No one any longer doubts that this is the most serious crisis that the world economy has faced since at least the 1930s. Nor is there any remaining doubt that this crisis affects virtually all areas, developed and developing, with large reserves or small. (The only exceptions are a handful of countries, like Nigeria, that are not integrated into the world financial market, export overwhelmingly primary commodities, in which the central government receives most of the revenue, and that budgeted for prices that now appear realistic but seemed conservative a year ago.) It is a crisis that started in the financial sector of what was thought of as the country with the most-sophisticated financial system, and that has spread almost universally and with startling rapidity by virtue of either financial or trade interdependence or both.
Some of us thought that a number of the crises of recent decades (notably the East Asian crisis) better reflected the inadequacies of the financial system than of the victims. This time around no one doubts that the blame lies with the financial system and those who have operated it. Preventing a recurrence of this type of crisis, which is a quite different exercise from overcoming the present crisis, accordingly demands reforms to the financial system. The question discussed in this essay is: What reforms? What needs to change?
Diagnosing the Problems
A necessary precondition to designing reforms is to agree on the diagnosis of what went wrong with the system that gave rise to the crisis. In the most general terms, there seem to be three candidates: overly large banks, excessively expansionary policies, and a misguided system of regulation.
We had become accustomed to the doctrine that some financial institutions are “too big to fail.” After Iceland, it seems that this doctrine has to be supplemented with a recognition that some banks are too big to be saved. Put the two together and one comes to the conclusion that some banks have become too big to exist. Martin Wolf put the same point in the Financial Times(March 4):
We are painfully learning that the world's mega-banks are too complex to manage, too big to fail and too hard to restructure. Nobody would wish to start from here. But, as worries in the stock market show, banks must be fixed, in an orderly and systematic way.