Crisis in International Finance

Is a new international financial regulatory system necessary?
The federal takeover of U.S. mortgage-lending giants Fannie Mae and Freddy Mac in the wake of the sub-prime mortgage crisis stunned the country and sent shockwaves through the international financial system, exposing risky lending and burgeoning trade deficits in countries around the world. Today, the international financial system is reeling from the destabilizing impact of the domestic financial crisis, leaving the future of financial markets far from certain.
There have been many unforeseen victims in this far-reaching crisis. Narvik, Norway, a small town north of the Arctic Circle, offers a solemn reminder that nowhere is so remote as to be unaffected. This town of 18,000 invested its entire savings in the Florida real estate market, convinced that mortgage-backed securities were both profitable and safe. Now the town must drastically shrink its budget to adjust for severe losses.
Given the magnitude of the crisis and its effects across the globe, policymakers must consider whether the international financial regulation system requires a wholesale overhaul to stem the hemorrhaging of capital markets and prevent future crises. Despite the borderless nature of the international economy and the many structural failures underlying the financial crisis, however, the only politically achievable method of improvement lies in system adaptation by private actors, not in the construction of a new supranational financial structure.
Causes of the Crisis
The American domestic financial crisis was triggered by the collapse of the housing bubble in the United States. Housing prices nationwide dropped dramatically, even surpassing the price drop during the Great Depression. Christopher Foote, a Senior Economist and Policy Advisor in the Research Department at the Federal Reserve Bank of Boston, explained in an interview with HPR that, for the past decade, the United States has received more foreign investment (capital inflow) than it has invested abroad (capital outflow), and has thus had to borrow significantly from the rest of the world to make up the difference. Most foreign investors chose to lend to the United States through the purchase of mortgage-backed securities, assets inextricably linked to the housing market which had consistently increased in value until the housing bubble burst.
Hung Tran, Senior Director of the Capital Markets and Emerging Markets Policy Department at the Institute of International Finance, described the crisis to the HPR as “a reflection of the belief many held that financial innovations spur distribution of risk without fully understanding the impact of such instruments in the up market as well as the down market.” The consequences of this optimistic attitude are now apparent, and now both the United States and the rest of the world must swallow the bitter pill of rising unemployment, falling housing prices, and shrinking GDPs.
International Regulation
Surveying the wreckage of the system, the question naturally arises as to what extent the international community should pursue new global regulatory standards for financial markets. Tran cited the Basel II Accords, a series of recommendations on banking laws that assess and manage risk against insolvency or instability, as one potential model. In Foote’s less prescriptive view, it “will be interesting to see how financial markets themselves change endogenously to prevent something like this from happening again” in light of lessons learned.
While international regulation is a tempting consideration for many policymakers, it is limited by the scope of the regulatory body’s jurisdiction. N. Gregory Mankiw, former chairman of the Council of Economic Advisors under President George W. Bush, argues against international regulation, telling the HPR, “a little bit of regulatory competition among jurisdictions is probably a good thing… and I’m not sure we have international organizations in place I would trust to regulate the world financial system.” Though Tran is more supportive of international cooperation, noting the benefits of an advisory board such as the Federal Reserve monitoring and mitigating the risk of the entire financial system, he strongly emphasized the role of private actors: “every part of the system needs to try to improve their part of it going forward.”
At this point in time, a complete overhaul of the international financial system seems unlikely, even though academics and policymakers may strategize possible long-term changes. The short-term goal is to restore confidence in the markets, rebuild banking systems, and give individual players the opportunity to implement the lessons they have learned as a result of this crisis.