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Why We Need to Act Now

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By Anne O. Krueger
Thursday, September 25, 2008

It is imperative that the United States act quickly to restore confidence and the flow of credit. The longer action is delayed, the more costly rescue is likely to be. Rescuing the financial system is in the interests of all Americans: Failure to do so would result in rising unemployment and falling output, with the greatest harm inflicted on the poor.

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The focus right now should be on strengthening the vital system underlying our economy, not on placing blame for who or what created this mess. A well-functioning financial system is imperative. The rising living standards of the past two centuries would not have been possible without the development of an increasingly sophisticated financial system. It assesses the prospects of alternative uses of investible resources and allocates those resources on the basis of risk-return calculations. A financial system incapable of appropriately assessing the trade-offs between risk and reward cannot support economic growth.

Fortunately, the reduction in U.S. construction activity has, to date, been offset by increases in net exports, and there has been no recession. But as uncertainty about the value of assets underlying various credit instruments has spread, the risks that credit will shrink, and thus lead to declining economic activity, have increased. There must be a rescue before that happens; sustaining credit availability to creditworthy borrowers is crucial for the economy as a whole. Simultaneously, viable banks must be recapitalized.

It is important that measures taken now do not impair the financial system's longer-term ability to function.

Japan's experience holds lessons. The real estate boom in Japan ended around 1990, and it was assumed that the banks could handle the nonperforming loans on their books. The result of that assumption was more than a decade of stagnation, until measures were taken to reduce the nonperforming loans on the banks' books, recapitalize the banks and restore the flow of credit. The costs of acting a decade or more earlier would have been substantially smaller. The choice Japan faced was not whether to act but whether to act now or later. That is almost certainly the decision United States faces now.

Any rescue should not reward shareholders and those who made the risky decisions. If a fund is established to buy up some of the banks' questionable assets, accurately pricing those assets will be critical. It will also be crucial to purchase assets only from financial institutions that are healthy enough to survive. The more transparent the rules for purchasing loans from banks, the more effective the system will be. Indeed, improving transparency of the entire financial system would be beneficial now and in the long run.

Enough resources must be provided to ensure the success of the operation: If "too much" is allocated, the funds will not need to be spent. Ironically, a larger pool of resources may ultimately cost less than a smaller one. If the allocation is "too small," it will not instill the confidence necessary to ensure that capital markets function. In that case, the inevitable next rescue effort will probably cost even more.

But the focus today should be on swift action. Decisions about regulatory changes should be postponed until the crisis has passed and cooler heads can assess what went wrong and then consider alternative regulatory options in light of those assessments. Overly tight regulation may constrain lenders so much that new activities, which would be major contributors to economic growth, would be unable to obtain needed financial support.

The writer, a professor of international economics at the Johns Hopkins University's School of Advanced International Studies, was first deputy managing director of the International Monetary Fund from 2001 to 2006. She is a professor emeritus at Stanford University.


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