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JOINT ECONOMIC COMMITTEE
CONGRESSMAN JIM SAXTON
RANKING REPUBLICAN MEMBER
RESEARCH REPORT #110-26
October 2008
GOVERNMENT POLICY BLUNDERS LARGELY CAUSED THE GLOBAL FINANCIAL CRISIS
Macroeconomic and microeconomic policy blunders by both the U.S. government and foreign governments inflated an unsustainable housing bubble in the United States and other developed economies. When this bubble inevitably popped, a global financial crisis ensued. Although misaligned private incentives, methodological errors in rating structured credit products, and the recklessness of some private financial institutions and investors did play a contributory role in the recent financial turmoil, individuals and firms could not have created and sustained such a large housing bubble over so long a time without major macroeconomic and microeconomic policy mistakes. These policy mistakes were:
1. The exchange rate policy of the People’s Republic of China (PRC) and the shadow exchange rate policies of governments in other Asian economies caused large and persistent international trade imbalances, suppressed price increases on tradable goods and services, and channeled monetary inflation in the United States and other developed countries with floating exchange rates disproportionately into housing prices;
2. The Federal Reserve pursued, at least in retrospect, an overly accommodative monetary policy after 2000 that kept U.S. interest rates too low for too long. Moreover, central banks in the PRC and other Asian economies invested most of their surging foreign exchange reserves in U.S. Treasury, Fannie Mae, and Freddie Mac debt securities, flatting the long-end of the yield curve in the United States. These policies combined to produce extremely low long-term interest rates that stimulated housing demand.
3. Financial regulators in the United States and other developed economies failed to exercise adequate prudential supervision over highly leveraged non-depository financial institutions in the alternative financial system;
4. Regulations mandating the use of value-at-risk models to determine the capital adequacy of financial institutions (1) caused both these institutions and their regulators to underestimate risk exposure, and (2) encouraged these institutions to increase their leverage;
5. Regulations mandating the use of “fair value” accounting (also known as “mark-to-market” accounting) for illiquid financial assets exacerbated liquidity problems at financial institutions after the housing bubble burst.
6. The strengthening of affordable housing regulations governing Fannie Mae and Freddie Mac in October 2000 had the unintended consequence of creating a large regulatory-induced demand for subprime residential mortgage loans that mortgage banks proceeded to satisfy.
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| | Posted 10/12/2008 9:36 PM - 111 Views - 8 eProps - 5 comments
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