What We Learned From The Financial Crisis

Martin Wolf wrote an impressive book that described the underlying dynamics of the financial crisis.  Paul Krugman took the opportunity to review Wolf's book  in order to add a missing dimension to Wolf description.  He agrees with much of Wolf wrote about the vulnerability of the financial system, and the factors that contributed to its vulnerability.  He takes issue with Wolf's conclusion that we should focus our attention on reforming the financial system in order to reduce the risk of future financial crises. 

Krugman points to two problems that are not addressed by Wolf.  He asserts that most of the advanced economies suffer from a problem of declining aggregate demand.  Larry Summers has called this secular stagnation.  We have secular stagnation when even very low interest rates are unable to produce a full-employment level of demand.  The financial bubbles that we experienced in the US and Europe provided an unsustainable solution to the demand problem.  We have not found a way to provide a sustainable solution.

The second problem that requires more focus is the intellectual shift within economics, and among policy makers, that caused us to unlearn much of what we learned from the Great Depression.  Instead of finding ways to stimulate demand, politicians decided to focus on ways to reduce public debt.  That only made the public debt problem worse in many countries because it reduced aggregate demand and tax revenues.  Its hard to reduce public debt in countries with declining aggregate demand.

There is an interesting graph in Krugman's review that was taken from Wolf's book.  It shows the rapid growth in PRIVATE debt that has created the deleveraging problems that have been undertaken by households and by business.  Wolf used the graph to show that much of private debt increase took place within the financial system.  Leverage was used to bolster financial industry profits and Wolf was primarily worried about excessive leverage in the financial industry that led to a credit crunch.

The unresolved problem that Krugman raises, but does not address with a solution, is the secular stagnation problem.  He was primarily concerned about the misuse of austerity during the recession which only prolonged the recession.  He has been fixated on that issue for the last several years.  Longer term, however, we have to produce a level of aggregate demand provides full employment without reliance on credit and asset bubbles which are not sustainable.

In summary, Wolf does a good job of reviewing the factors that led to the financial crisis and Krugman provides an excellent description of Wolf's analysis.  Krugman also does a good job of describing the intellectual shifts in economics and politics that exacerbated the demand problem that should have been fixed.  We are left, however, with western economies that cannot provide a level of demand that is consistent with full employment.