Krugman, Wolf and the Roots of the Financial Crisis

Review of Paul Krugman's The Return of Depression Economics and the Crisis of 2008 and Martin Wolf's Fixing Global Finance

Date Posted

7 Jan 2009


Issue 6, 14 Jul 2009


Krugman, Wolf and the Roots of the Financial Crisis

Book Title: The Return of Depression Economics and the Crisis of 2008
Author: Paul Krugman
Published by: W. W. Norton, 2008









Book Title: Fixing Global Finance
Author: Martin Wolf
Published by: Johns Hopkins University Press, 2008


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.


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.

Banking and currency crises have become more frequent since the 1970s, due to financial globalisation and the resultant upsurge in international capital flows.


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.

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.


However, Krugman and Wolf disagree on the crisis’ inevitability. Accusing government officials of malign neglect, Krugman argues that investment banks and other non-depository institutions could and should have been prevented, by government regulation, from engaging in such risky behaviour. Wolf takes a different view, arguing that risky lending is an inevitable consequence of an expansion in credit as banks search for higher returns. Ironically, Wolf, British born and trained, largely absolves the US of blame for the current crisis. I tend to agree with Wolf. In boom times, it is extremely difficult for any central banker to detect and ease an asset bubble, particularly in a low inflationary environment.

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.


Krugman’s and Wolf’s differing viewpoints on the culpability of regulators and the inevitability of the crisis are not mutually exclusive. However, they lead to different priorities regarding the longer-term reform of the financial system.

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.


The perspectives found in Krugman’s and Wolf’s books offer longer-term lessons for Singapore. Here, I discuss three of them.

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.

Policymakers must remain cognisant that their policies may inadvertently exacerbate the very fluctuations that they are attempting to smooth.

Second, in our drive to become a financial services hub, we have to maintain an active and forward-looking regulatory regime while avoiding overregulation. Risk Assessment and Horizon Scanning (RAHS) methodologies, predominantly employed for security risks today, may yield insights for financial regulation. Tighter regulation of domestic financial institutions by other countries may also affect Singapore’s attractiveness as a hub.

Third, while Singapore remains too small to generate sufficient domestic demand for our industries, the inability of the US to sustain current account deficits indefinitely suggests that we must constantly seek new export markets for our goods and services, without neglecting existing ones. Our capital investments must also continue to be diversified across geographical and asset classes, particularly in view of the heightened risk of a depreciation of the American dollar.


He Ruimin is a Research Economist in the Economics & Strategy Division, Ministry of Trade and Industry. A Naval Officer by training, he was formerly an Operations Officer on board the Singapore Navy frigate RSS Intrepid. He holds a PhD in Economics and a Bachelor’s degree in Electrical Engineering and Science, both from the Massachusetts Institute of Technology. The views expressed in this article are his own.


  1. Krugman is the 2008 recipient of the Nobel Memorial Prize in Economic Science for his work on the new trade theory, and a Professor of Economics at Princeton. Wolf is a Professor of Economics at Nottingham.

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