By Martin Wolf 

Paul Volcker is the giant among contemporary central bankers, both literally and figuratively. He it was who had the moral courage to crush inflation as chairman of the Federal Reserve between 1979 and 1987. When Mr Volcker speaks, people listen. What he had to tell the economic club of New York last month was well worth listening to. His summation, cited above, was so devastating, because so true.

Mr Volcker noted that this crisis is not unique. On the contrary, “today’s financial crisis is the culmination, as I count them, of at least five serious breakdowns of systemic significance in the past 25 years – on the average one every five years. Warning enough that something rather basic is amiss.” Those who do not heed such warnings are fated to suffer something yet worse.

So what is to be done? There is a part of me – quite a large part, in fact – that says: “Forget regulation: it will never work. Apart from normal laws against fraud, let the financial system live and die by the laws of competitive markets. If businesses fail, let them simply go down, with all their shareholders, customers and employees. Meanwhile, we will remind users constantly of the dangers.”

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Lawrence Summers

Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession, saw no need for a fiscal stimulus, and thought that inflation fears should constrain monetary policy. Now, Washington is more or less settled on a stimulus package that will exceed $150bn; markets at one point last week expected a Fed funds rate below 2 per cent by September. The debate about recession is now about how deep and global its impact will be.

There is enormous uncertainty around economic or financial forecasts. It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further as perceptions of declining growth increase credit spreads and risk premiums in financial markets, leading to reduced lending, borrowing and spending exacerbating the pessimism about growth.

Perhaps inevitably given the complexity of the problems, policy measures have seemed ad hoc and reactive: measures to increase bank liquidity one week; to help homeowners avoid foreclosure another; to work towards fiscal stimulus another; to lower interest rates most recently. Confidence would be well served by a comprehensive programme of measures that offers the prospect of accelerating growth and insures against a prolonged downturn. Until that happens, it will be difficult for confidence to return.

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macro-economic stimulus in the US, there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Lawrence Summers

Central to every policy discussion in response to a financial crisis or the prospect of a crisis is the concept of moral hazard. Unfortunately, there is great confusion in many quarters about the circumstances when moral hazard is, and is not, a problem. The world has at least as much to fear from a moral hazard fundamentalism that precludes actions that would enhance confidence and stability as it does from moral hazard itself.

The term "moral hazard" originally comes from the area of insurance. It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precaution with respect to avoiding fire or when holders of health insurance use more healthcare than they would if they were not insured.

In the financial arena the spectre of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions. In particular, it is used to caution against creating an expectation that there will be future "bail-outs".

Moral hazard forms the basis for criticism of a wide range of measures including, among others; large International Monetary Fund loans to countries experiencing financial panics; public sector actions to facilitate co-ordination of creditors, as in the famous 1998 case of the New York Fed and Long Term Capital Management; lender of last resort activities by central banks through their discount window; aggressive cuts in interest rates following collapses in asset prices; and the extension of government guarantees or quasi-guarantees to liabilities of financial institutions, as in deposit insurance or the US government’s support for the credit of mortgage lenders Fannie Mae and Freddie Mac.

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The financial markets have taken the world economy hostage. This has presented the world’s central banks with a dilemma. They fear the consequences of paying off those responsible for the mess. But they cannot let hundreds of millions of innocents suffer. Last week’s announcement of the first US monthly fall in employment for four years has made a cut in interest rates from the Federal Reserve this month a virtual certainty. So act it will. But making the right decisions is going to be hard.

Martin Feldstein of Harvard university put the case for big cuts in a powerful summing up at this year’s Jackson Hole monetary conference. He argued that the US housing sector was at the heart of three interrelated events. First was “a sharp decline in house prices and the related fall in home-building that could lead to an economy-wide recession”. Second was “a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets”. The third was “a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending”.

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We are living through the first crisis of our brave new world of securitised financial markets. It is too early to tell how economically important this upheaval will prove. But nobody can doubt its significance for the financial system. Its origins lie with credit expansion and financial innovation in the US itself. It cannot be blamed on “crony capitalism” in peripheral economies, but rather on irresponsibility in the core of the world economy.

What has happened raises important questions. Here are seven.

First, why did this crisis start in the US? The answer is: “The borrowing, stupid”. Default on debt – actual and feared – always drives big financial crises because creditors think that they ought to be repaid. US households were the world economy’s most important net borrowers in the mid-2000s, replacing the emerging markets of the 1990s.

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Sometimes a picture is worth a thousand words. The one last Wednesday showing Christopher Dodd, chairman of the US senate’s banking committee, flanked by Hank Paulson, Treasury secretary, and Ben Bernanke, governor of the Federal Reserve, was such a picture. This showed Mr Bernanke as a performer in a political circus. Mr Dodd even announced Mr Bernanke’s policies: the latter had, said Mr Dodd, told him he would use “all the tools” at his disposal to contain market turmoil and prevent it from damaging the economy. The Fed has its orders: save Main Street and rescue Wall Street.

Such panic-driven politicisation is almost certain to lead to both overreaction and the creation of bad precedents. What then would be the right response to this latest scrape that supposedly sophisticated financial markets have fallen into?

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By Lawrence Summers

Over the past 20 years major financial disruptions have taken place roughly every three years, starting with the 1987 stock market crash; the Savings & Loans collapse and credit crunch of the early 1990s; the 1994 Mexican crisis; the Asian financial crises of 1997 with the Russian and Long-Term Capital Management events of 1998; the bursting of the technology bubble in 2000; the potential disruptions of the payments system after the events of September 11 2001 and the deflationary scare in the credit markets in 2002 after the collapse of Enron.

This record suggests that by 2007 the world had been overdue a major disruption. Sure enough the problems of subprime mortgages – initially seen as a confined issue – went systemic as the market began to doubt the creditworthiness of even the strongest institutions and rushed to buy US Treasury debt. Financial crises differ in detail but, just as there are plot cycles common to literary tragedies, they follow a common arc.

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Fast growth, huge current account “imbalances”, low real interest rates and risk spreads, subdued inflation and easy access to finance characterise the world economy. Is this party about to end? Probably not. But to identify the risks we must first decide what drives the strange world economy we see around us.

The two interesting alternative explanations are the “savings glut” and the “money glut”. Both share common themes: globalisation; the revolution in finance; the rise of China; low inflation; and macroeconomic stability. Beyond this, however, they diverge. In particular, they reverse the role of victim and villain: in the savings-glut story, the thrifty are the villains and profligate the victims; in the money-glut story, it is the other way round. This is a contemporary version of the old Keynesian versus monetarist dispute.

The “savings glut” hypothesis is associated with Ben Bernanke, now chairman of the Federal Reserve. But the idea was floated earlier by others. Brian Reading, of Lombard Street Research, lays out the line of argument in a recent note*. A substantial excess of savings over investment has emerged, he says, predominantly in China and Japan and the oil exporters (see chart). This has led to low global real interest rates and huge capital flows towards the world’s most creditworthy and willing borrowers, above all, US households. The short-term effect is an appreciation of real exchange rates and soaring current account deficits in destination countries. To sustain output in line with potential, domestic demand in those countries must also be substantially higher than gross domestic product. A country must choose fiscal and monetary policies that bring this result about.

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Is the market turbulence of the last week telling us something or is it no more than “a tale told by an idiot, full of sound and fury, signifying nothing”? Some analysts are prepared not only to explain day-to-day movements in markets, but to predict them. I am neither clever enough for the former, nor rash enough for the latter. I am prepared, however, to make four statements: first, a period of market volatility is welcome; second, core equity markets do look overvalued; third, that this does not appear to be the case is due to the extraordinary condition of the world economy; finally, the big question is how long those conditions will endure.

Any long period of market stability encourages speculation. Taken to excess, such risk-taking, particularly when fuelled by huge amounts of borrowing, can create significant instability. At a time when asset markets are generally buoyant and risk premiums low, the need for a reminder of riskiness is valuable. It is far better, as natives of San Francisco must know, to suffer a series of mini-earthquakes than a long period of calm, followed by a huge one. Similarly, euphoria in markets is dangerous. From time to time it needs to be punctured, before bubbles reach the proportions seen in Japanese markets in 1990 and US markets in 2000.

The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free.

The barbarians are again at the gates. The announcement this week of the largest ever private equity buy-out of a public company – the $45bn takeover of TXU, one of the largest utilities in the US, by Kohlberg Kravis Roberts and Texas Pacific Group – confirms the trend. To its defenders, private equity makes companies more efficient. To its attackers, its practitioners are financial manipulators and asset-strippers. So who is right? An obvious answer is that private equity is a growing activity in which willing sellers meet willing buyers. If it prospers, it must be profitable. If it is profitable, it should also be adding value. Where private equity finances start-ups or small and medium-sized companies, few would question this argument. The taking private of well-known public companies with huge numbers of employees is a different matter. Why, though, should the benefits of such deals be doubted? Do they not also fall under the broad category of beneficial transactions? To this there are three answers. The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free.