Two years after its onset, the effects of the worst financial crisis in decades are still being felt and the crisis leaves a legacy that will be with us for many years: trade is expected to remain 10–15 percent below pre-crisis trends in the foreseeable future; public debt levels are 20–30 percent higher than pre-crisis levels as a share of GDP and are rising; banks, particularly in Europe, are still fragile; a large liquidity overhang remains; and the Euro crisis highlights the pressure now on fiscal policy in many countries.

Carnegie hosted the World Bank’s Justin Lin and the International Monetary Fund’s José Viñals to discuss the lessons that can be drawn from the financial crisis and what policy makers can do to prevent a similar crisis from happening again. Carnegie’s Uri Dadush moderated.

The Crisis

  • Causes: Risk may emerge during bad times, but it accumulates during good ones. Over the 5-10 years that preceded the financial crisis, low inflation and stable growth led everyone—from regulators to credit rating agencies to individual investors—to disregard or underprice risk, argued Viñals.

  • Transmission Mechanisms: Developing countries felt the effects of the crisis through financial and trade flows, Lin explained; shocks to commodity prices, tourism, and remittances were also significant for certain economies.

  • Resilience: East Asia weathered the crisis best, while Europe and Central Asia exhibited the worst performance. According to Lin, countries with open economies, macroeconomic stability, high savings and investment rates, and credible, committed governments were best able to respond to the crisis, though many of them—being the most open—also experienced the biggest shocks.

Policy Lessons

Looking toward the future, Lin focused on the importance of economic fundamentals, while Viñals discussed the value of macroeconomic policy and financial system regulation.

  • Fundamentals: Sufficient fiscal room, significant foreign reserves, and greater exchange rate flexibility are essential for long-term growth and also increase resilience to shocks during crisis, as do a sound central bank and a credible banking sector. A lower short-term-debt-to-reserves ratio and less domestic debt denominated in a foreign currency also help.

  • Fiscal Policy: Policy makers must create fiscal surpluses and lower debt in order to create the fiscal room needed to maneuver during a crisis. They should enact automatic and easily verifiable countercyclical rules to create fiscal buffers during periods of economic growth.

  • Monetary Policy: Apparent macroeconomic stability can undermine financial stability: even if inflation is stable, credit growth and asset prices can get out of control. While monetary policy makers should continue to prioritize their mandates (price stability and, in some cases, growth) and financial regulators should be responsible for financial stability, monetary policy should take financial considerations into account at the margin.

  • Financial System: Financial institutions should pay for their costs to society through a financial levy and by adopting  remuneration schemes that discourage excessive risk-taking. In addition, ratings agencies, which had a hand in creating the crisis, must be better regulated, particularly with regard to their ratings of complex products. At the same time, responsibility also rests on investors, who must do their own due diligence, and on officials, who should reduce their reliance on ratings, as the European Central Bank is doing.


Viñals noted that new financial regulation is essential to preventing another crisis, but argued that any regulation must find a balance in six crucial areas.  

  • Micro and Macro: Before the crisis, not only did regulators fail to see the forest for the trees, but they also failed to see the trees, Viñals said. Individual financial institutions and the financial system as a whole must be better monitored.

  • Rules and Enforcement: Both regulation and supervision are necessary. The Great Recession resulted from a failure in both the regulations that were in place and the willingness of regulators to enforce them.

  • Banks and Non-Banks: A safer banking system is not enough. The shadow banking system—non-bank financial institutions—must also be better regulated.

  • Safety and Dynamism: Regulations should not preclude innovation in the financial sector.

  • National and International: Minimum safety standards should be applied at the international level, with flexibility for national governments to do more.

  • Public and Private: Better supervision and better behavior are both needed. Regulation helps, but private financial institutions must also make better decisions.

Moving Forward

With exits still to be made from both monetary and fiscal policies, particularly in high income countries, emerging markets must help sustain growth by reducing global imbalances.

  • Fiscal Policy: The exit from fiscal stimulus will likely prove the most challenging, said Viñals. If all advanced countries have to exit in the next few years, there will be a drag on growth, but if fiscal policy is not changed soon, the effects will be even more damaging. Countries must develop credible plans for fiscal consolidation that are seen as sustainable over the medium term.

  • Emerging Markets: Global rebalancing will help to sustain growth as developed countries withdraw fiscal stimulus. Exchange rate flexibility is also crucial.

  • Developed Countries: Lin argued that the best way out for developed countries is to promote growth. Underutilization of capacity poses the biggest challenge; countries need to find new sources of growth, potentially through green jobs or further development of infrastructure.

  • Financial Regulation: An IMF-proposed financial levy will be discussed at the Toronto G20 meeting, while an international agreement on other changes in financial regulations, from too-big-to-fail initiatives to capital and liquidity requirements, is expected to come out of the November summit in Seoul. Changes in national legislation may prove more difficult.