The posts by Jamie Galbraith and Liaquat Ahamed together make a very strong case for a drastically downsized financial sector; as Mr Ahamed put it: "however we got here the eventual goal should be a financial system that is tightly regulated, boring and safe." Not surprisingly, this was the conclusion reached by the majority of participants at the Levy Economics Institute annual conference in the honor of the late Hyman Minsky, held at the Ford Foundation last week.

However, nothing but bad news continues to dribble out of Washington. For example, here is a recent headline: "Fannie Mae CEO Allison Nominated to Run TARP Office". As a former (successful) regulator put it, Mr. Allison's most recent accomplish was the destruction of Merrill Lynch "through nonprime CDOs -- Merrill actually kept many of the toxic CDOs it originated in its portfolio. The fact that he was brought into Fannie with regulatory blessing is the conclusive proof of why we need a new regulatory head for that agency. The fact that the administration is selecting him, after a track record of failure, to run TARP 2 is simply a continuation of the conclusive proof of that obscenity."

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A common theme in much of the discussion so far is that the current crisis originated with a financial system that was completely out of control--too large, too risky, with massive liquidity mismatches between assets and liabilities. In another setting I described it as a sort of financial Frankenstein.

There are different explanations of how we got here. Some see it as simple policy mistake of taking deregulation too far. Others attribute it to the malign influence of free market ideology misapplied to financial markets which are unusually prone to market failures. Others point to the political power of Wall Street and the financial elites. I am persuaded that all played a part. Most discussants seem to agree that however we got here the eventual goal should be a financial system that is tightly regulated, boring and safe.

To get from here to there is the challenge. Even a boring and safe financial system needs capital.

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Please excuse the late intervention. I stayed up last night to finish Lords of Finance and should say first that I recommend it.

This is not a polemical book and it is also not primarily a work of economics, though there is a huge amount of economic history in it. It is first of all the social history of a small, important and largely forgotten group: the central bankers of the early 20th century, in the four countries whose finances, empires and ambitions dominated the globe. No question that the cover image is well-chosen.

At this time the central bank was just beginning to be merged into the nation-state. So one thing that stands out is the extent to which the central banks retained their private character, structures of governance and class allegiances, except in Germany where the war had changed everything. This is not to say that the lords of finance were dishonorable or venal or dumb. It rather points to the limitations of government by people raised in very small clubs.

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There is little doubt that the world faces the worst economic crisis since the 1930s, with a few economists and policymakers beginning to talk about the possibility of a depression. References to Keynesian economics are commonplace, with only committed free marketeers arguing against government intervention. Even the wizards on Wall Street are begging for re-regulation of financial markets. The Obama administration has projected current year federal budget deficits at $1.75 trillion (12% of GDP) and $1.17 trillion for 2010--although some private forecasters project $1.9 trillion for 2009, representing 13.5% GDP, and it is not likely that it will fall next year.

If anything, prospects facing the rest of the world are worse. The Fed has become the global lender of last resort, providing up to $600 billion in loans of dollar reserves to foreign central banks. Further, it is widely understood that the bail-out of US financial institutions (most prominently, of AIG) helps to protect foreign financial institutions (AIG is the biggest supplier of CDS "insurance" for debt held by European banks). Still, the run to relative safety in US treasuries has threatened exchange rates and increased risk spreads around the world. Social and political unrest is spreading around the periphery nations. Many economies will not recover until the US does. While I believe that the US has at its disposal ample policy space to resolve its crisis, many other nations do not. Mark Thoma has called for international coordination--a good idea, but one that I fear has little political support. Euroland will not expand its economy out of fear that markets will run out of its government's debts. And I think they would--since the Euro is not a sovereign currency for any individual Euronation.

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The second question at the end of Ahamed's introductory essay asks if we are at a point similar to the 1930s when an absence of global economic leadership made the Great Depression much worse:

Charles Kindleberger ... attributed the 1929 collapse to a failure of global economic leadership. In his view a well functioning world economy required some country to act as the leader, in effect to do more than its fair share ... recognizing that smaller countries will freeload off its efforts... But the leaders of the U.S. were too parochial and insular to seize the opportunity. ...

Has the US been so weakened by its accumulated current account deficits, its banking debacle and its foreign policy disasters that it is incapable of bearing more than its fair share of the burden?

As I noted here, I think we are in a situation where we were more than big enough to break the U,S. and world economies, but are not big enough to fix the problem on our own - particularly after absorbing the costs of financial collapse onto our domestic balance sheets. However, while crisis has made it clear that we cannot fix the world economy by ourselves, I don't think the crisis is the fundamental reason for this, the distribution of world economic growth in recent decades would have led to this outcome with or without the crisis.

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What is remarkable in Ahamed's book are both the parallels and contrasts of the 1920s to the past decade. The most obvious parallel is the amazing ability of smart people to collectively believe such dumb things-- and inflict pain on others justified by those wrong beliefs.

In the 1920s it was the Gold Standard-- the firm faith that price consistency between nations must be maintained at all costs. What is striking is how much the costs of deflation and joblessness imposed by it was understood; as is described on p. 161, Britain in 1920 very consciously went back on the gold standard and "two million men were thrown out of work" and, note a decade before the Great Depression, mass unemployment would persist for the next two decades. Some like Keynes identified the madness but most "smart" people thought such the gold standards and its costs the height of sanity.

Just as "securitization" and deregulation were the obvious financial orthodoxy in recent years, with groups condemning "predatory lending" and demanding more financial regulation treated as cranks.

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Though Liaquat Ahamed's book focuses on individuals, it is really about the economic and ideological orthodoxies that drove them in a particular period. Even the best and brightest in the world of finance often could not see beyond a certain set of assumptions. He focuses on Benjamin Strong of the Federal Reserve Bank of New York, Emile Moreau of the Banque de France, Hjalmar Schact of the Reichsbank and Montagu Norman of the Bank of England.

The well-written history explores how all of these individuals insisted that the gold standard was essential to economic stability at a time that was not the best course of action. Their world view caused them to take and to promote monetary actions that destroyed their economies, and severely impacted German wartime reparations .

It is easy to see how a comparable book may soon be written about the individuals who shaped the political economy during the 1990s, the glory days of globalization and free market economics, when individuals such as Lawrence Summers and Robert Rubin ruled the day and could not seem to do any wrong in Washington. There were vigorous debates between Republicans and Democrats in the 1990s, just as there were in the 1920s, but these debates were contained with certain parameters. Now politicians are living with the effects of the economy they created, and many Americans will be paying the price for their decisions for decades to come.

The book, and post, by Liaquat Ahamed, The Lessons of the Great Depression, provide a nice antidote to much nonsense promulgated by the right wing. The Great Depression was not caused by stupid Fed tricks, nor was it extended by stupid New Deal programs. It was - rather - the predicted result of the normal operation of a small government, Laissez-faire economy constrained by a gold standard. And, yes, it was predicted - by the greatest social scientist produced by America (and the greatest economist who ever spent time at the University of Chicago), Thorstein Veblen, in (among other trenchant analyses) "Sabotage" in 1919, the story of the coming great depression manufactured by oligopoly capital. Liaquat rightly notes the constraints placed on US policy-makers when they attempted to deal with the crisis. The references to blood-letting are apt, a practice that continued long after abandonment of the gold standard and Bretton Woods, which rendered such medieval medicine wholly anachronistic. The World Bank, IMF, and Washington continued to prescribe blood-sucking remedies until the US and developed world plunged back into another Great Depression last year, at which time they (re)discovered the benefits of Keynesian "big government" policy. Last weekend, I participated in a conference at the University of Chicago on the current financial crisis, where I found the last remaining blood-sucking Neanderthals pushing for "free" market solutions to this disaster.

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At the end of his introductory essay, Liaquat Ahamed asks two questions. One is:

...has the structure of the economy changed so much ... that the traditional instruments of policy we thought we could rely on to jumpstart the economy will no longer work?

New approaches are required, but it's not so much the nature of the economy that has changed, it's that we forgot or never fully learned the lessons of the Great Depression.

One of the lessons of the Great Depression should have been that the financial authorities need to monitor and regulate excessive build-ups of systemic risk. In addition, once a crash occurs and fear is one of the main factors that is causing markets to freeze up, financial authorities need to know how to quickly reduce risk - they need some means of removing the questionable assets from the market place - and this must be done in a politically palatable, least cost manner.

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I would like to thank TPM Café for hosting this discussion.

Lords of Finance is intended to be a popular narrative history about the causes of the Great Depression. I chose to tell the story by looking over the shoulders as it were of the four major central bankers of the period, Montagu Norman of the Bank of England, Benjamin Strong of the New York Fed, Hjalmar Schacht of the Reichsbank and Emile Moreau of the Banque de France. It was a way of turning the spotlight on key economic decision makers of the era, thus highlighting that the Great Depression was caused by a series of policy mistakes, especially by central bankers. Moreover by telling the story through individual biographies, I thought it would make the book more accessible to more people.

The economic story that underlies Lords of Finance is an eclectic one. The book emphasizes three broad factors behind the Great Depression. First was the gigantic overhang of international debts after the First World War, the result of the failure of statesmanship at the Paris Peace Conference of 1919. German reparations and European war debts left massive fault-lines in the world financial system, which cracked at the first pressure.

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