When asked in the 1960s for his assessment of the French Revolution, Chinese Premier Zhou Enlai famously observed that it was still too early to draw definitive conclusions. The same might be said of the present global credit crunch, which is still roiling international financial markets one year after it started. And if former Federal Reserve Chairman Alan Greenspan is right to say that this crisis is a once- or twice-in-a-century event, the credit crisis may still have a long way to go. Of course, policymakers cannot afford to wait for the crisis to play out before drawing the relevant lessons; indeed, their actions—or inactions—will affect how the crisis plays out. 

Until now, the debate has focused on why the crisis occurred and on what reforms might be needed to prevent a similar crisis in the future. We have learned that large and complex financial institutions require at least a minimum amount of effective outside regulation. We also have learned that the incentives of rating agencies and investors must be better aligned, and that government must address the lack of transparency resulting from rapid financial market innovation. 

The credit crunch will not end until the U.S. housing market has been stabilized—policymakers must understand that.

These lessons are important. But the credit crunch has raised other, more pressing questions. For example: Are we facing only a liquidity problem, as central bankers have assumed, or a deeper problem of financial solvency? Is the financial system simply in need of periodic bailouts on an ad hoc basis, or does it require more sweeping regulatory reforms to minimize the risk of moral hazard? Will the U.S. housing market—whose collapse triggered the credit crunch—stabilize itself, or will further government intervention be necessary? 

By now, central bankers should have figured out that this is more than just a liquidity dilemma; in fact, we are dealing with profound solvency issues that might demand a more radical solution. After all, the International Monetary Fund now estimates that the eventual cost to the global financial system from poor lending practices could be in the range of $1 trillion, which is more than double the amount of losses that banks have recognized to date. The losses could be even higher if U.S. home prices continue falling and/or if a global recession occurs. 

It now seems clear that, before long, the U.S. government will be directly involved with managing a wide swathe of the American banking system. Over the past six months, we have seen the emergency bailout of Bear Stearns, the failure of IndyMac, and the approval by Congress of a Treasury rescue plan for Fannie Mae and Freddie Mac. We have also witnessed a staggering $1.6 trillion reduction in the market capitalization of global banks. 

The Bush administration should be seeking to overhaul financial institutions in such a way that would make the system more efficient and reduce moral hazard. Regrettably, it has allowed major reform opportunities to slip by; institutions like Fannie and Freddie operate very much as they did before the crisis began. 

The credit crunch will not end until the U.S. housing market has been stabilized— policymakers must understand that. Unfortunately, U.S. house prices are declining at an accelerating rate, while unsold housing inventories remain at record levels and a rising tide of foreclosures threatens to drive prices even lower. The available policy options are not pretty. But a policy of inaction is not a viable alternative. 

Desmond Lachman is a resident fellow at the American Enterprise Institute.

Image by The Bergman Group/ Darren Wamboldt.