ............................................................................40 Figure 7. Capital Flows to Latin America (in percent of GDP)...................................................42 Figure 8. Capital Flows to Developing Asia (in percent
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