From Financial Crisis to Debt Crisis?

How can policymakers be so certain that financial catastrophe won’t soon recur when they seemed to have no idea that a crisis would erupt in the first place? The answer is not very reassuring, because there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.

CAMBRIDGE – Everyone from the Queen of England to laid-off Detroit autoworkers wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe won’t soon recur when they seemed to have no idea that such a crisis would happen in the first place?

The answer is not very reassuring. First, the fact is that economics tells us much more about a country’s vulnerability to financial crises than it does about the timing.  Second, there is every reason to worry that the banking crisis has simply morphed into a long-term government debt crisis.

After all, why exactly are most investors now so confident that it is over? Mainly because they see that the governments of the world have cast a vast and expansive safety net over the major financial institutions and markets. At the same time, policymakers have turned on all the tools of modern macroeconomic stimulus to full blast, with huge fiscal deficits and near zero policy interest rates. 

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