Introduction

The international economy is now well into the nearly yearlong financial crisis that has been extraordinary in its persistence, its global reach, and the questions it has raised about the workings of the financial system. In past episodes of systemic stress—such as the Asian financial crisis of 1997 or the market turmoil associated with the failure of Long-Term Capital Management in 1998—which have occurred from time to time in many economies over the years, the policy questions in the aftermath have tended to center around such issues as how to encourage more responsible behavior among borrowers and how to resolve bad-debt problems more effectively. While these questions have rightly been asked in the context of the current crisis, there have also been more fundamental questions about the financial system itself that need to be addressed.

To understand the crisis, financial authorities have had to look very closely at such questions as how credit has been intermediated, how losses are propagated, and how market liquidity is generated and lost. To address the problems, authorities have had to ask what information should be available about borrowers and instruments, how regulation can most effectively prevent unnecessary disruptions to the functioning of the system without stifling innovation, and how central banks should act in their capacity as lenders of last resort.

In this paper, we focus on the turmoil itself and the short- and medium-term policy responses it has elicited. First, we describe the chain of events that constituted the crisis, discuss the underlying causes, and draw lessons from the events. In characterizing the crisis, we distinguish among the elements that are new, those that have remained the same, and those that we do not understand. Second, we examine the policy responses thus far, both in terms of efforts by central banks to stabilize markets in the short term and efforts by financial authorities to strengthen the underpinnings of the system over the longer term. We end by emphasizing the importance of recognizing the issue of procyclicality.

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