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Cause and effect, Part I

Cause and effect, Part I

Nobel laureate Paul Krugman tells Ian Munroe about the origins of the financial crisis, and how its fallout will change the global economy, Part I.

August 26, 2009 10:50 by

Paul Krugman, recipient of the 2008 Nobel Prize for Economics, is a professor at Princeton University. He writes opinion pieces for New York Times twice weekly and has authored several books including, most recently, “The Great Unraveling.”

There were a lot of indications that a crisis was coming, but decision-makers seemed to ignore them until things got really bad. Why was that?

The first thing is that when people are making money, telling them that it’s not based on well-grounded fundamentals is not a popular position. Nobody wants to hear it. This is always true when you have a bubble and too many people are profiting from the bubble to want to listen. I think there was also a deeper problem among policymakers and many economists, which was an excessive belief that markets are efficient. We saw this proliferation of financial markets, of various kinds of financial derivatives – a rapid increase in the sheer scale of the finance sector. And the assumption was that this all had to make sense, despite substantial evidence that it did not. So most people just didn’t look, even though there were quite obvious clues in the data that something was very wrong. Most people simply chose to ignore that.

What caused the financial crisis?

One reason was simply a prolonged period without a major crisis. The roughly 25 years between the second oil shock and the coming of this crisis bred a lot of complacency. Nothing really bad happened to the global economy and so people took more risks. They forgot that bad things can in fact happen. There were too many risks, too much leverage and too much debt.

The second thing that happened was the change in the nature of the financial system. Twenty-five years ago we had a system that was centered on conventional banks, which were quite tightly regulated; there was limited ability to take risks. Since then we had the growth of a much more complex, much harder to pin down financial sector, with conventional banks making up less than half the total sources of credit. This new system was unregulated, it lacked a safety net and there was no explicit insurance. So we found ourselves exposed to a banking crisis in a way that hadn’t happened since the 1930s.

So it was a willingness to take risks on the one hand, and a failure of regulation on the other?

Yes – people were taking too many risks and regulators hadn’t kept up with the changing financial system, so we had a financial system that was largely without any form of support. There were no airbags on it, you might say.

We’ve witnessed some astonishing financial losses. In everyday terms, where did the money go?

Mostly, the money was never there. People had large sums in their accounts, but it was a mirage. It was only there until someone tried to spend it, and then it was no longer there. But on top of that, there is a lot of real destruction going on.

The world economy is probably now operating 4 or 5 percent below its capacity, which means we’re losing several trillion dollars each year of output that we could have produced but haven’t. That’s a real impoverishment of the world. If it goes on for any length of time it will end up eliminating a substantial fraction of the world’s wealth.

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