Paul Krugman
The central premise of the recent financial catastrophe is not just a failure of banking, but a collapse of the intellectual framework that governed global economics for decades. By the early 2000s, leading economists and policymakers, including Robert Lucas and Alan Greenspan, had declared the problem of depression prevention solved. They believed the business cycle had been tamed and that rational, efficient markets would prevent severe instability. This optimism was built on a dangerous delusion. The reality is that "depression economics" has returned. We have re-entered an era where economies are not constrained by their productive capacity or limited resources, but by a severe lack of demand. The critical lesson of 2008, much like the Great Depression, is that a functioning economy can simply stall because there is insufficient spending to employ the available workers and factories. The "free market" does not automatically correct this; instead, it can trap an economy in a state of prolonged stagnation.
The mechanism of the 2008 collapse was not a traditional run on deposit banks, which are protected by government insurance, but a run on the shadow banking system. Following the deregulation of the late 20th century, particularly the repeal of the Glass-Steagall Act, a vast network of non-bank financial institutions emerged. These entities - hedge funds, investment banks, and creators of complex derivatives - performed the essential functions of banking by converting short-term borrowing into long-term lending. However, they operated without the regulatory safety nets of commercial banks. When the housing bubble burst, revealing that subprime mortgage assets were toxic, confidence evaporated. Because these institutions were highly leveraged, often owing thirty times their equity, even a small decline in asset values wiped out their capital. This triggered a vicious feedback loop of forced selling and deleveraging that traditional regulation was powerless to stop because it did not legally recognize these entities as banks.
A key insight into why the crisis became global so rapidly lies in the international finance multiplier. Traditional economic models assumed crises spread through trade: if the US buys fewer imports, foreign economies slow down. But 2008 proved that financial linkages are far more potent. The transmission mechanism operates through the balance sheets of highly leveraged financial institutions that hold assets across borders. When asset prices fall in one country, these institutions suffer capital losses that force them to contract their lending everywhere. This is a balance-sheet contagion. It explains why a crisis originating in the US housing market could instantaneously freeze interbank lending in Europe and crash stock markets in Asia. We witnessed a synchronized global slump not because trade collapsed first, but because the shared balance sheets of global finance acted as a conductor for panic, turning a local housing bust into a worldwide credit freeze.
The most terrifying aspect of the modern crisis is the impotence of standard monetary policy, a phenomenon known as the liquidity trap. In a normal recession, the central bank cuts interest rates to encourage borrowing and spending. But when an economy is awash with excess savings and paralyzed by fear, cutting rates to zero is not enough. This was the lesson of Japan in the 1990s, ignored by the West until it was too late. Once interest rates hit the zero lower bound, cash becomes a perfect substitute for bonds, and people simply hoard money rather than spend it. In this environment, the "paradox of thrift" takes hold: as individuals and companies try to pay down debt and save more to survive hard times, they collectively reduce total spending, worsening the economic contraction. Monetary policy becomes pushing on a string; the central bank can print money, but it cannot force it to circulate if the public perceives the expansion as merely temporary.
Because monetary policy loses its traction in a liquidity trap, the government must become the spender of last resort. This is the re-emergence of the "Keynesian compact." The argument against government deficits - that they crowd out private investment - is invalid when the economy is depressed. In a liquidity trap, there is a "free lunch" available: the government can spend money to put unemployed resources to work without displacing private activity, because that private activity is currently dormant. The true cost of government spending in such a crisis is negligible because it utilizes labor and capital that would otherwise be wasted. Policymakers must overcome the psychological barrier of "sound finance" and embrace aggressive fiscal stimulus. The danger is not doing too much, but doing too little. To escape the trap, governments must commit to sustaining demand until the private sector creates a self-sustaining recovery, even if that requires temporarily higher inflation or deficits.