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Ethos Issue 6, Jul 2009
Krugman, Wolf and
the Roots of the Financial Crisis
The Return of Depression Economics and the Crisis of 2008
Author : Paul Krugman
Published by : New York, NY: W. W. Norton, 2008
Fixing Global Finance
Author : Martin Wolf
Published by : Baltimore, MD: Johns Hopkins University Press, 2008
Reviewed by He Ruimin
Two heavyweight observers of
global economics have weighed
in with their views on the global
financial crisis. Amid a rash of books
seeking to contextualise, describe, and
offer solutions to the current economic
tsunami, the recent tomes of Nobel
Laureate Paul Krugman and respected
commentator Martin Wolf offer two
refreshing yet differing insights on the
most pressing economic dilemma of
present times.1
Both Krugman and Wolf are
economics professors who bring a sound
understanding of economic theory
into their analyses. Both comment
on economics for major newspapers—Krugman for the New York Times, and
Wolf for the Financial Times. However,
the transatlantic difference shows.
Krugman has penned a macroeconomics
primer suitable for those without deep
training. Informal, lucid and free of
academic footnotes, The Return of
Depression Economics employs simple
metaphors such as the “Baby-sitting
Coop” analogy to explain recessions
and policy responses. In contrast, Wolf
has put forward a decidedly more sombre
and intellectually ambitious volume,
based on a series of academic lectures,
that requires more effort to take in
but which ultimately provides a more
sophisticated analysis of international
capital flows.
CONTEXTUALISING THE CRISIS
Both Krugman and Wolf started working
on their books before the onset of the
current crisis: their books offer a broader
perspective of recent economic history.
Krugman surveys a string of recent financial crises, including Japan, Southeast
Asia, Britain, Sweden, Russia and
Latin America, and argues that almost
all of them can similarly be traced to
asset booms, imperfect regulations, and
moral hazards—which eventually led to
over-borrowing and defaults. Wolf notes,
the current crisis notwithstanding, that
these problems have been especially
prevalent in emerging markets, which
tend to have weaker governance and
macro-economic foundations.
Both authors observe that banking
and currency crises have become more
frequent since the 1970s, due to financial
globalisation and the resultant upsurge in
international capital flows. Wolf argues
that there are limits to accountability,
trust and safeguards when investing
across borders. At any hint of a crisis,
international investors are more likely
than domestic financiers to pull their
money out. Krugman describes why
investors fleeing from a particular market
are likely to simultaneously pull out from
emerging markets altogether, thereby
causing self-fulfilling contagion effects.
Separately, Krugman also highlights
the role of hedge funds in exacerbating
crises through speculative attacks.
Krugman and Wolf also agree that
financial crises translate into economic
crises at great cost and with dire results.
While the consequences would differ
across countries, they are likely to
include unemployment, poverty, lost
output, increased public debt, and some
degree of social and political unrest.
With more frequent economic shocks
in future, my sense is that governments
will have to learn to mitigate these social
consequences in a cost-effective way.
HOW THE CRISIS CAME ABOUT
Both Krugman and Wolf note that low
interest rates played a significant role in
creating the housing asset bubble that
triggered the current crisis. However,
they attribute responsibility differently.
Krugman puts the blame squarely on
former Federal Reserve Chairman Alan
Greenspan for his failure to raise interest
rates in order to rein in irrational
exuberance in the financial markets.
In contrast, Wolf takes a wider
“Savings Glut” view that is consistent
with the general thrust of his Financial
Times columns. Wolf suggests that
the current crisis is a consequence
of previous emerging markets crises.
The painful outcomes of these crises
encouraged many emerging economies to avoid borrowing, keep exchange rates
down, sustain strong currency positions,
and accumulate official reserves. These
resulted in a global savings glut that
the US, as borrower and spender of last
resort, was compelled to absorb and
consume. Under these circumstances,
the US Federal Reserve had to pursue
an expansionary monetary policy to
generate adequate domestic demand in
order to avoid deflation. Hence, the low
interest rates.
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