The weekend G8 communiqué, coming after four months of stabilisation in most financial markets, seemed to mark the official end of the financial crisis. If so, what lessons should be learnt for economic and financial policies in the months ahead? The history of the crisis in the next few paragraphs may not be the standard version presented by most commentators and economists, yet recent events suggest it to be a plausible account of what went wrong.

The blunders that produced last autumn’s financial crisis had nothing to do with the supposedly inflationary monetary policies of Alan Greenspan, or the fiscal profligacy of Gordon Brown, or with Mervyn King’s lack of practical market experience, or Hu Jintao’s mercantilist approach to currencies and exports. All these and many other factors contributed to the vulnerability of the world economy, but none of them would have been enough to cause its near-collapse last autumn. For that we can blame the unforced errors of a man almost forgotten since he slipped quietly out of office at the beginning of this year: Henry Paulson, the former US Treasury Secretary and ex-chairman of Goldman Sachs.

To understand how a localised financial problem in one segment of the US mortgage market turned into a near-collapse of the global financial system we need to recall Mr Paulson’s astonishing misuse of mark-to-market accounting standards to expropriate the shareholders of Fannie Mae and then to bankrupt Lehman Brothers. What made matters even worse was his inability to understand the systemic consequences of what he was doing. Anyone who doubts the importance of individuals in economic history should recall that the single worst day of last autumn’s entire financial crisis, as measured by the widening of risk spreads on interbank credit, was September 23. That was the day Mr Paulson appeared before the Senate Finance Committee to explain what he wanted to do with the $700 billion he had requested from Congress. This was the moment when everyone realised the world’s most powerful economic official did not know what he was doing.

Once the key role of personalities and financial policies is recognised, it is hardly surprising that things began to improve almost as soon as Mr Paulson was replaced by a competent Treasury Secretary, Tim Geithner. A collapse of share prices on Wall Street triggered by the Lehman bankruptcy in September ended the very day after President Obama responded to attacks on Mr Geithner’s personal probity by offering his unqualified support. A week later, the suicidal mark-to-market accounting regulations were dismantled. And it is no coincidence that the financial crisis, at least in America and Britain, effectively ended that week. From that point onwards, the US Government found itself collecting tens of billions of dollars in repayments from supposedly insolvent banks. Far from being forced to nationalise almost every bank and running out of money with which to refinance toxic assets, as predicted by panic-mongering Nobel Laureate economists, the US Treasury now finds itself almost embarrassed by the hundreds of billions of dollars it has budgeted for supporting a banking system that no longer needs state support.

So much for the history of this crisis. What does all this imply for economic policies in the months ahead? First, that borrowing by the US and British governments, whether from their own citizens or from China, was not among the main causes of the crisis. This is not to deny that excessive public spending will damage long-term productivity growth and living standards in Britain, America and much of Europe. But the fact that fiscal policy needs to be tightened does not mean that it should be blamed for causing last year’s crisis. In fact, it was the financial crisis that caused enormous government deficits, not the other way round. It is, therefore, essential for governments to wait for their economies to return to adequate growth rates before they cut public spending in the years ahead.

The same is true of monetary policy. Last year’s crisis was not caused by Greenspan’s monetary policies after the 2001 recession, as is often suggested. And nothing in recent experience should discourage the Fed and other central banks around the world from keeping interest rates at rock-bottom levels until growth is restored and unemployment is reduced to more acceptable levels. In fact, the best contribution that central banks can now make is to keep interest rates extremely low for much longer than markets are expecting. By doing this, they can create conditions for governments to tighten fiscal policies without jeopardising economic growth. For central banks to raise interest rates at the same time as governments are increasing taxes or cutting public spending would be economically suicidal and fiscally counterproductive, as evidenced by 15 years of experience in Japan.

Finally, what about regulation? Perhaps the clearest lesson of the crisis, if only policymakers are willing to accept it, is that regulation needs to be better targeted and more intelligent, rather than more extensive. Rather than extending their reach into areas such as hedge funds, which had nothing to do with the financial crisis, regulators must make sure that systemically important banks have enough capital and risk-free government bonds or central bank reserves to cope with liquidity withdrawals. Equally, regulators must avert any repetition of fiascos such as mark-to-market accounting, risk-based capital requirements and reliance on private credit-rating agency models. All of these errors reflected the market-fundamentalist ideology that the markets are always right.

If markets were always right, there would no need for regulation and there would never be any financial crises. The reality is that markets are usually right, but are sometimes disastrously wrong. The challenge for governments and central bankers is to judge when markets should be left alone and when they require intelligent and focused regulation. A good way to start would be to look more objectively at the mistakes of the past 12 months.

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