The world economy got a shock in 2008. First, the US financial system came under stress; defaults on mortgage loans given to the poor sent a few financial institutions into bankruptcy and endangered bigger ones. Second, three European countries — Ireland, Iceland and Greece — came to the verge of default, and had to be rescued by their sounder neighbours. These crises were overcome; but they made governments take the possibility of further defaults seriously. They also made them fear that the crises could go beyond the capacity of any individual country, and had to be tackled cooperatively. The world’s big countries — the Groups of 8 and 20 — have settled down to frequent consultations, and to meetings twice a year where financial and political leaders take stock and confer. They realize the need to cooperate and to coordinate policies; and the policies would not work unless they are based on sound economics. Thus, economics has come to occupy the centre of policy debate. The situation is reminiscent of the 1930s except that there is far more international communication and discussion. A possible starting point to an understanding of this debate is an 8,000-word book review on the subject by Paul Krugman and Robin Wells in the New York Review of Books. They say that the 2008 crisis was due to the collapse of a real estate bubble in Europe and North America, and list four explanations that have been advanced of its origins, three of which they reject.

First, the 1990s saw a prolonged boom in the US led by information technology. It lost steam in 2000. To stop it from deepening, Federal Reserve cut interest rates drastically; its overnight interbank rate came down from 6.5 per cent in early 2000 to 1 per cent in 2003. The low interest rates fed a real estate boom. The European Central Bank did not cut rates so aggressively, but still there were real estate bubbles in Britain, Ireland and Spain. So the rate cut could not be blamed for the bubble.

Second, financial innovation distorted risk perception. Packaging and securitization of mortgage loans made them liquid and easy to sell; their holders suffered under the illusion that they could avoid the risks the loans involved because they could sell off the securitized packages. But when the underlying mortgages turned sour, the packages turned illiquid, and their holders went bankrupt. However, commercial real estate was not touched by these financial innovations; nor was Europe, but both managed to have crises. So financial innovation was not responsible for the bubble.

Third, technological change reduced demand for unskilled labour in the US; as a result, real incomes of the poor stagnated, while the rich continued to get richer. To divert the attention of the poor from their plight, the government organized cheap housing mortgages for them. But the poor did not have steady incomes and hence the financial capacity to service the loans; so this political ploy plunged them into mass defaults. However, Krugman and Wells think that government loans and guarantees came late in the crisis and played a minor role.

Finally, some major countries — notably China and Germany — saved too much. The excess savings were reflected in their balance of payments surpluses, which were balanced by deficits run by the US, Britain and Spain. As capital flowed into the latter countries, their interest rates went down, leading to housing bubbles. Cheap money was available from banks and mortgage lenders, so people went on borrowing. As long as they borrowed and spent the money, the boom continued. The moment they began to repay loans (called the Minsky moment by Krugman), expenditure contracted and the boom ended. Thus, international savings imbalances were responsible for the crisis. Once they created the preconditions for the crisis, the other factors mentioned above deepened it. Keynes’s explanation of the Great Depression of the 1930s ran in terms of savings exceeding investment and the excess starting a deflationary spiral. Krugman and Wells’s explanation of the 2008 crisis is similar, except for the international dimension that savings in some countries cause deflation in other countries. And the remedy that countries adopted was also Keynesian — namely that governments offset excess private savings by spending more and running fiscal deficits. The policies were not always deliberate; the US, for example, ran deficits not as a matter of policy but because its revenue collapsed. But the effect was the same. Government spending prevented crises. But it did not revive growth rapid enough to absorb unemployment.

The high unemployment levels suggest that the stimuli were too small — that governments of industrial countries should run even larger fiscal deficits. They hesitated to do so out of fear that their public debt would become unsustainable and markets would stop buying their bonds; high interest rates would choke off recovery. Would they? We have a case where this possibility was tested and disproved. In the 1990s, Japan borrowed heavily and spent in an attempt to get out of deflation. Its government did not lose credibility; its borrowing rates did not rise. Krugman and Wells believe that the US and Europe similarly have excessive unemployment today and should run larger deficits; the fear that lenders would be scared by rising debt-GDP ratios and interest rates would rise to choke off recovery is misplaced. They also think that export-surplus countries like China and Germany have been using exports to stimulate their own economies at the expense of their neighbours. They consider it anti-social; their fellow countries must force them to stop exporting unemployment.

The Krugman-Wells view has become the official line of the United States; at their meeting in September on the sidelines of the UN general assembly, President Obama spent time pressing this line on China’s prime minister, Wen Jiabao; he will no doubt continue pursuing Wen when they attend the G20 meeting soon. China has allowed its currency to appreciate, but very slowly and very little; it keeps arguing that more drastic appreciation would disrupt its economy and cause social unrest. The same talk of currency realignment dominates meetings of international leaders. Being polite and reasonable people, they agree every time that their currencies must be realigned, and that exchange rates must not be used to export unemployment. They would have no difficulty in agreeing also that their stimuli must be coordinated. But these agreements will be in principle; they are unlikely to be able to work out practical measures and start actually coordinating their fiscal and exchange rate policies.

What we do not realize is that the people of China and Germany are proud of their “strong” economies and payments surpluses, and contemptuous of countries that continue to run deficits. Economic policy is the latest arena in which nationalism is being played out; it is unlikely that countries will set aside national pride and prejudice and help out other countries at their own expense. Their leaders will continue to meet frequently in beautiful resorts and talk incessantly of coordinated international action. But they will coordinate nothing; the less they do, the more reason they will have to meet. Internationally, there will be polite inaction; within countries, raucous debate over underperforming economies will prevail.