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

There is general consensus on the subsequent mechanics of the crisis, which parallel previous market failures. Investment banks and other nondepository institutions engaged in hazardous securitisations that rendered the entire financial system vulnerable. Sub-prime lending, foreclosures and a credit crunch followed, while crossborder investments transmitted the crisis overseas.

To overcome the immediate recession, Krugman recommends getting credit f lowing through internationallycoordinated recapitalisation and direct lending to the nonfinancial sector; complemented with Keynesian-style fiscal spending. Although Krugman’s book was published in the early days of the current crisis, these remain sensible suggestions. Wolf has made similar recommendations in his columns. Countries like South Korea and China that have successfully eased credit and enacted fiscal stimulus have seen some positive results.

If, as Krugman believes, the crisis was partially caused by regulatory failure, then a new regulatory regime may be necessary. Krugman proposes that "anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated when there isn’t a crisis so that it doesn’t take excessive risks". However, I am skeptical that this will ever work. The multinational nature of these financial institutions complicates regulation. Due to the multiplicity of interests present, international institutions like the International Monetary Fund (IMF) are comparatively better at treatment than prevention. While countries agreed to "closely coordinate" regulation at the April 2009 G-20 meetings, this falls well short of a viable replacement regime.

If, on the other hand, the current crisis is fundamentally a result of an unsustainable and undesirable global financial system, then regulatory reform alone is insufficient. (Krugman recognises the dangers of financial globalisation but does not offer solutions in his book.) Hence, while recognising the merits of financial regulation to mitigate inevitable crises, Wolf argues that these must be complemented by macroeconomic reforms. These include sound exchange rates, monetary, and fiscal policies within each country; and a restructuring of the IMF and other international groupings globally. Wolf concludes that a better-balanced global flow of funds will occur only if emerging economies feel that it is safe to accept large net inflows of foreign capital. We are starting to see this shift. Given comments in March 2009 by Chinese Premier Wen Jiabao expressing "worry" over the safety of US Treasury holdings, it is clear that emerging countries have come to realise the potential downsides of parking the bulk of their current account surpluses in the US. In time, they will take these lessons to heart, and are likely to re-adjust their macroeconomic policies out of self-interest. This will lead to global rebalancing in the long run.

First, currency and banking crises across the world are likely to recur with increasing frequency for some time to come. While they may not be global recessions, we can expect regional crises to spill over to tiny and connected Singapore. Singapore’s small domestic market and dependence on the global economy make it particularly susceptible to knock-on effects from such crises. This may lead to higher frequency fluctuations in our economic performance. Policymakers must thus continue to look ahead, and respond early, decisively, and effectively to changes in the global environment, while remaining cognisant that their policies may inadvertently exacerbate the very fluctuations that they are attempting to smooth.

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