The financial and economic crises of the Western world became visible in the summer of 2007 and reached their apogee in the autumn of 2008. The response was an unprecedented government-led rescue operation. That, in turn, triggered an economic turn-around in the course of 2009. But the recovery of the high-income countries was, in general, disappointing: output remained depressed, unemployment stayed elevated, fiscal deficits remained high, and monetary policy seemed, by conventional measures, unprecedentedly loose. This is beginning to look like a Western version of Japan’s prolonged post-bubble malaise.
 
One reason for persistent disappointment is that the Western crisis became, from 2010 onwards, also a deep crisis of the Eurozone. Crisis dynamics engulfed Greece, Ireland, Portugal, Spain and even Italy. All these countries were pushed into deep recessions, if not depressions.1 The price of credit remained high for a long time. By early 2013, the sense of crisis had abated. But chronic economic malaise continued, with no certainty of a strong recovery or even of enduring stability.
 
Meanwhile, emerging economies, in general, thrived. The worst hit among them were the countries of Central and Eastern Europe, many of which had run huge current-account deficits before the crisis. Like the members of the Eurozone in Southern Europe, these were then devastated by a series of ‘sudden stops’ in capital inflows. Other emerging and developing countries proved far more resilient. This was the result of a big improvement in policy over the previous decades. Particularly important was the move towards stronger external positions, including a massive accumulation of foreign-exchange reserves, particularly by Asian emerging countries, notably including China. This gave them the room to expand domestic demand and so return swiftly to prosperity, despite the crisis. Those emerging and developing countries that could not expand demand themselves were often able to piggyback on the stimuli of others, particularly China. That was particularly true of the commodity exporters. This represents an important – and probably enduring – shift in the world economy: the old core is becoming more peripheral. But the sustainability of the expansionary policies adopted by emerging economies, and so their ability to thrive while high-income countries continue to be weak, is in doubt. Particularly important is the risk of a sharp slowdown in the Chinese economy and the likely associated weakness of commodity prices.
 
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From Crisis to Austerity
 
The central problem of depression-prevention [has] been solved, for all practical purposes, and has in fact been solved for many decades.
 
Robert E. Lucas, 20031
 
When I became Treasury secretary in July 2006, financial crises weren’t new to me, nor were the failures of major financial institutions. I had witnessed serious market disturbances and the collapses or near collapses of Continental Illinois Bank, Drexel Burnham Lambert, and Salomon Brothers, among others. With the exception of the savings and loan debacle, these disruptions generally focused on a single organization, such as the hedge fund Long-Term Capital Management in 1998.
 
The crisis that began in 2007 was far more severe, and the risks to the economy and the American people much greater. Between March and September 2008, eight major US financial institutions failed – Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual, and Wachovia – six of them in September alone. And the damage was not limited to the US. More than 20 European banks, across 10 countries, were rescued from July 2007 through February 2009. This, the most wrenching financial crisis since the Great Depression, caused a terrible recession in the US and severe harm around the world. Yet it could have been so much worse. Had it not been for unprecedented interventions by the US and other governments, many more financial institutions would have gone under – and the economic damage would have been far greater and longer lasting.
 
Hank Paulson, On the Brink (2010)2
 
Hank Paulson is a controversial figure. For many Americans, he is the man who bailed out Wall Street too generously. For others, he is the man who failed to bail out Wall Street generously enough. In his thought-provoking book, Capitalism 4.0, the British journalist Anatole Kaletsky blames him for the disaster, writing that ‘the domino-style failure of US financial institutions that autumn [of 2008] was not due to any worsening of economic conditions – it was simply a consequence of the US Treasury’s unpredictable and reckless handling first of Fannie and Freddie, then of Lehman, and finally of AIG.’3
 
Whatever we may think of Mr Paulson’s culpability, we cannot deny his outline of what actually happened in 2007 and 2008. In this chapter, I will not attempt a detailed account of how the crisis that hit the core high-income countries in those years unfolded. That has been done in other publications.4 My aim here is rather to demonstrate its scale, the extraordinary policy response and the economic aftermath. I will postpone detailed discussion of the economic and financial origins of the crisis to Part II of the book and analysis of the very different impact upon emerging and developing countries to Chapter Four. By focusing on the high-income countries, I want to show that this was no ordinary economic event. To pretend that one can return to the intellectual and policymaking status quo ante is profoundly mistaken.
 
THE SCALE OF THE CRISIS
 
The world economy of the 2000s showed four widely noticed and, as we shall see, closely related characteristics: huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably including the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain. Many observers doubted whether this combination could continue indefinitely. The questions were: when would it end, and would it do so smoothly, bumpily or disastrously?
 
The answers, it turned out, were: in 2007 and 2008, and disastrously. Already in March 2008, I assessed the unfolding crisis as follows:
 
What makes this crisis so significant? It tests the most evolved financial system we have. It emanates from the core of the world’s most advanced financial system and from transactions entered into by the most sophisticated financial institutions, which use the cleverest tools of securitisation and rely on the most sophisticated risk management. Even so, the financial system blew up: both the commercial paper and inter-bank markets froze for months; the securitized paper turned out to be radioactive and the ratings proffered by ratings agencies to be fantasy; central banks had to pump in vast quantities of liquidity; and the panic-stricken Federal Reserve was forced to make unprecedented cuts in interest rates.5
 
Far worse was to follow in the course of 2008.
 
This crisis had become visible to many observers on 9 August 2007,...