New challenges and policy in managing financial risk.(The U.S. Financial Crisis: The Global Dimension with Implications for U.S. Policy)

The Challenges

So far, the actions of the United States and other nations in coping with the global financial crisis have been primarily to contain the contagion, minimize losses to society, restore confidence in financial institutions and instruments, and lubricate the wheels of the system in order for it to return to full operation. There is considerable uncertainty, however, over whether the worst of the crisis has passed, how nations will cope with second phase of the crisis (global recession and the spread of the crisis to emerging markets), and whether the current crisis is an aberration that can be fixed by tweaking the system, or whether it reflects systemic problems that require major surgery. The challenges of the third phase still remain. They arguably are to change regulatory structure and regulations and the global financial architecture to ensure that future crises do not occur or, at least, to mitigate their effects. The fourth phase is to cope with long-term political and social effects of the financial crisis and ensuing slow down in economic growth.

On a more philosophical plane, the fundamental assumption that markets are self correcting and that individuals pursuing their own financial interests like an "invisible hand" tend also to promote the good of the global community has been questioned. Will the losses of this financial crisis hurt investors and institutions enough that the system will become more prudent in the future, or is further regulation and oversight necessary to fill gaps in information and technical expertise to compensate for faulty or incomplete methods of modeling risk, and to provide more resilience in the system to offset human error? A related question is whether there should be a system of controls on flows of capital during a financial crisis that would be aimed at temporarily calming markets.

At the G-20 Summit on Financial Markets and the World Economy on November 15, 2008, in Washington, DC, the leaders of these nations seem to have concluded that major changes are needed in the global financial system. The G-20 recommendations imply that most saw the system as functional but major measures were needed to reduce risk, to provide oversight, and to establish an early warning system of impending financial crises. The G-20 leaders also agreed, however, that "needed reforms will be successful only if they are grounded in a commitment to free market principles, including the rule of law, respect for private property, open trade and investment, competitive markets, and efficient, effectively-regulated financial systems." (See Appendix C and section of this report on the G-20.)

A related philosophical question for the United States deals with the nature of capitalism. Should U.S. government ownership of stock in private corporations113 also provide Washington a voice in how the corporations are managed? What conditions should be attached to large loans provided to corporations? A key dispute in the Cold War was capitalism versus socialism. Should major companies in the economy be owned by private investors and entrepreneurs or should they be national assets owned and managed by the government? Should the main objective of large companies be to maximize returns to shareholders, or should the government use its investment in company shares to turn management objectives more toward maximizing the national well being? Should limits, for example, be placed on executive compensation in companies that receive government assistance? Also, should the government be in the business of "picking winners and losers" in the process that the economist Joseph Schumpeter described as creative destruction in capitalism?114 Should the government "prop up companies" that should actually be "destroyed" so that stronger and more innovative companies can emerge? Is there really a company that is "too big to fail?" This question is being raised in conjunction with proposals to provide loans to U.S. automobile makers.

For other nations of the world, what has become clear from the crisis is that U.S. financial ailments can be highly contagious. Foreign financial institutions are not immune to ill health in American banks, brokerage houses, and insurance companies. The financial services industry links together investors and financial institutions in disparate countries around the world. Investors seek higher risk-adjusted returns in any market. For example, in the "carry trade," investors borrow funds in a country with low interest rates (such as Japan and Switzerland) and invest in higher yielding securities in another country (such as New Zealand, Australia, or the United States). This trade has involved amounts estimated in the hundreds of billions of dollars and has been a major factor in the appreciation of the yen in late 2008 as investors unwound yen carry trade positions. (115) In financial markets, moreover, innovations in one market quickly spread to another, and sellers in one country often seek buyers in another. AIG insurance, for example, …