The Arab Academy

For Banking and Financial Sciences

MBA course 2008-2009

Financial
crisis of 2008

A Term Paper Prepared By:

Walid Hosn Abdelghany

Mohamad Talat
Ahmad Samy
Under The Supervision Of:

Professor M. Atef (PhD)

CONTENTS
Introduction
American History, Capitalism and the
Crisis on Wall Street

Overview
United States Economic History and Government Intervention
The American Revolution
The Great Depression 1929-1941
Tax Cuts and Budget Deficits
Recent Problems on Wall Street and the Role of Government
Problems that must be solved

Financial Crisis of 2008 Questions to be

Answered

How did USA get into this mess?

The four shockwaves of the financial crisis

o
The first wave U.S. sub-prime mortgages
o
The second wave the growing risk of systemic default
o
The third wave recession in developed countries
o
The possible fourth wave a severe global recession

Who is to blame?
What should USA do now?
What should USA do in the long term?
What not to do lessons from the Great Depression

The Role of the International Monetary

Fund (IMF)
Whither the IMF?
Immediate Crisis Management
Reforming Global Macroeconomic Surveillance

Lessons to be Learned
Lessons From Japan
Lessons From Chile

Introduction
Philosophically, it is important to examine how the current financial crisis evolved
and what the root circumstances are before addressing issues of how to address the
problem and what effect various actions on the part of the government might or might
not generate. It is indeed ironic that some of the same mechanisms that fuel an
economys growth at one point in time turn out to be the very same mechanisms that
contribute to its decline at a different point in time, which is essentially where we are
today. Over the last decade we saw a few things happen, which when considered in
isolation, would be considered innocuous and even hugely beneficial to the economy.
Much like an individual medications, that are so beneficial in fighting diseases, in
combination may interact to quietly create the perfect stormthe financial
catastrophe that the world is experiencing is the result of an interaction of
circumstances in the financial sector.
At the end of the previous century and beginning of the current, certain policy shifts
occurred at the federal level that are important contributors to todays events. The
Gramm-Bliley Leach Act and the Commodities and Modernization Act were passed
in 1999 and 2001, respectively. What these legislations accomplished was essentially
the rescinding of the same banking regulations that were put in place by the Glass
Steagall Act. Glass Steagall established the Federal Deposit Insurance Corporation
and also placed barrier between commercial banks and investment banks. This
legislation came in the wake of the 1929 stock market crash and it was instituted in
1933. The Gramm-Bliley Leach Act of 1999 essentially removed the barrier and
allowed commercial banks to operate as investment banks. The justification for this
was to place U.S. banks in a stronger position to compete internationally with banks
from other countries that were not so constrained.
Two important banking activities can be traced to the joint operations in the
commercial and investment arenas. The banks that evolved under deregulation in the
early part of the century were able to securitize their commercial lending activities
and use the securities as leverage to raise funds. With the new administration in 2000,
the Federal National Mortgage Association (also known as Fannie May) and the
Federal Home Loan Mortgage Corporation (also known as Freddie Mac) were given
the mission to increase home ownership in the U.S. At some point, this mandate to
increase home ownership was interpreted to mean that the goal should be reached
regardless of whether home buyers could afford to sustain home ownership. Such
unwise lending required a mechanism to insure against default and the so-called
Credit Default Swap (CDS) was born. Initially, the CDS were meant to apply to
municipal bonds, corporate debt, mortgage securities and were sold by banks, hedge
funds, and other institutions. However, in the last decade these CDS contracts
expanded into structured finance contracts containing pools of mortgage and, more
importantly, these pools contained subprime borrowers that were increasingly getting
loans through the Freddie Mac and Fannie May programs. In isolation, CDS is an
insurance contract taken out by banks to protect their loans against default, much like
and individual or family would secure a homeowners insurance policy to protect their
investment in a home. However, by referring to them as swaps (and not insurance)
they became classified as investment products rather than insurance products. This
allowed the CDS industry to avoid the regulation and scrutiny that applies to the
insurance industry and rendered CDS totally outside the purview of any regulatory
mechanisms.

The pieces for an explosion of classic proportions were all in place by early 2005. All
that remained was a match to set off the explosives. That match came in the form of a
downturn of the housing market and the resulting waves of default among subprime
borrowers that caused the holders (which comprised all major banks) of trillions of
dollars in CDS contracts to exercise their option to trigger the insurance policies.
Unfortunately, there was no one on the other side of the relationship to honor them
because, thanks to deregulation, the CDS had been sold, resold again many times over
by banks to investors across the globe who had no interest in the original contracts
and had simply bet on them much like a gambler might bet on the outcome of a sports
competition. To these speculators, the CDS was purely a speculative position of high
risk. Defaults in the CDS market led very quickly to the great uncertainty concerning
the financial positions of major banks that held these mortgage backed securities. It is
now difficult for the banks themselves to determine the exact value of their CDS
portfolio not to mention the difficulty faced by potential creditors in evaluating the
ability of these banks to repay loans.
Thus, the great risk to the economy is that this uncertainty has reduced and threatened
to halt the willingness of banks to lend to one another creating a liquidity crisis in
financial markets. In such a situation, there is great potential that businesses find it
impossible to secure operating capital and are forced to shut down. We are already
seeing the first signs of borrowing limits, and if this kind of a crisis were to truly take
hold, the result would be an economy that would come to a screeching halt and create
a panic in the banking sector. The economy would unquestionably be careening
toward a very severe recession or even depression. Recent Congressional action was
targeted toward loosening the lending between banks and providing liquidity to
capital markets. What has not happened to date is a re-evaluation of regulations such
as the Glass Steagall Act and the Gramm-Bliley Leach Act to close loopholes in
regulation of banking and investment activities.
The Japanese experience of the nineties provides one final note of caution. Namely,
when Japan went through its economic crisis in the early 1990s, the central bank of
Japan employed a similar approach to that which the Federal Reserve and the
Treasury are now undertaking. The Japanese were not successful in stemming an
economy wide recession that lasted over a decade. This highlights the important
distinction between a credit crisis and a recession in the context of current events (see
the paper by Abbott and Foster in this series of publications for more detail). What is
not known at this point is how severe the U.S. recession will be and how long will it
last. Granted the American economy is more resilient than the Japanese economy ever
was. The ability of our economy to stand a macro shock such as this and still be the
dominant force is exponentially better than any other country. That is precisely what
gives us hope at the end of the day that we may yet come out of the current crisis with
minimal long term damage to the U.S. economy.

American History, Capitalism and the

Crisis on Wall Street
I. Overview

Almost 232 years ago, on December 23, 1776, American statesman Thomas Paines
American Crisis Volume I was published. The work opens with his now famous
words, These are the times that try mens souls. The summer soldier and the

sunshine patriot will, in this crisis, shrink from the service of their country, but he that
stands now, deserves the love and thanks of man and woman. Also during this time,
Paine authored a series of pamphlets entitled, Common Sense, through which the
American colonists and the Continental Army could in clear and thoughtful terms
understand the issues and difficulties facing a new nation just into revolution. Perhaps
the current crisis on Wall Street (and the impending financial meltdown some have
predicted) is not yet trying our souls but certainly it is a time that calls for common
sense and for clear and thoughtful reasoning, justification, statesmanship and a longterm solution.
One simply needs to watch the Sunday news shows on television or read a wide
range of internet, newspaper or magazine articles to find that there is no common
sense agreed to explanation for the root cause of the crisis burdening Wall Street.
There are numerous alleged unfounded causes including the many explanations that
point to the failure of capitalism or even more disturbing pronouncements that
capitalism has simply run its course in economic history. To this we stand as a clear
and dissenting voice in opposition to this uninformed and misguided logic.
Capitalism is not nor has it ever been positioned to be a perfect economic system. It is
simply the best that humankind has been able to devise to date. According to Nobel
Laureate Friedrich von Hayek, I very seriously believe that capitalism is not only a
better form of organizing human activity than any deliberate design, any attempt to
organize it to satisfy particular preferences, to aim at what people regard as beautiful
or pleasant order, but it is also the indispensable condition for just keeping that
population alive which exists already in the world. I regard the preservation of what is
known as the capitalist system, of the system of free markets and the private
ownership of the means of production, as an essential condition of the very survival of
mankind. Capitalism (1776 AD to date) is an ethical economic system based on
private ownership of and responsibility for the means of production with the
allocation of goods, services, and assets taking place through a voluntary, free market
pricing system. Capitalism as an economic system has been responsible for the
greatest leap forward in global human progress in the history of the world. Capitalism
has also been the intellectual godfather of the decline of Communism in Eastern
Europe and China and has guided the United States from infancy to an economic
position that has been the envy of the world.
What is often lacking of history in trying to frame the debate over todays financial
crisis, is the knowledge that government, well-intended as it usually is, has often been
the source of economic instability and hardship in American history. Also absent is
the knowledge that markets are efficient and self-correcting when left alone.

II. United States Economic History and Government Intervention

A. The American Revolution

The Continental Congress of the United States decided to develop a currency to foster
economic stability and to more effectively attain needed supplies to feed and pay the
troops who were to fight the British if war broke out and the American Revolution
began. According to the basics of economics there are three ways to finance
government; taxation, borrowing and/or inflation (excess printing of money).
Inflation, which often creates distrust and chaos between consumers and producers, is
not well understood in terms of root cause. From 1776 to 1781, the Continental
Congress decided it would greatly reduce the tie of the Continental currency, the

Greenback (paper dollar), to gold and silver so as to allow for more printing of
Greenbacks to fund the war effort. The belief was that the purchasing power of the
currency would stay constant and the war effort could be more effectively funded
through additional printing. Just the opposite was true. In an article in The Canadian
Journal of Economics and Political Science (November 1952), it was noted that the
inflation rate for the Greenback went from roughly 6 percent before the American
Revolution to roughly 2,000% in 1781. The currency became nearly worthless and
officials began to barter commodities and trade gold and silver to attain the supplies
necessary to fight the war. Farmers and merchants often refused to accept the almost
valueless greenback as legal tender often leaving the Continental Army in a
deficient position. It was largely the result of a complex barter system, a partial
shoring up of the currency with gold and silver to combat the hyperinflation, a war
tax, and the bravery and heroism of the Continental Army that turned the tide and
allowed for colonial victory in 1783.
B. The Great Depression 1929-1941

Many people today accept the view that it was the failure of capitalism that caused
The Great Depression. As a result, they cling to the unsubstantiated myth that
government intervention lightened the consequences of and eventually ended The
Great Depression. Nothing could be further from the truth.
A series of misdirected government policies caused and then lengthened the U.S.
Great Depression. In his book, Americas Great Depression, Murray Rothbard notes
the Federal Reserve increased the money supply by more than 60% from mid-1921 to
mid-1929, driving up the stock market and fueling the Roaring Twenties. In the
book, A Monetary History of the United States: 1867-1960, Nobel Laureate Milton
Friedman and his co-author, Anna Schwartz, proved conclusively that the money
supply then contracted by 33% from mid-1929 to early 1933. The inflationary bubble
and deflationary bust were clearly the result of erratic and wrong-headed government
monetary policy which caused malinvestment, wide-scale bankruptcy and
unemployment. By 1933, the Dow Jones Industrial Average had lost 90% of its 1929
value, and the U.S. unemployment rate stood at nearly 25%. Lawrence W. Reed, in
The Great Myths of The Great Depression, notes irrational monetary policy was
exacerbated by the Smoot-Hawley Tariff of 1930, which almost closed the U.S.
borders to foreign goods and ignited a vicious international trade war. Reed notes
tariffs went from 20 to 34% on agricultural products, 36 to 47% on wines and spirits,
and from 50 to 60% on woolen products. Foreign nations reciprocated with trade
barriers on U.S. exports compounding the error of high U.S. tariffs and deflationary
monetary policy. Next, the U.S. Congress passed and President Hoover signed into
law the Revenue Act of 1932. According to Reed, the Revenue Act of 1932 was the
largest tax increase in U.S. peace time history to that point. It doubled the income tax
with the top tax bracket increasing from 24% to 63%. It should also be noted that tax
exemptions were lowered, the earned income tax credit was abolished, corporate and
estate taxes were raised, new gift, gasoline, and auto taxes were imposed, and postal
rates were sharply increased.
Subsequently, each time market forces tried to bring the economy out of its downturn,
additional government policies made it difficult if not impossible for the market to
function. President Roosevelts New Deal, much of which would be declared
unconstitutional by the U.S. Supreme Court, added costly regulations that handcuffed
business. The Wagner Act (1935) created an extremely difficult labor environment for
business by 1938. In a 1939 American Institute of Public Opinions national poll,
almost 70% of Americans surveyed said the Roosevelt administrations attitude

toward business was delaying the recovery. The Great Depression did not end until
the U.S. entered World War II.

C. Tax Cuts and Budget Deficits

It is often argued that tax cuts on individuals and/or corporations lead to budget
deficits. According to the National Center for Policy Analysis, the Joint Economic
Committee of the Congress of the United States, and a study published in the July
1986 edition of The Journal of Business and Economic Statistics, this was not true at
least relative to the Kennedy and Reagan tax cuts. In both cases, while tax cuts
resulted in higher tax revenue to the federal government, larger increases in
government spending resulted in increased deficits. Tax revenue grew by 56 percent
from 1981 to 1989 (despite a severe recession in 1982), while government spending
increased by 69 percent during the same time frame.
In an April 1996 Joint Economic Committee of the Congress (JEC) of the United
States report, Christopher Frenze, Chief Economist and the Vice Chairman of the
JEC, notes high marginal tax rates discourage work, saving, and investment, while
promoting tax avoidance and evasion. A reduction in high marginal tax rates will
boost long term economic growth, and reduce the attractiveness of tax shelters and
other forms of tax avoidance. The report also noted that economic benefits of the
Reagan tax cuts were summarized by President Clintons Council of Economic
Advisers in 1994: It is undeniable that the sharp reduction in taxes in the early 1980s
was a strong impetus to economic growth.
From 1994 to 1996 the JEC provided information about the impact of the tax cuts of
the 1980s. The JEC has published IRS data on federal tax payments of the top 1
percent, top 5 percent, top 10 percent, and other taxpayers. This data shows after the
high marginal tax rates of 1981 were cut, tax payments and the share of the tax burden
borne by the top 1 percent climbed sharply. For example, in 1981 the top 1 percent
paid 17.6 percent of all personal income taxes, but by 1988 their share had jumped to
27.5 percent, a 10 percentage point increase.
The 1996 report also points out the share of the income tax burden borne by the top
10 percent of taxpayers increased from 48.0 percent in 1981 to 57.2 percent in 1988.
Meanwhile, the report shows the share of income taxes paid by the bottom 50 percent
of taxpayers dropped from 7.5 percent in 1981 to 5.7 percent in 1988. Frenzes report
concludes the Reagan tax cuts, like similar measures enacted in the 1920s and 1960s,
show reducing excessive tax rates stimulates growth, reduces tax avoidance, and can
increase the amount and share of tax payments generated by the rich. High top tax
rates can induce counterproductive behavior and reduced revenues, variables usually
missed or understated in many government reports depicting static revenue flows.
III. Recent Problems on Wall Street and the Role of Government

Recent problems on Wall Street have reignited the debate over the role of government
in the U.S. economy. A dispassionate analysis of the issues points to a complex
situation meriting serious reflection and reliance on sound economics and
statesmanship not populist partisanship.
The first issue deserving critical analysis is the extent of the severity of this problem.
Should we take experts at their words, most of whom have been consistently
wrong? It was just a few months ago when many on Wall Street and in Washington
assured us that the fundamentals of the economy and our financial markets were

strong and there was no need to worry. Is it possible they are wrong again and are
seriously overestimating or underestimating the extent of this problem? If they are,
then this rescue package is either unnecessary or inadequate. If they are wrong, they
will come back with more requests or perhaps will have committed almost $1.8
trillion unnecessarily. The problem on Wall Street is two- fold: there is a problem of
solvency and there is a problem of liquidity. The problem of solvency is partly
addressed in the bailout, where the government has pledged to use tax payer money to
bail out securities that are losing market value. Once the bad assets are removed
from the balance sheets, banks or non-bank financial institutions would become more
solvent. That belief is only partially true. It is entirely possible the extent of these bad
assets are still unknown or unrevealed to date. So it is entirely possible these
pledges of the federal government may not go far enough. Then will we need a new
round of bailouts? That scenario would definitely be worse than no bail out at all. We
should not forget that panicked reactions always lead to short run fixes for a problem
that is essentially long run in nature. The problem of liquidity is not addressed in this
bailout package. When the President of The United States warns of an impending
recession or an economic calamity unless Congress passes a massive bailout, people
often have asymmetric reactions to such a dire prediction. Investors do not necessarily
believe Congress has the right solution for the problem (why should they, when
government has allowed this crisis to continue so long), but they seem to believe that
a recession is imminent or here. So they do what most rational economic agents
would do. They lose confidence in the financial system and they start withdrawing
their bank deposits. This is what happened with Washington Mutual Bank, even when
it was certain that some version of the bailout package would be passed. This is
exactly what could have happened to Wachovia this week if Citibank had not stepped
in. So the bailout package has failed to soothe consumer anxiety over the perceived
impending failure of the financial system. The call is now for the government to
guarantee all financial deposits and transactions even beyond what the FDIC is
currently doing. This is a true problem that the bailout package fails to address to
date.
The second issue needing serious attention is whether government should be in the
business of bailing out or subsidizing any business. Should government feed into this
moral hazard problem by using tax payer money to bail out businesses that made
risky investments? What the government is essentially doing is privatizing corporate
profit and socializing corporate losses. Is this a path we want American business and
the U.S. government to travel together? We think not. We have to remember that
Treasury secretary Paulson is the former CEO of Goldman Sachs. Without implying
anything about his motive, it can be safely assumed he is trained to think events on
Wall Street shape events on Main Street rather than the other way around. The actual
truth may be that the events on Wall Street have a marginal impact on Main Street.
What we need is serious thinking on how the fundamentals of the overall American
Economy can be strengthened. The last thing we should do to strengthen the
fundamentals of the economy is to reward unproductive, inefficient and perhaps
criminal behavior on the part of a small number of Wall Street movers and shakers.
The moral hazard issue is amplified significantly if we allow backdoor negotiations
among the rich and powerful to steer the largest transfer of tax revenue in U.S. history
to private coffers with a simultaneous takeover of many private businesses by the
federal government.
The third issue meriting serious discussion is what happens if the government refuses
to bail out Wall Street? What will be the extent of the damage? Will a complete
meltdown of the market result or is the market smart enough to factor such losses in
its deliberation so that the extent of the loss will be much less than forecasted. The

fundamental rationale behind this bailout is that most of these assets the government
intends to buy are inherently sound, and if there is an investor who is patient and has
the capacity to wait before selling (like the federal government can) it will regain its
value. However, that is what the market does best. While the decline of the price of an
asset is grave from the perspective of the supplier of those assets, it is actually very
good news for the investor who wants to buy those assets. Thus, bargain hunters often
put the market back on track without any government intervention. In fact, if history
is any guide, government intervention often extenuates the problem by sending the
wrong price signal to the market. In his initial proposal, Secretary Paulson planned to
pay more for some assets than the current market value. His argument was the market
is currently assessing them lower than it should. How did he decide what the current
market value should be? He believes that he knows better. We do not think so. This is
reminiscent of the old socialist planning models, where the price signal was always
suppressed, because the planners knew better. What a remarkable transformation in
our thought process! We are willing to sacrifice the basic tenets of capitalism, the
power of the market and replace it with failed socialist style planning? This is
profound. We are not talking about regulating the market, we are talking about
eliminating the market. The idea behind Secretary Paulsons proposal is to deal with
capitalism in an asymmetric way. Let us reap the benefits of the market, but when
market calls for painful adjustment we should shun it in favor of central planning. The
Federal bailout included BearStern, AIG, Fannie Mae and Freddie Mac, but did not
include Lehman Brothers. So the Federal Government is now picking winners and
losers. This is industrial policy at its core and also uniquely un-American.
The fourth issue deserving serious analysis is the fallout from this government
bailout. When government gets involved, it usually comes with a price tag. The price
tag, in this case, will be increased regulation. This bailout will reward inefficient,
incompetent, and perhaps a few corrupt corporations, but hamstring smart, ethical and
innovative businesses with overregulation. This will interfere with what famed
Harvard economist Joseph Schumpeter called the process of creative destruction.
This process allows inefficient or wrong minded businesses to fail and be replaced by
innovative and forward thinking competitors. What is even more disconcerting is the
fact that these regulations are designed for twentieth century financial instruments.
Today, financial markets are highly integrated internationally and what a foreign
business does is often more impactful to the domestic financial market than that of
another domestic firm. How are we supposed to reign in foreign corporations with
American regulation? This global market requires regulation much more fluid in
nature than currently exists. Our government lacks a fundamental understanding as to
what these regulations might and/or should look like. In a rush fueled by political
expediency the government will substitute poorly thought out arcane regulation for
sound economic thinking, thereby potentially killing future financial innovation?
Secretary Paulson recommended Congress increase the debt ceiling to approximately
$11.4 trillion dollars. The U.S. debt to GDP ratio is astronomically high and some
might argue unsustainable. This high debt to GDP ratio can have two significant
impacts on the US economy. On one hand, it will raise the cost of capital both in the
domestic and international markets making productive investment very expensive,
thereby reducing it. Simultaneously it will make the dollar strong against other
currencies, reducing our exports, increasing our imports and thereby worsening our
current account deficit. But that is the good news. The other likely scenario is our
creditors decide this debt is unsustainable and refuse to lend us more money.
Americans have been living beyond their means for a long time. This will mean that
the party is over. The impact on the dollar and whether or not it can continue as the
worlds major reserve currency will be in doubt. Both are likely scenarios and not
confidence enhancing for the U.S.

The fifth and perhaps most important issue is the role of government in the cause or
causes of our current problems on Wall Street. We must carefully examine the role of
the Clinton and Bush Administration regulatory authorities at all levels throughout
our financial system. Were they negligent in their responsibilities? If so, why? Did
monetary authorities, largely Mr. Greenspan, over shoot interest rate targets allowing
for excessively low interest rates in the recent past triggering the malinvestment we
see today? We must investigate charges that the noble intentions of the Community
Reinvestment Act led to a reckless surge in mortgage lending pushing much of our
financial system to the brink of chaos. We must investigate the role of Fannie Mae
and Freddie Mac in the explosion of the subprime housing market. What was/is the
role of government in funding these loans that ordinarily would not have been made
based on long-held underwriting standards that historically call for: a) a down
payment, b) a ratio of income to purchase price, and c) a payment history indicating
credit worthiness? Was this proper public policy? How could subprime lending grow
2,757% from $34 billion in 1994 to a total of nearly $1 trillion by 2007 without any
major intervention over 14 years and two administrations? What happened to
proposed 2005 Senate legislation designed to reform Fannie Mae and Freddie Mac
due to concerns voiced three years ago? And finally, is the government mandated
mark to market method of valuing assets good and proper or is it a contributing
factor in the financial crisis? Is mark to economic value a more logical
methodology?
A sixth issue or concern is the extent to which the prospect of the bailout is
interfering with the market adjustments and spreading panic. How many people
reacted to President Bushs speech by selling off their assets, buying gold or T-bills?
IV. Problems that must be solved

What is the proper and prudent response to this financial crisis? History shows new
challenges can bring new opportunities if led by statesmen who desire to fix the
problem for the long-term. This is a pivotal moment for to reach a national consensus
on what the major long term structural problems are within the US economy and what
the best solutions are to said problems. The following suggestions can be addressed:
1. High budget deficits and an unsustainable national debt. After the proposed

bailout, the United States will be the 13th most indebted country in the world as
measured by public debt as a percent of GDP at 82.37% (just behind the country of
Sri Lanka) with China ranked 102nd at 18.4%. In 2008 the U.S. budget deficit is
projected to be $500 billion which is larger than the entire GDP of the 20th largest
economy in the world (Sweden). In 2008, interest on the U.S. National Debt will
surpass $230 billion which is slightly smaller than the total GDP of Ireland. The
United States is the worlds largest debtor nation with more than $12.2 trillion in
external debt as of the end of 2007.
2. High corporate tax rate which makes business investment expensive in the
U.S. The United States currently has the second highest corporate tax rate in the

industrialized world at 39.3%, trailing only Japan at 39.5%. In fact, nine members of
the Organization of Economic Cooperation and Development (OECD) dropped their
corporate tax rates last year to attract more investments (including Canada, Germany,
and the UK). Sweden just recently announced its intention to reduce its top corporate
tax rate from 28% down to 26.3% to attract additional investment, as well.
3. Lack of a comprehensive energy policy.

4. Two expensive wars USA is unable or unwilling to finance using tax revenue
5. The belief high income earners can and somehow should pay an even higher
percentage of federal individual income taxes than current law mandates. In

2006, the top 1% of all income earners paid 39.89% of all federal income taxes, the
top 5% of all income earners paid 60.14% of all federal income taxes, the top 25% of
all income earners paid 86.27% of all federal income taxes, while the bottom 50% of
all income earners paid 2.99% of all federal income taxes in 2006.
6. The counterproductive idea USA can balance the budget by taxing more and
spending more. The U.S. must come to a consensus. The U.S. need to adopt sensible

fiscal policy to address the issue of deficit spending and its impact on the economy.

How did USA get into this mess?

The four shockwaves of the financial crisis
The global financial crisis has seen three waves of what might ultimately be a
fourwave economic tsunami. The first wave concerned the U.S. sub-prime mortgage
market and the housing bubble. The accumulation of bad debt undermined a number
of key banks, putting them and their customers at risk. In the second wave, the demise
of Lehman Brothers and anxiety over the creditworthiness of many banks and
insurance companies led to a worldwide nationalization and bailout of the financial
industry. In the third wave, cash hoarding, frozen loans, and stock market panic led to
massive realignment of expectations that dooms the developed world to a serious
recession. In the final wave, if it happens, the contagion could spread to emerging
markets, which in the last decade have been the primary engine of global economic
growth.

The first wave U.S. sub-prime mortgages

In the first phase of the crisis it was discovered that many mortgages written during
the housing boom were headed for default and that the mortgages themselves had
been repackaged and resold across the globe as if they were secure assets. In total,
these liabilities, once thought to be assets, totaled around $300 billion. All of this was
exaggerated by the fact that most of the repackaged mortgages lacked transparency.
The toxic assets could not be easily valued and thus resold at any price. Moreover,
the weak U.S. economy also put commercial loans, credit cards, and other mortgages
at risk. To offset the macro-economic impact, Congress authorized a tax rebate for
U.S. consumers, and the resulting bump in cash propped up the real economy
through the summer of 2008.
However, the illness was bound to spread. Like unwelcome woodland ticks, more
than a few toxic mortgages were embedded in banks, which operate on a thin margin
between assets and liabilities. As housing prices declined, the toxicity of mortgages
grew and the asset base dwindled. Banks overloaded with bad debt suffered as the
relentless pressure of the market drove down their stock prices. Major financial
institutions, such as Bear Sterns and IndyMac, were forced into unappetizing mergers
or dissolution, with the federal government accepting responsibility for much of the
bad debt. The broad scale of the problem became apparent on September 7, when the
federal government was forced to seize control of federally-sponsored mortgage
companies, Fannie Mae and Freddie Mac, which hold the majority of U.S. mortgages.

The second wave the growing risk of systemic default

As the crisis wore on and mortgage defaults mounted, a more serious problem
emerged. It turned out that insurance companies and investment banks had sold
trillions of dollars of Credit Default Swaps (CDSs). These swaps were not limited to

the housing market or to sub-prime mortgage loans, but covered a broad set of

investments funds, bonds, and other financial instruments. Banks that had been
weakened by sub-prime mortgage holdings, such as Lehman Brothers, had also issued
CDSs. Secretary of the Treasury Henry Paulson and other U.S. officials had borne
heavy criticism over the bailout of Bear Sterns earlier in the year. They were
persuaded by the moral hazard argument and were determined to demonstrate that
those who take risk must bear the responsibility. Likewise, potential buyers of
Lehman Brothers, noting that JP Morgan had acquired Bear Stearnss assets while the
U.S. government underwrote the risk, backed away from any deal without a
partnership from the U.S. Treasury. Negotiations failed and Lehman Brothers
declared bankruptcy on September 15, which tripped obligations in many CDS
contracts. Within a few hours, the U.S. Treasury was forced to bail out American
International Group (AIG) with an $85 billion loan and acquisition of equity. Almost
immediately other dominos began falling around the globe. The resulting chaos set off
a global drop in stock markets, which further weakened the asset base of many
financial institutions.
The U.S. was not the only country that enjoyed a significant increase in housing
prices; it was to a large extent a worldwide phenomenon. In particular, the fastest
growing European countries had experienced housing price surges even greater than
those in U.S. Moreover, most European banks and insurance companies had been
involved in the CDS market. Over the weekend of September 27, the credit crunch hit
Europe full force. Within a few days Belgium and the Netherlands were forced to bail
out Fortis, the U.K. nationalized Bradford & Bingley, and Iceland took control of its
third largest bank, Glitnir.
As the financial stress deepened it became apparent that a piecemeal approach was
unworkable. The problem crystallized on September 30, when the Irish government
announced that it would guarantee all deposits in its banks, amounting to 400 billion
twice its annual GDP. Although Ireland was a small country, it had adopted the euro
as its currency. This meant that Irish banks were the safest across the whole eurozone.
It did not take central bankers in Germany and other eurozone countries long to
realize they faced the threat of bank runs if they did not follow the Irish example.
Even though the U.K.s currency was still in pounds sterling, it faced a similar threat.
By mid-October virtually every European country had adopted some sort of deposit
guarantee or bank nationalization.
In the meantime, the U.S. groped for a strategy to save its banks. For a combination of
ideological reasons and previous experience with the U.S. Savings and Loan Crisis in
the 1980s, U.S. officials focused on pulling out the banks bad loans, rather than
recapitalizing them by direct investment. The plan, however, looked too much like a
bailout of Wall Street to Congress, and the House of Representatives squashed the
idea on September 28. Finally, on October 3, the basic plan (with a lot of sweeteners
and enhanced deposit insurance) passed both houses of Congress. Ironically, however,
as the Treasury sought to implement its buyback of toxic assets it shifted strategies
and began investing directly in major banks. In fact, Treasury officials had little
choice: without a clear demonstration of government guarantees, the international
market would quickly pull cash from any institution perceived to be under-financed.

It is difficult to put together a precise accounting of the amount of government

support that has been necessary to shore up the global financial system. The direct
infusion of cash would appear to be more than $2 trillion and implicit guarantees are
worth at least another $2 trillion, so $4 trillion is not a bad estimate. The overall cost,
however, will be much greater as the global economy suffers through what could be
the worst recession since World War II.

The third wave recession in developed countries

Despite the central bank infusion, it was obvious that developed nations economies
were in for a hard time. The IMF had pegged global economic growth at 3.8% for
2009, but a new forecast in early October dropped it to 3.0%. Within a few days,
however, pessimism deepened: Deutsche Bank, for example, dropped its 2009 global
GDP forecast to 1.2%, signaling the third wave of growing concern over the health of
the real economy. In response to the new pessimism, stock and commodity markets
plunged, as traders folded in the lowered expectations. The massive infusion of cash
may have short-circuited bank runs, but the banks have remained extremely
conservative in their lending.
The depth and length of the developed countries recession is unclear, but early
indicators are decidedly negative. There are also features of this recession that are
significantly different from anything experienced since the Great Depression. Most
importantly, there is already a massive asset deflation, in real property, stocks, and
commodities. This is in sharp contrast to the oil price shocks of the 1970s. In that era
stock prices dropped, but commodities and real estate values increased along with
general price inflation. Most economists would agree that aggregate consumption is
dependent on both income and perceived wealth. In this regard, consumers perceived
wealth has just taken a substantial hit and it may take years to fully recover. The asset
deflation is exacerbated by the fact that there is huge debt outstanding against these
assets. Many homeowners are underwater, owing more than the value of their
home. Government treasuries are also depleted. Hopefully much of the cash infusion
will be recovered as banks regain solvency, but some will be permanently lost. This
means that taxpayers will have to support a deadweight loss for years to come. It is
important to recall John Maynard Keyness critique of German reparations following
World War I. The excessive debt levied on Germany caused extraordinary social,
economic, and political upheavals. The relative cost here is not that great, but the
principle remains. Economic recovery will be burdened by excessive debt, which
reduces flexibility for both governments and consumers.

The possible fourth wave a severe global recession

If there is a fourth wave it will concern emerging economies. China still expects
economic growth on the order of 8% in 2009 and its leaders have announced
infrastructure investments intended to support it. However, legitimate questions can
be raised about the viability of such plans when economies around the world are
faltering. After all, China has prospered by selling manufactured goods to consumers
in developed economies. Chinas infrastructure investments had worked during the
Asian financial crisis, but then the problem was limited to one continent; now the
problem is global.
The swift rise in commodity prices, particularly crude oil, is partially responsible for
the meltdown. It was learned in the oil price shocks of the 1970s that the sudden shift
in cash from consumers to energy producers jolts the economy and provokes a
combination of inflation and recession. Oil is not as important to the overall energy
market now as it was in the 1970s, but it is still significant, particularly for the U.S. In
1974 the U.S. produced more oil than it imported, so much of the money associated

with higher prices recirculated. The situation is reversed today and most of the money
spent on oil flows out of the country in inflation-adjusted terms the shock of higher
oil prices in 2007 and 2008 was about four times higher than it was in 1974, when
calculated in this way. As in the 1970s, rapid oil price increases meant a steady
buildup of cash reserves in oil-producing nations, particularly in the Persian Gulf.
Recently these reserves have been converted into investment vehicles in the form of
sovereign wealth funds. Again, the rapid shift in funds had a financial impact. In
effect, it withdrew liquidity from banks in the U.S. and Europe, making it difficult for
them to recapitalize.
The drop in demand for manufactured goods and commodities will reverse the
financial trends of the last few years. The countries with huge pots of cash now may
find the funds rapidly depleted over the coming months, in which case they too may
become vulnerable to the global contagion.

Who is to blame?
Needless to say, there is more than enough blame to go around. But the lions share of
the blame should lie at the feet of those agents that initiated the process that led to the
current economic crisis.
Presidents Bill Clinton and George W. Bush, along with Congressional leaders,
pushed for increasing the homeownership rate as a major social initiative. It is not a
coincidence that in 1994 President Clinton requested that the U.S. Department of
Housing and Urban Development (HUD) develop the National Homeownership
Strategy a strategy to significantly increase homeownership, especially in low- and
middle-income households. In a 1995 policy brief,1 HUD describes its mission: At
the request of President Clinton, the U.S. Department of Housing and Urban
Development (HUD) is working with dozens of national leaders in government and
the housing industry to implement the National Homeownership Strategy, an
unprecedented public-private partnership to increase homeownership to a record-high
level over the next 6 years. The ideal of homeownership is so integral a part of the
American Dream that its value for individuals, for families, for communities, and for
society is scarcely questioned.
The cooperative, multifaceted campaign described in the National Homeownership
Strategy was committed to: "MAKING FINANCING MORE AVAILABLE,
AFFORDABLE, and FLEXIBLE". The inability (either real or perceived) of many
younger families to qualify for a mortgage is widely recognized as a very serious
barrier to homeownership. The National Homeownership Strategy commits both
government and the mortgage industry to a number of initiatives designed to:
1.Cut transaction costs through streamlined regulations and technological and
procedural efficiencies.
2.Reduce downpayment requirements and interest costs by making terms more
flexible, providing subsidies to low- and moderate-income families, and creating
incentives to save for homeownership.
3.Increase the availability of alternative financing products in housing markets
throughout the country.
To put this simply, the government launched a campaign to increase homeownership
by reaching out to populations that would have never qualified for a mortgage under
standard financial practices. To do this, they loosened the restrictions on financing,
opening the floodgates to financial institutions eager to find new customers, while

creating an environment ripe for unethical (or at least questionable) lending practices.
These are the seeds of the current economic crisis.
The Bush administration continued to water these seeds. At the signing of the
American Dream Downpayment Act 2003, President Bush stated, Government is
supporting homeownership because it is good for America, it is good for our families,
it is good for our economy. He acknowledged that the rate of homeownership was at
a record high of 68.4 percent but stated that there is room for improvement. To
solve this problem, the legislation provided $200 million per year in down payment
assistance to more than 40,000 low-income families that could otherwise not afford to
own a home. (That is $1 trillion of taxpayer money poured into the housing price
bubble from 2003 to 2007!) But others share the blame. Wall Street was all too
willing to play along with this game and made scores of very poor decisions in the
process. The rapid increase in housing prices from 2003 to 2006 coincided with an
explosion in private asset-backed securities (those not backed by Fannie and Freddie).
In addition, these assets are made up of some of the most risky types of exotic
mortgage schemes. We must admit that many financial insiders acted inappropriately
at best, and that some committed fraud and encourage deceptive practices while the
government stood by and did nothing.
It is not believed that Wall Street (or government) is inherently corrupt. However,
there is ample reason to be very concerned about the incentives facing our political
and business leaders. The get-rich-now mentality is worrisome and seems to be
completely grounded in a short-term focus with little regard for the long-term
consequences.
The Federal Reserve is also to blame for allowing the flood of cheap credit to fuel the
increase in housing asset values far above normal levels. In his book The Age of
Turbulence, Alan Greenspan states that he is increasingly persuaded that
governments and central banks could not have importantly altered the course of the
boom either. The fact is they helped create and fuel the boom. It is utterly ridiculous
to state that alternative government and central bank policies could not have altered
the run-up in housing prices.
The cheap credit policy of the Fed is also related to the maturity mismatch that was
mentioned earlier. It allowed investment firms to finance long-term assets with large
amounts of short-term debt, which was very cheap relative to other debt and equity
finance options. In addition, low interest rates encouraged firms to offer adjustablerate mortgages, which offered the potential for higher returns as interest payments
would increase over time as the initial low interest rate reset. However, short-sighted
(and deceptive) business practices failed to account for the massive foreclosures that
would be driven by the increases in mortgage payments.
The American consumers also deserve blame. Because they fail to save as a nation,
foreign investors have invested heavily in American debt (much of which is implicitly
backed by the American taxpayer). Consumerism is an addiction that is slowly
destroying America. It is thought that the term American Dream is now just a catch
phrase for consuming more housing and other goods and is used in the title of
irresponsible legislation that is aimed at supporting the consumption of goods beyond
the means of many low- and middle-income Americans.
Yes, owning a home is a worthwhile endeavor, but it can also be a tremendous burden
for many that are not financially capable of facing the inherent risk of asset
ownership.

What should USA do now?

There is substantial disagreement about the potential for a depression similar to that of
the 1930s. International Monetary Fund chief economist Oliver Blanchard and his
colleagues stated the optimistic view that there is no chance of a repeat of the global
depression of the 1930s because the lesson of that painful decade has been learned.
The pessimistic view is espoused most ardently by Nouriel Roubini, a notable
economist at New York University, who predicted the coming crisis more than
two years ago. He warned in February 2008 that there is now a rising
probability of a catastrophic financial and economic outcome, and, in October
2008, he stated that it is clear that the U.S. financial system is now in cardiac
arrest and at risk of a systemic financial meltdown as he outlined in February.
He predicts that radical policy action can only prevent what will now be an ugly
and nasty two-year recession and financial crisis from turning into a systemic
meltdown and a decade-long economic depression. While this is a rather
extreme view, it is not completely without merit. One thing that seems certain is
that extraordinary steps must be taken to stabilize the economy.
There is general agreement that stabilizing housing prices is a necessary step to
stabilize the economy. If not, housing prices may fall an additional 17 percent before
reaching a bottom. Such a decline would increase the risk of a more severe financial
and economic crisis.

Here are the major points of the governments current strategy, although many
smaller actions have also been taken that are very important:

In September 2008, the U.S. government seized control of Fannie Mae and
Freddie Mac. A total of $200 billion was pledged by the U.S. government to prop
up the struggling companies which hold or back a combined $5 trillion in home
loans.

Out of fears that a collapse of insurer American International Group, Inc.

(AIG) would have dire national and global financial consequences, the U.S.
government seized control of AIG. Why AIG but not Lehman Brothers Inc.? AIG had
sold credit default swaps, insurance against bad loans, to almost every major financial
company. Allowing AIG would to collapse would have had far reaching
consequences in the financial sector. The government took a 79.9 percent equity stake
in the firm and agreed to lend $85 billion to the company in September 2008. In
October, the government provided an additional $37.8 billion to AIG in order to hold
the company over until the asset sales are completed.

After one failed attempt, Congress then crafted and passed an allencompassing $700 billion bailout plan in early October 2008. The bailout allowed
the Treasury to access a total of $700 billion in stages to buy troubled mortgagerelated assets from financial institutions, thus purchasing a stake in these companies.
However, it now appears that the Treasury will settle for an initial $250 billion
infusion of cash in return for preferred shares. I prefer this strategy over the plan to
buy troubled assets. The purchase of troubled assets seems much to difficult to
implement as the government would have to know both which assets it should buy
and how much it should pay for those assets.

The bailout also called for the curbing of executive pay, set up two financial
oversight committees, gave the Securities and Exchange Commission the power to
change accounting rules, temporarily raised the Federal Deposit Insurance Corp.s
insurance cap from $100,000 to $250,000, as well as extended numerous tax breaks.


Additionally, the plan sought to mitigate foreclosures by encouraging loan
services to modify mortgages and, through the exemption from federal income tax,
any debt forgiven by a bank to a borrower in foreclosure.

What should USA do in the long term?

First, an exit strategy should be used to return ownership of firms to the private sector,
and to ensure that the government refrains from unnecessary interference in the
decisions of the banks that it infuses with capital.
The government must also implement reforms that will reduce the probability of
asset-price bubbles and that will regulate financial innovation without being too
restrictive. Some starting points are:
1.The creation of a Financial Product Safety Board to evaluate financial products,
such as mortgage loans;
2.Leverage/capital ratios alone do not yield enough information to determine the
financial strength of companies. It is recommended to consider the ratio of short-term
liabilities and assets so as to avoid the maturity mismatch problem;
3.Improved financial disclosure off-balance-sheet accounting is still a problem,
despite Sarbanes-Oxley and the other post-Enron reforms;
4.The United States should use covered bonds to finance mortgages and loans; they
are similar in many ways to asset-backed securities. Two advantages are that they stay
on the issuers balance sheet and investors have two recourse options: the issuer and
pool of assets.
The government also needs to sell its newly acquired shares of banks and other
institutions as soon as is feasible.

What not to do lessons from the

Great Depression
The federal government is largely responsible for the current crisis. There are some
policies that the federal government should avoid to keep from exacerbating the
current crisis. The federal government should NOT:
1.Increase tax rates;
2.Attempt to insulate domestic producers from foreign competition;
3.Encourage unionization. For example, the United States should not pass the
Employee Free Choice Act, which would effectively take away private union voting.
This would increase unionization and, thus, increase unemployment and make the
labor market less flexible.

The Role of the International Monetary

Fund (IMF)
The current global financial crisis, which began with the downturn of the U.S.
subprime housing market in 2007, is testing the ability of the International Monetary
Fund (IMF), in its role as the central international institution for oversight of the
global monetary system. Though the IMF is unlikely to lend to the developed
countries most affected by the crisis and must compete with other international
financial institutions as a source of ideas and global macroeconomic policy

coordination, the spillover effects of the crisis on emerging and less-developed

economies gives the IMF an opportunity to reassert its role in the international
economy on two key dimensions of the global financial crisis: (1) immediate crisis
management and (2) long-term systemic reform of the international financial system.
The role of the IMF has changed significantly since its founding in July 1944. Late in
World War II, delegates from 44 nations gathered in Bretton Woods, New Hampshire
to discuss the postwar recovery of Europe and create a set of international institutions
to resolve many of the economic issues such as protectionist trade policies and
unstable exchange rates that had ravaged the international economy between the
two world wars. As the global financial system has evolved over the decades, so has
the IMF. From 1946 to 1973, the main purpose of the IMF was to manage the fixed
system of international exchange rates agreed on at Bretton Woods. The U.S. dollar
was fixed to gold at $35 per ounce and all other member countries currencies were
fixed to the dollar at different rates. The IMF monitored the macroeconomic and
exchange rate policies of member countries and helped countries overcome balance of
payments crises with shortterm loans that helped bring currencies back in line with
their determined value. This system came to an abrupt end in 1973 when the United
States floated its currency and subsequently introduced the modern system of floating
exchange rates. Over the past three decades, floating exchange rates and financial
globalization have contributed to, in addition to substantial wealth and high levels of
growth for many countries, an international economy marred by exchange rate
volatility and semi-frequent financial crises. The IMF adapted to the end of the fixedexchange rate system by becoming the lender of last resort for countries afflicted by
such crises.
Current IMF operations and responsibilities can be grouped into three areas:
surveillance, lending, and technical assistance. Surveillance involves monitoring
economic and financial developments and providing policy advice to member
countries. Lending entails the provision of financial resources under specified
conditions to assist a country experiencing balance of payments difficulties. Technical
assistance includes help on designing or improving the quality and effectiveness of
domestic policy-making.

Whither the IMF?

The current financial crisis represents a major challenge for the IMF since the
institution is not in financial position to be able to lend to the United States or other
Western countries affected by the crisis (with the possible exception of Iceland). The
IMFs total financial resources as of August 2008 were $352 billion, of which $257
billion were usable resources. The most the IMF ever lent in any one year period (the
four quarters through September 1998 at the height of the Asian financial crisis) was
$30 billion. The most lent during any two-year period was $40 billion between June
2001- 2003 during the financial crises in Argentina, Brazil, Uruguay, and Turkey. The
IMF is wholly unequipped to provide by itself the necessary liquidity to the United
States and affected industrialized countries. In addition, the United States and other
Western countries, along with some Middle Eastern oil states, are the primary
contributors to IMF resources, and it is unlikely that these countries would seek IMF
assistance. The last time that developed countries borrowed from the IMF was
between1976 and1978, when the United Kingdom, Italy, and Spain borrowed from
the IMF to deal with the aftershocks of the 1973 increase in oil prices.
Since the financial crises of a decade ago, many emerging market economies, largely
in response to their criticism of the policy conditions that the IMF required of
countries receiving IMF loans, have built up extensive foreign reserve positions in

order to avoid having to return to the IMF should such a crisis occur again. From a
level of around $1.2 trillion in 1995, global foreign exchange reserves now exceed $7
trillion. The IMF tabulates that by the second quarter of 2008, developing countries
foreign reserves were $5.47 trillion compared to $1.43 trillion in the industrialized
countries. This reserve accumulation was driven by increasing commodity prices
(such as oil and minerals) and large current account surpluses combined with high
savings rates in emerging Asian countries.
Emerging market foreign reserve accumulation fueled by rising commodity prices and
large emerging market trade surpluses, and net foreign direct investment flows has led
to a decrease in demand for IMF lending and a weakening in the IMFs budget
position. IMF lending peaked in 2003 with IMF credit outstanding totaling $110.29
billion. By September 30, 2008, outstanding IMF loans had decreased by $92.6 billion
to $17.72 billion. Since the IMF earns income on the interest paid on its loans, the
decrease in demand for IMFs lending led to a budget shortfall in 2007. The IMF is in
the process of seeking authorization from national legislatures to sell a portion of gold
that the IMF holds in reserve to create an investment fund whose profits can be used
to finance IMF operations. Congress is expected to face a vote in FY2009 on whether
or not to authorize this proposal.
The rise of emerging market countries over the past decade, has created new
challenges for the IMF. Many emerging market economies argue that their current
stake in the IMF does not represent their role in the world economy. Several
countries, particularly in East Asia and South America, believe that their new
economic weight and status should afford them a larger quota and a greater voice at
the institution. In addition, many poor countries believe that the IMFs quota system
is prejudiced against them, giving them little voice even though they are the majority
of the IMFs borrowers. In response to these concerns, the IMF embarked in 2006 on
a reform process to increase the quota and voice of its emerging market country
members.
While the IMF has struggled to define its role in the global economy, the global
financial crisis has created an opportunity for the IMF to reinvigorate itself and
possibly play a constructive role in resolving, or at the least mitigating, the effects of
the global downturn, on two fronts: (1) through immediate crisis management,
primarily balance of payments support to emerging-market and less-developed
countries, and (2) contributing to long-term systemic reform of the international
financial system.
Immediate Crisis Management. IMF rules stipulate that countries are allowed to
borrow up to three times their quota over a three-year period, although this
requirement has been breached on several occasions where the IMF has lent at much
higher multiples of quota. While many emerging market countries, such as Brazil,
India, Indonesia, and Mexico, have stronger macroeconomic fundamentals than they
did a decade ago, a sustained decrease in U.S. imports resulting from an economic
slowdown could have recessionary effects overseas. Emerging markets with less
robust financial structures have been more dramatically affected, especially those
dependent on exports to the United States. Increased emerging market default risk can
be seen in the dramatic rise of credit default swap (CDS) prices for emerging market
sovereign bonds. Financial markets are currently pricing the risk that Pakistan,
Argentina, Ukraine, and Iceland will default on their sovereign debt at above 80%.On
October 24, the IMF announced an initial agreement on a $2.1 billion two-year loan
with Iceland. On October 26, the IMF announced a $16.5 billion agreement with
Ukraine. On October 27, the IMF announced a $15.7 billion loan to Hungary. Other

countries in talks with the IMF are Belarus and Pakistan. Other potential candidates
for IMF loans are Serbia, Kazakhstan, Pakistan, Lithuania, Latvia, and Estonia.
IMF Managing Director Dominique Strauss-Kahn has stressed that the IMF is able
and poised to assist with crisis loans. At the IMF annual meetings in October 2008,
Managing Director Strauss-Kahn announced that the IMF had activated its
Emergency Financing Mechanism (EFM) to speed the normal process for loans to
crisis-afflicted countries. The emergency mechanism enables rapid approval (usually
within 48-72 hours) of IMF lending once an agreement has been reached between the
IMF and the national government. As noted before, while normal IMF rules are that
countries can only borrow three times the size of their respective quotas over three
years, the Fund has shown the willingness in the past to lend higher amounts should
the crisis require extraordinary amounts of assistance.
A second instrument that the IMF could use to provide financial assistance is its
Exogenous Shock Facility (ESF). The ESF provides policy support and financial
assistance to low-income countries facing exogenous shocks, events that are
completely out of the national governments control. These could include commodity
price changes (including oil and food), natural disasters, and conflicts and crises in
neighboring countries that disrupt trade. The ESF was modified in 2008 to further
increase the speed and flexibility of the IMFs response. Through the ESF, a country
can immediately access up to 25 % of its quota for each exogenous shock and an
additional 75% of quota in phased disbursements over one to two years.
On October 29, 2008, the IMF announced that it plans on creating a new three month
short-term lending facility aimed at middle income countries such as Mexico, South
Korea, and Brazil. The IMF plans to set aside $100 billion for the new Short-Term
Liquidity Facility (SLF). In a unprecedented departure from other IMF programs, SLF
loans will have no policy conditionality.
The IMF is not alone in making available financial assistance to crisis-afflicted
countries. The International Finance Corporation (IFC), the private-sector lending arm
of the World Bank, has announced that it will launch a $3 billion fund to capitalize
small banks in poor countries that are battered by the financial crisis. The InterAmerican Development Bank (IDB) announced on October 10, 2008 that it will offer
a new $6 billion credit line to member governments, as well as increase its more
traditional lending for specific projects. In addition to the IDB, the Andean
Development Corporation (CAF) announced a liquidity facility of $1.5 billion and the
Latin American Fund of Reserves (FLAR) has offered to make available $4.5 billion
in contingency lines. While these amounts may be insufficient should Brazil,
Argentina, or any other large Latin American country need a rescue package, they
could be very helpful for smaller countries such as those in the Caribbean and Central
America that are heavily dependent on tourism and property investments. In Asia,
where countries were left no choice but to accept IMF rescue packages a decade ago,
efforts are under way to promote regional financial cooperation, so that governments
can avoid having to borrow from the IMF in a financial crisis. One result of these
efforts is the Chiang Mai Initiative, a network of bilateral swap arrangements among
east and Southeast Asian countries. In addition, Japan, South Korea, and China have
backed the creation of a $10 billion crisis fund. Contributions are expected from
bilateral donors, the Asian Development Bank (ADB), and the World Bank.
Lastly, economic conditions over the past decade have created a new class of bilateral
creditors who could challenge the IMFs role as the lender of last resort. The rise of
oil prices has created vast wealth among Middle Eastern countries and persistent trade

surpluses in Asia have created a new class of emerging creditors. These countries
either have the foreign reserves to support their own currencies in a financial crisis, or
they are a potential source of loans for other countries.
Reforming Global Macroeconomic Surveillance. In addition to revising its
emergency lending assistance guidelines to make the IMFs financial assistance more
attractive to potential borrowers, there is a role for the IMF to play in the broader
reform of the global financial system. Efforts are underway to expand the IMFs
ability to conduct effective multilateral surveillance of the international economy. In
addition, there are efforts to increase cooperation with the international financial
standard setters as the Financial Stability Forum (FSF), the Bank for International
Settlements (BIS), as well as in various international working groups such as the
Basel Committee on Banking Supervision and the Joint Forum on Risk Assessment
and Capital. The deepening interconnectedness of the international economy may call
for such increased cooperation between the IMF, which performs global
macroeconomic surveillance, and the individual global financial regulatory bodies.
The IMF Articles of Agreement require (Article IV) that the IMF oversee the
international monetary system in order to ensure its effective operation and to
oversee the compliance of each member with its obligations to the Fund. In
particular, the Fund shall exercise firm surveillance over the exchange rate policies
of member countries and shall adopt specific principles for the guidance of all
members with respect to those policies. Countries are required to provide the IMF
with information and to consult with the IMF upon its request. The IMF staff
generally meets each year with each member country for Article IV consultations
regarding the countrys current fiscal and monetary policies, the state of its economy,
its exchange rate situation, and other relevant concerns. The IMFs reports on its
annual Article IV consultations with each country are presented to the IMF executive
board along with the staffs observations and recommendations about possible
improvements in the countrys economic policies and practices.
As the global financial system has become increasingly interconnected, the IMF has
conducted multilateral surveillance beyond two bi-annual reports it produces, the
World Economic Outlook and the Global Financial Stability Report, four regional
reports, and regular IMF contributions to intergovernmental fora and committees,
including the Group of Seven and Group of Twenty, and the Financial Stability
Forum. These efforts at multilateral surveillance, however, have been criticized as
being less than fully effective, too focused on bilateral issues, and not fully
accounting for the risks of contagion that have been seen in the current crisis. A 2006
report by the IMFs internal watchdog agency, the Independent Evaluation Office
(IEO) found that, multilateral surveillance has not sufficiently explored options to
deal with policy spillovers in a global context; the language of multilateral advice is
no more based on explicit consideration of economic linkages and policy spillovers
than that of bilateral advice. Participants at an October 2008 IMF panel on the future
of the IMF reiterated these concerns, adding that many developed countries have
impeded the IMFs efforts at multilateral surveillance by largely ignoring IMFs
bilateral surveillance of their own economies and not fully embracing the IMFs first
attempt at multilateral consultations on global imbalances in 2006. According to
Trevor Manuel, South Africas Finance Minister, one has to start from the
fundamental view that if you accept public policy and you accept the
interconnectedness of the global economy, then you need an institution appropriate to
its regulation. Analysts argue, however, that developed countries have long ignored
IMF advice on their economic policy, while at the same time pressuring the IMF to

use its role in patrolling the exchange rate system to support their own foreign
economic goals.

Lessons From Japan

When the U.S. Treasury planned the $700 billion bailout package (Emergency
Economic Stabilization Act of 2008, H.R. 3997) to address the U.S. financial crisis, it
reportedly examined the experience of Japan as it grappled with its banking crisis in
the 1990s. This report reviews the major actions by the Japanese government in
dealing with its crisis and highlights some of the lessons learned from their
experience.
Like the current U.S. financial crisis, Japans began with stock market and real estate
bubbles. During the latter half of the 1980s, Japans monetary authorities flooded the
market with liquidity (money) in order to enable businesses to cope with the rising
value of the yen. Businesses did invest in new capital equipment to become more
competitive in international markets, but the excess liquidity also found its way into
speculation in Japans stock market, in real estate ventures, and in foreign
investments. At that time, the market value of both land and equities was rising so fast
that investors and speculators could hardly miss. Investors tended to ignore risks. The
larger mistake for them was not to borrow and invest and consequently not be
positioned to reap the returns from rising markets. Banks considered most loans with
real estate as collateral as being unquestionably secure. Then the bubbles burst.
Japans Nikkei stock market average peaked in 1989 at 40,000 and dropped by 50%
in one year and more than two-thirds to about 12,000 by August 2001. Japans banks
are allowed to hold equities as part of their capital base. The value of the unrealized
capital gains on such stock holdings dropped from $355 billion in 1989 to $42 billion
in 2001. This drastically reduced key capital reserves for many banks. Also, by 2000,
commercial land values in the six major metropolitan areas had fallen by 80% from
their peak level in 1991. Residential and industrial land values also had fallen by
nearly 20%.
The bursting of this economic bubble caused the value of collateral underlying many
bank loans to drop below the value of their loan principal. Also, commercial real
estate ventures, especially office buildings, became unprofitable as rents fell. As the
economy slowed, companies also faced excess capacity, excess inventories, and lower
profits. Also as more and more loans turned sour, more and more of the underlying
real estate had to be sold at bargain prices. In 1995, Japans banks reported $280
billion in nonperforming loans, but this figure turned out to be vastly understated.4
Japanese financial institutions at this time, however, generally did bundle and
repackage these loans as collateralized debt obligations or rely extensively on
derivatives or other financial instruments. Mortgage defaults tended to be on
commercial property, not on private residences.
At first, the Japanese governments strategy was forbearance, a strengthening of
deposit protection, provision of emergency liquidity, and some assistance to
encourage mergers of failed institutions. The crisis worsened in 1995-1996 following
the bankruptcy of several specialized housing loan companies (jusen). In 1996, the
government made its first injection of capital to purchase assets from ailing housing
lenders. This bailout proved to be quite unpopular politically and may have
contributed to tentativeness later on the part of government as the downward spiral
quickened.

By 1997, Japans banking sector was in a full systemic crisis. The government
responded by making $250 billion (30 trillion) available of which $108 billion (13
trillion) went to banks and $142 billion (17 trillion) to the Deposit Insurance
Corporation of Japan. In 1998, the government bought the bankrupt Long-Term
Credit Bank and Nippon Credit Bank. These two banks had no consumer deposit
system but borrowed funds on financial markets to lend on a long-term basis to
businesses. These banks were eventually sold to private investors. The government
also took over the management of many financial institutions.
In March 1998, the government injected another $14 billion (1.8 trillion) to bolster
bank balance sheets and in March 1999 injected another $62.5 billion (7.5 trillion).
By October 1998, the government had invested $495 billion (60 trillion yen), or 12%
of gross domestic product, for the financial support of banks.
For much of the 1990s, however, the hope of the government was that if it could keep
banks operating, their profits from operations and capital gains from equity holdings
could fund the writeoffs of bad loans. The Bank of Japan kept its interest rate for
banks low so that they could increase profits from new lending. Between 1995 and
2003, Japans banks wrote off a cumulative total of $318 billion (37.2 trillion) in
nonperforming loans, but new ones appeared so fast that the total outstanding amount
kept increasing and peaked in March 2002 at $330 billion (43.2 trillion) or 8.4% of
total lending.
Through a combination of capital injections, new laws and regulations, stronger
oversight, a reorganization of the banking sector, moderate economic recovery, and
several years of banks working off their non-performing loans, the Japanese banking
sector now has recovered. By September 2005, the banks reported 3.5% of their total
lending as non-performing, a tolerable amount. By 2008, Japanese banks and
brokerage houses had become strong enough that Nomura Holdings had agreed to buy
the Europe and Middle East operations of Lehman Brothers as well as Lehmans
franchise in Japan and Australia. Mitsubishi UFJ Financial Group has agreed to buy
20% of Morgan Stanley.

Net Cost of Bailouts

: The various bailout packages in Japan were

administered primarily by the Deposit Insurance Corporation of Japan (DICJ). When

a financial institution fails, the DICJ may extend assistance to another financial
institution that purchases assets or merges with the failed financial institution in order
to facilitate the transaction. The DICJ also works to prevent financial institutions from
failing. The forms of assistance include a direct money grant, a loan or deposit of
funds, purchase of assets, a guarantee or assumption of debts, a subscription of
preferred stock, and loss sharing. Not all of the activities of the DICJ, however, are
related to the bailout packages. It also has ongoing operations associated with its
traditional function of insuring bank deposits. The annual reports of the DICJ,
however, provide detail on the disposition of $399 billion of the $495 billion in funds
announced in Japans financial assistance packages.
As shown in Table 1, as of March 2007, the DICJ had provided financial assistance in
the amount of $399 billion. This included 180 cases with grants of $159 billion, asset
purchases of $83 billion, capital injections of $106 billion, and other assistance
(mostly loans) of $51 billion.
The grants were funded by $110 billion (13 trillion) in DICJ bonds issued (repaid
from taxpayer funds) and from premiums from deposit insurance. Of the asset

purchases of $83 billion, the DICJ recovered $79 billion. The asset purchases
included $54 billion in assets from failed financial institutions (of which $60 billion
had been recovered) and $25 billion in shares purchased (of which $14 billion had
been recovered).

Capital injections of $106 billion came under five different bailout packages and
included subscriptions to preferred or common stock, purchases of subordinated
bonds, and the extending of subordinated loans. The DICJ had injected capital into 25
different banks. As of March 2007, $31.3 billion of these assets was still held by the
DICJ in the form of preferred shares, common shares, and subordinated loans.

The $51 billion in the Other category included loans to banks which were under
special public management, taking delivery of assets under warranty for latent
defects, compensation for losses, lending to assuming financial institutions, and debt
assumption. The last capital injection reported by the DICJ was in March 2003.
The Resolution and Collection Corporation (RCC), a subsidiary of the DICJ, borrows
funds from the DICJ to purchase and dispose of assets (within three years) from sound
financial institutions and some under special public management. As of March 2007,
the RCC had purchased assets with claims of $34.5 billion (4.0 trillion) for a
discounted price of $3.0 billion (355.7 billion). These assets had been sold for $5.2
billion (609.4 billion) for a gain of 172% for the RCC. In essence, the RCC paid

about 9 cents on a dollar for the troubled assets and was able to dispose of them at a
profit. The DICJ consults with the Purchase Price Examination Board (an advisory
body to the DICJ) with respect to the price it pays for assets. The RCC made no
purchases in FY2006 (ending in March 2007).

Lessons Learned: The following are various lessons and observations that
observers have gleaned from the Japanese experience.
! Authorities underestimated the nature and seriousness of the banking problem at
first. Most thought the financial problems would resolve themselves through
economic growth and by keeping central bank interest rates low in order to increase
bank margins and profitability.
! There was a slow recognition of the extent of non-performing loans and the carrying
of zombie firms that technically were bankrupt but were kept alive by banks. This
delayed resolution of the problem.
! Transparency and an updating of definitions and reporting requirements with respect
to non-performing loans was important in realizing the true extent of the problems.
Many of the rescues of ailing financial firms by a healthier financial institution
required a government injection of capital in some form.
! There appeared to be a lack of domestic or external constraints and of political
leadership that would have urged authorities to take more decisive action earlier.
! The government began by creating new institutions to handle emergency financial
assistance but later transferred such activities to the Deposit Insurance Corporation of
Japan (DICJ), an institution that already was working with troubled financial
institutions. The DICJ also was given permanent authority to assist ailing financial
institutions when so ordered by the Prime Minister.
! The Japanese government injected capital into financial institutions in several ways
depending on the situation. In most cases, the DICJ could use its discretion in
determining the nature of the assistance.
! Troubled assets were bought at a steep discount from their face value from sound
financial institutions (to inject capital) and disposed of without unduly disturbing
markets usually within three years. The two banks that were nationalized were
later sold to private investors. Capital injections also took the form of subscriptions to
stock, grants, and subordinated loans.
! Even with the $495 billion financial bailout packages, between 1998 and 2003,
Japans banks wrote off some $318 billion in non-performing loans. The burden was
shared.
! Government holdings of corporate shares have generated dividend income and
capital gains for the DICJ.
! Since there are fewer banks in Japan, the authorities could focus recovery efforts on
several large banks and fewer than 200 smaller financial institutions (there are about
8,500 banks in the United States) which facilitated information gathering and
coordination.
! When Japan announced an early financial bailout package, it placed stringent
conditions on the assistance that banks were unwilling to accept. The net result was
that the banks ignored the package and tried to bolster their balance sheets by not
lending. This was seen as worsening the economic conditions for the country. Most of
the assistance to failing institutions, however, carried conditions that were
enforced by the DICJ.
! New technologies, globalization, and the blurring of boundaries between types of
financial products and institutions made risk management increasingly difficult for
financial regulators.

! The bursting of the real estate bubble in Japan caused more difficulty for banks than
the bursting of the bubble in stocks because the decline in real estate values effected
the value of collateral on much bank lending.
! Japan is considered to have acted too slowly with respect to monetary policy, fiscal
policy, and the resolution of problems in the banking sector. Once the economy began
to recover, fiscal policy is thought to have tightened too soon.

Lessons From Chile

The U.S. Congress is contemplating a $700 billion government assistance package to
arrest the financial crisis in the United States. President Bush argued that failure to
enact legislation quickly could result in a wholesale failure of the U.S. financial
sector. As discussion of the Administrations plan unfolded, however, questions in
Congress arose over issues of magnitude and management of the bailout, the need
for oversight, and the possibility that less costly and perhaps more effective
alternatives might be available.
In this light, Chiles response to its 1981-84 systemic banking crisis has been held up
as one example. The cost was comparable relative to the size of its economy to that
facing the U.S. Government today. In 1985, Central Bank losses to rescue financially
distressed financial institutions were estimated to be 7.8% of GDP (equivalent to
approximately $1 trillion in the United States today). The policy options Chile chose
had similarities as well as differences from those contemplated in the United States
today. Their relevance is debatable, but they do highlight an approach that succeeded
in eventually stabilizing and returning the Chilean banking sector to health, while
keeping the credit markets functioning throughout the crisis.

Comparing Financial Crises: The seeds of the Chilean financial crisis were
much different than those in the United States. Nonetheless, in both cases, the
financial sector became the primary problem, with policy makers concerned over the
prospect of a system-wide collapse. Chiles problems originated from large
macroeconomic imbalances, deepening balance of payments problems, dubious
domestic policies, and the 1981-82 global recession that ultimately led to financial
sector distress. Although most of these are not elements of the U.S. crisis, there are a
number of similar threads woven throughout both cases.
Broadly speaking, both countries had adopted a strong laissez-faire orientation to their
economies and had gone through a period of financial sector deregulation in the years
immediately prior to the crisis. A group of scholars characterized Chiles orientation
toward the financial sector as the radical liberalization of the domestic financial
markets and the belief in the automatic adjustment mechanism, by which the
market was expected to produce a quick adjustment to new recessionary conditions
without interference by the authorities.
In both cases, given the backdrop of financial sector deregulation, a number of similar
economic events occurred that ultimately led to a financial crisis. First, real interest
rates were very low, giving rise to a large expansion of short-term domestic credit.
With credit expansion came the rise in debt service, all resting on a shaky assumption
that short-term rates would not change. In both cases, but for different reasons, rates
did rise, causing households and firms to fall behind in payments and, in many cases,
to default on the loans. The provision for loan losses was inadequate causing financial
institutions to restrict credit. Soon, many found themselves in financial trouble or
insolvent, resulting in the financial crisis. Chiles response may prove useful as policy
makers evaluate options.

The Chilean Banking Crisis of 1981-84: Following the coup against

socialist President Salvador Allende in 1973, General Augusto Pinochet immediately
re-privatized the banking system. Banking regulation and supervision were
liberalized. Macroeconomic conditions and loose credit gave way to the economic
euphoria of 1980-81. The exuberance included substantial increases in asset prices
(reminiscent of a bubble) and strong wealth effects that led to vastly increased
borrowing. The banking system readily encouraged such borrowing, using foreign
capital, that because of exchange rate controls and other reasons, provided a negative
real interest rate. From 1979 to 1981, the stock of bank credit to businesses and
households nearly doubled to 45% of GDP. This trend came to a sudden halt with the
1981-82 global recession.
The financial sector found itself suddenly in a highly compromised position. Weak
bank regulations had allowed the financial sector to take on tremendous amounts of
debt without adequate capitalization. Debt was not evaluated by risk characteristics.
Most debt was commercial loans, but banks also carried some portion of consumer
and mortgage debt. As firms and households became increasingly financially stressed,
and as asset prices plummeted, the solvency of national banks became questionable.
Two issues would later be identified: the ability of borrowers to make debt payments,
and more importantly, the reluctance of borrowers to do so given there was a broadlyheld assumption that the government would intervene. By November 1981, the first
national banks and financial institutions that were subsidiaries of conglomerates failed
and had to be taken over by regulatory authorities.
Most debt was short term and banks were in no position to restructure because they
had no access to long-term funds. Instead, they rolled over short-term loans,
capitalized the interest due, and raised interest rates. This plan was described by one
economist as an unsustainable Ponzi scheme, and indeed was a critical factor in
bringing down many banks as their balance sheets rapidly deteriorated. From 1980 to
1983, past-due loans rose from 1.1% to 8.4% of total loans outstanding. The sense of
crisis further deepened because many of the financial institutions were subsidiaries of
conglomerates that also had control over large pension funds, which were heavily
invested in bank time deposits and bank mortgage bonds. In the end, although the
roots of the banking crisis were different than those in the United States, the Chilean
government faced the possibility of a complete failure of the financial sector as credit
markets contracted.

The Government Response: The Central Bank of Chile took control of the
crisis by enacting three major policies intended to maintain liquidity in the financial
system, assist borrowers, and strengthen lender balance sheets. These were: 1) debt
restructuring for commercial and household borrowers; 2) purchases of
nonperforming loans from financial institutions; and 3) the expeditious sale, merger,
or liquidation of distressed institutions.
Debt Restructuring. From the outset of the rescue plan, the Chilean Central Bank
considered providing relief to both debtors and lenders. There were two rationales.
First, as a matter of equity, there was a sense that households as well as firms should
be helped.
Second, to maintain a functioning credit market, both borrowers and lenders needed to
be involved. The Central Bank decided to restructure commercial, consumer, and
mortgage loans. The goal was to extend the loan maturities at a reasonable interest
rate. The debtor was not forgiven the loan, rather banks were given the means to
extend the maturities of the loans to keep the debtor repaying and the credit system
functioning. Restrictions were in place. Eligible firms had to produce either a good or

service, eliminating investment banks that held stock in such firms. Only viable
businesses were eligible, forcing the bankruptcy procedures into play where
unavoidable. To keep the program going, the loan conditions of each subsequent
iteration of the program became easier: longer maturities; lower interest rates; and
limited grace periods.
The program allowed Central Banks to lend firms up to 30% of their outstanding debt
to the banking system, with the financing arrangement working in one of two ways.
At first, the Central Bank issued money, lent it to debtors, which used it to pay back
the bank loans. Later, the Central bank issued money to buy long term bonds from the
banks, which used the proceeds to restructure the commercial loans. Variations of this
process were applied to consumer and mortgage debtors. In cases where loans were
made directly from the Central Bank to the debtor, repayment was expected usually
beginning 48 months after the loan was made. The fiscal cost was significant,
approximating 1% of GDP in 1984 and 1985.
Restoring Bank Balance Sheets. This program was more controversial and had
to be adjusted over time to be effective. The key idea was to postpone recognition of
loan losses, not forgive them. It relied on identifying nonperforming loans and giving
banks time to provision against them, without risking insolvency. The process has
been variously characterized as the Central Bank taking on bad debt through loans,
purchases, or swaps. All three concepts play some part of this complex, largely
accounting-driven arrangement.
Initially, this program was described as a sale, although there was no exchange of
assets. The Central Bank technically offered to buy nonperforming loans with
noninterest bearing, 10-year promissory notes. Banks were required to use future
income to provision against these loans and buy them back with the repurchase of
the promissory notes. In fact, they were prohibited from making dividend payments
until they repaid the Central Bank in full. The banks, though, actually kept the loans
and administered them, but did not have to account for them on their balance sheets.
This arrangement was intended to encourage banks to stop rolling over nonperforming loans, recognize the truly bad ones, and eventually retire them from their
portfolios. The banks benefitted by remaining solvent and gaining time to rebuild
their loan loss reserves so to address nonperforming loans. The credit market was
served by banks being able to continue operating with increased funds from released
loan-loss reserves.
This program did not work as hoped at first and had to be adjusted. The Central Bank
allowed more time for banks to sell nonperforming loans and also permitted a greater
portion of their loan portfolios to qualify. It also began to purchase these loans with an
interest-bearing promissory note. The banks, however, actually repaid the interestbearing note at a rate 2 percentage points below that paid by the Central Bank to the
banks. This added differential was sufficient incentive for the banks to sell all their
bad loans to the Central Bank, beginning a process of identifying good loans and
allowing for the eventual retirement of bad loans from the balance sheets (and the
banking system). The cost to the Central Bank increased, but by 1985, the portfolio of
non-performing loans at the Central Bank began to decline and was eventually
eliminated.
Restructuring Distressed Banks. A major goal of government actions was to
ensure that bank owners and creditors were not absolved of responsibility to help
resolve the crisis, including using their own resources to absorb some of the costs.
The government worked closely with all financial institutions to impose new riskadjusted loan classifications, capital requirements, and provisioning for loan losses,

which would be used to repurchase loans sold to the Central Bank. The banks,
through the Central Bank purchase of substandard loans, were given time to return to
profitability as the primary way to recapitalize, and became part of the systemic
solution by continuing to function as part of the credit market.
A number of banks had liabilities that exceeded assets, were undercapitalized, and
unprofitable. Their fate was determined based on new standards and they were either
allowed to be acquired by other institutions, including foreign banks, or liquidated.
The too big to fail rule was apparently a consideration in helping keep some
institutions solvent. A total of 14 financial institutions were liquidated, 12 during the
1981-83 period. In most cases, bank creditors were made whole by the government on
their deposits with liquidated banks. For three financial institutions that were closed in
1983, depositors had to accept a 30% loss on their assets.

Possible Lessons from Chiles Bank Crisis: The overriding goal of a

strategy to correct systemic crisis in the financial sector is to ensure the continued
functioning of credit markets. Chile succeeded in accomplishing this goal and
restoring a crisis-ridden banking system to health within four years. The single most
important lesson of the Chilean experience was that the Central Bank was able to
restore faith in the credit markets by maintaining liquidity and bank capital structures
through the extension of household and consumer loan maturities, the temporary
purchase of substandard loans from the banks, and the prompt sale and liquidation of
insolvent institutions. Substandard loans remained off bank balance sheets until the
viable institutions could provision for their loss from future profits. Other losses were
covered by the government.
In addition, a number of other insights emerged from the Chilean crisis:
! The market could not resolve a system-wide failure, particularly in the case where
there was a high expectation of a government bailout.
! The expectation of a bailout became self-fulfilling and increased the cost.
! Appropriate prudential supervision and regulation were critical for restoring health
and confidence to the financial system. Observers lamented the a priori lack of
attention to proper regulation.
! Private institutions that survived shared in the cost and responsibility to resolve the
crisis to the apparent long-term benefit of the financial sector.
! The fiscal cost of the three policies discussed above was high. Liquidating insolvent
institutions had the highest cost followed by the purchase of non-performing loans
and rescheduling of domestic debts. The strategy, however, is widely recognized as
having allowed the financial system and economy to return to a path of stability and
longterm growth.

REFERENCES

The Evolution of Financial Crisis in 2008, Sugato Chakravarty, Department of

Consumer Science and Retailing Ken Foster, Department of Agricultural
Economics Purdue University.
U.S. FINANCIAL CRISIS, FALL 2008, NORTHWOOD UNIVERSITY, Dr.
Timothy G. Nash and Dr. Debasish Chakraborty.
THE FINANCIAL CRISIS OF 2008, JOHN W. DIAMOND, PH.D., EDWARD A.
AND HERMENA HANCOCK KELLY FELLOW IN TAX POLICY, JAMES A.
BAKER III INSTITUTE FOR PUBLIC POLICY, RICE UNIVERSITY.
The Global Financial Crisis, CRS Report for Congress, Martin A. Weiss,
Specialist in International Trade and Finance, Foreign Affairs, Defense, and
Trade Division, October 30, 2008.
The U.S. Financial Crisis: Lessons From Japan, CRS Report for Congress,

Dick K. Nanto, Specialist in Industry and Trade, Foreign Affairs,

Defense, and Trade Division, September 29, 2008.
The U.S. Financial Crisis: Lessons From Chile, CRS Report for Congress,

J. F. Hornbeck, Specialist in International Trade and Finance, Foreign

Affairs, Defense, and Trade Division, September 29, 2008.