Martin Wolf, the associate editor and chief economics commentator at the Financial Times, is one of the world's most influential financial journalists. He's an associate member of the governing body of Nuffield College at the University of Oxford; an honorary fellow of Corpus Christi College at Oxford; an honorary fellow at the Oxford Institute for Economic Policy (Oxonia); a special professor at the University of Nottingham; and a member of the board of governors for the Ben-Gurion University of the Negev in Israel. His column in FT, the U.K. counterpart of The Wall Street Journal, is available online and is almost always brilliant. In his latest book, Fixing Global Finance, Wolf clearly and concisely dissects the world economic crisis.

Gluck: The global meltdown that we're seeing-was the U.S. the main cause?

Wolf: This was caused by deep systemic failings in the world system. ... Over the last three decades, there's been an extraordinary expansion in credit. This led to an extraordinary amount of bad lending, as one would expect.

So this is an enormous credit bubble, and in the process a very large amount of bad debt has been created all over the place. The second thing that has happened over these 30 years is we tried to transfer capital-or some of this credit-to emerging economies. Every time that happened, we ended up with a huge financial crisis and ultimately, after the last and biggest of these waves of crises in '97-'98 in Asia, most emerging economies ... started to run very large current account surpluses. The capital they were receiving from the developed world came back out as foreign currency reserves, which were deposited in developed countries-particularly the U.S.-creating very low real interest rates in the U.S. and very large accumulations of liquidity in our banking system-further promoting, on a very large scale, the credit boom.

It's no doubt exacerbated by the fact that a large part of the credit that was supplied in the last few years was to households that could never pay it back. And it was obviously made worse by the fact that the instruments used to finance the credit bubble were very complicated securities that are distributed across the whole financial system of the world and nobody knows where they are, which has created vast uncertainty, and they're almost impossible to value. So there are clearly very important failures of regulation within the financial system which have also made the crisis worse than it would otherwise be. But I hold a view, at least at the moment, that we would have had a very severe correction in the economy even if that had not been the case because the credit bubble was going to burst at some stage.

Gluck: But you think that the real problem and solution may lie with China, which has accumulated these large foreign currency reserves. You argue that China must become a better borrower, right?

Wolf: Yes. It's very important that we do two things now: restructure the global stock of credit and debt (and in particular restructure the debt of households), and restructure the financial system so it's solvent. That's a task predominantly for the developed countries-particularly, obviously, the U.S. But beyond that, we have to get back to a different pattern of income and expenditure in the world, such that it doesn't rely so heavily on this massive borrowing by the household sectors of a relatively small number of developed countries, which are now maxed out. They just can't really be expected to borrow anymore. It's obvious that U.S. and U.K. households are going to save more. This is a very big deal because U.S. consumer demand alone is about 20% of world demand. It's equal to double China and India together. It's simple arithmetic. If we're going to sustain high levels of economic activity across the globe, then somebody else must offset this decline.

The longer-term solution is for those people who are saving too much to spend some more, and the obvious example of that is China, where consumption is actually only 30% of GDP as against more than 70% of the U.S. The question for the Chinese is: How can they go about this? In the short run, it's very, very hard because the structure of the economy is not easy for them to change.

Gluck: They need a more sophisticated financial system.

Wolf: They need several things. In the long run, first of all, they have to raise disposable incomes as a share of GDP. At the moment, household disposable income is only about 40% of GDP. You can't have a mass consumption society when disposable income is so small. The rest is corporate and government income and they have to transfer more income to households. That is actually a very big and complicated problem. Second, as you mentioned, the Chinese need a financial system. They've moved a long way in that direction, but must be better at extending credit to households. Third, the government needs to think of ways to promote more labor-intensive growth. The recent growth of China has been very dependent on massive investment and much of that has been very capital-intensive and hasn't been generating much jobs. That's one of the reasons why income growth has been so low for households despite the very rapid growth of the economy. They save about a third of their disposable income. In the short run, they have to do basically what the Americans do-spend more.

Gluck: In your book, you point out that China has not done all that much in this direction. Just about a week into the Obama administration, Tim Geithner criticized China for not allowing its currency to float more freely.

Wolf: China is, in my view, a currency manipulator. But I don't believe that is the heart of the crisis, and therefore focusing on it is a mistake. The crucial thing to focus on is the level of domestic spending in China. If domestic spending rises by enough-and it has to rise a lot relative to potential output-then the current account surplus will take care of itself.

Gluck: The stimulus plan being finalized in Congress right now-is that going to be enough to jolt the economy out of recession here in the U.S.?

Wolf: My reading of the numbers suggests very, very strongly that the answer to this question is no. But I never really thought it could. There still seems to be a lot of thinking in the U.S. that you can have a short-term stimulus that pump-primes the economy and then everything goes back to normal. I think this is nonsense. We are in a world in which, at least for the moment, private spending is collapsing. The government can and should fill the gap to sustain demand in the economy. Otherwise, we risk a cumulative collapse in demand. As private sector demand collapses, this leads to higher unemployment and more bankruptcy, which leads to more cutbacks in spending and so on, all the way down. That's how you get a real depression.

In 2005-2006, the U.S. household sector was outspending its income by about 5% or 6%. That has never happened in American history. This was partly on residential investment and partly on the purchase of consumer durables. This was, of course, all debt-fueled, and U.S. households were borrowing more than ever before, and its debt to disposable income ratio doubled. This can never happen again.

As I said, the fiscal package is just palliative. In the long run, you need higher investment in the economy-particularly from the private sector. The other thing that has to happen, as I've frequently said, is exports have to rise. There has to be more demand from abroad.

The fiscal stimulus likely is going to have to last for quite a while. It's not just a one-off. It's a holding operation until these bigger adjustments occur, but it is not about pump-priming so that American households can spend crazily again-because they are cashed out.

Gluck: You have written in your column in the Financial Times that economic "shock and awe" are needed to keep the U.S. from slipping into malaise or possibly worse. Explain what you mean, because a lot of Americans consider an $800 billion spending package to be shock and awe.

Wolf: Well, it's $800 billion over two years, so it's $400 billion a year, roughly. I think many people in America seem not to understand how big their own economy is, so they get a bit confused by all this.  The U.S. economy is roughly $14 trillion a year. That's $14,000 billion a year. Eight hundred billion dollars, therefore, is about 6% of GDP. Over two years, that's 3% of GDP a year. In the context of a massive downshift in private spending, which is the main reason for the fiscal deficit today, a 3%-a-year stimulus is going to be an inadequate offset.

It is possible that the Fed's actions will be enough to prevent it, but I'm not convinced of that because the Fed ultimately-while offsetting the collapse of the financial system-is not itself creating final demand which the government spending plans can do.

The $800 billion will be fine if it were all spent in a year. In my own back-of-the-envelope calculations my guess is that the stimulus package probably needed to be twice as big.

I understand the very difficult politics of all this in America. But I actually think they are taking too much the view that the private sector should be left to heal itself. The people who believe that's what we should do don't realize how damaged the private sector is and how long that healing would take and how incredibly painful the recession would be.

Gluck: The whole emphasis that has been paid to getting the toxic assets off the bank balance sheets-what do you think of that?

Wolf: I'm worried about it very much. It seems to rest on the view that what went wrong here was that the banks went overboard on a very specific subclass of bad assets. My view is they went overboard with credit in all directions. We're going to find, as this recession unfolds, bad debt emerging everywhere. You can't simply find a class of toxic assets, take them off the balance sheet and everything's fine. This focus on the toxic assets-because it's the politically convenient thing to do-is not going to solve the problem and is going to lose a lot of the momentum and credibility for the Obama administration.

Gluck: What three things in coming months would you look for if things are going to work out well?

Wolf: Passage of a bigger and effective stimulus package, No. 1. We're going to get a stimulus package, and I hope it works. But I would have liked to have seen it bigger. The second thing I would like to see are clear signs that the American administration has a package for the financial system which is sufficiently radical and comprehensive to make it absolutely plain to anybody that the financial system is viable and functioning under almost any conceivable circumstances. The third thing that I would like to see to be optimistic is a productive and effective meeting of the group of 20 developing countries in London in April in which they begin to emerge with a credible plan for demand expansion across the world and reform of the global financial system in support of it.

The pessimistic things are essentially the inverse of this. Namely, that it becomes obvious that the stimulus package is far too small and it's not working.

Gluck: When will that be obvious?

Wolf: It will probably be obvious in six months.

Gluck: A lot of people fear that the U.S. taking control of banks and nationalizing them is taking us down the wrong path. What do you think about this fear of compromising capitalism?

Wolf: It's complete baloney. I wouldn't call it nationalization at all. I would call it a bankruptcy process. The government doesn't have to control a bank for very long. If they want, they can control it for three weeks or even a week. If you accept for the moment that the financial sector is undercapitalized-that there isn't enough equity in the system to absorb the losses while still remaining sufficiently healthy to be soundly managed for the interest of shareholders-then take hold over all the institutions that are undercapitalized by some standards. You would then say to the bondholders, starting with the most junior credits on upwards, that a certain proportion of the debt is converted into equity. And you would say to the bondholders, just as you do in a normal bankruptcy, "Congratulations, you now own the bank."

Gluck: But the existing equity holders ...

Wolf: Would be wiped out. But that's what happens in a bankruptcy. If we allow a normal private company to go bankrupt, the shareholders lose their money. This is capitalism. You've got to bear some risk as equity holders. It's true socialism to say the government has an obligation to save the value of equity. The second possible way of doing it, which is closer to nationalization, is to say, "We're not going to wipe out creditors because we think that will create too big a problem for confidence in the financial system."  We suppose the government will then have a majority shareholding in many cases. ... If you want to be more radical, you could say-which I rather like, actually-the government could give its shareholding to all the American citizenry. Each American citizen will get a share in the new Citibank, or whatever it might be.

The crucial point only is that, if a bank is undercapitalized and cannot adequately write off bad debt, it will inevitably be unable to reveal the truth on its balance sheet-because the truth will be that it has negative net worth. This will be a zombie bank that can't lend.

Gluck: What are the chances of one of those creative solutions actually being adopted in your view? Will the leadership be there?

Wolf: I actually think they are getting close to it again. The problem is that because the TARP was so incredibly mismanaged, a lot of the credibility of the U.S. government was shot. One thing they can do is put in preference capital, which is, of course, a form of debt, but it's junior debt. If it is the case, as many fear, that the banking system is fundamentally decapitalized, then in the end they're going to have to do one of these things. I would rather they did it sooner than later while the credibility of the government is still solid.

If the American body politic is too ideological or unwilling to spend the money, then it will have a zombie banking system. Sooner or later, that will become intolerable.

Historically, like most foreigners, I've always admired American pragmatism. I'm absolutely sure the U.S. will choose a means of resolving this problem. I wish it were sooner rather than later.

Andrew Gluck, a longtime writer and journalist, is CEO of Advisor Products Inc. (www.advisorproducts.com), a Westbury, N.Y., marketing company serving 1,800 advisory firms. To read a more in-depth report of Andy's interview with Martin Wolf, click here.