Martin Wolf is the chief economics correspondent for the Financial Times. His new book, "The Shifts and the Shocks," on the causes and implications of the financial crisis comes out Thursday. We spoke recently about what we have learned from the crisis and why he fears that governments have not made the necessary reforms to ensure it never happens again. This conversation has been edited for length and clarity:

DV: One of the themes you talk about a lot in the book is how fragile our economic system is and that this fragility is a new phenomenon that has grown over the past few decades. Can you talk about that theme and its implications going forward?

MW: First of all, I’d like to stress that it’s not a new phenomenon. It’d probably be best described as a recurrence of an old phenomenon, but in a new guise. My argument is essentially that the past 35-40 years have seen the interaction of two linked processes, both connected to some degree to the return of relatively free markets. The first is globalization: the entry of new powerful competitors in the world economy, the opening of economies to trade and capital flows, and the restoration of an open global economy, which is something we haven’t had since the late 19th century. All of which created part of the conditions for the fragility.

The other part is that, ever since the 1970s onwards, we have progressively liberalized our financial system. Just as with the economy, in this modest form, this financial form is, in one respect, radically different and even more fragile than in the past. It’s balance sheets are much bigger than ever before. It’s structurally much more complex than ever before with a host of new instruments and markets that have never existed before. The possibility through technological improvements of integrating trading across the entire globe, the creation of universal banks that combine with them both enormous retail banking operations and gigantic trading and market securities operations in one house—this is really a quite new phenomenon.

I argue this has essentially created a new world which is even more fragile and prone to panic than before, and is going to require vastly greater government support, involvement and commitment to its survival than in any crisis in history. And I think that’s crucial point: The scale of the government support in the Western world in this crisis has no precedent.

DV: How did this phenomenon affect the recent crisis, particularly in the U.S. and Eurozone?

MW: It proved so destabilizing I think for two reasons. The first, which is the most obvious, it is that the panic itself was absolutely enormous. It is arguable, though difficult to prove, that the crisis that occurred in the fall of 2008 was the most complete breakdown of the core financial system of the world there has ever been. If, for example, you contrast it with the 1930s, there were an enormous number of bank failures, notably in the United States. But actually the core money center banks in the U.K. and U.S., which were the core of the financial system, survived quite well. This was not true this time. It needed a much greater commitment by the authorities—central banks and governments—to support the core financial system than has ever occurred before.

The second point is that the credit bubbles and asset price bubbles, which were linked prior to the crisis, were unsustainable and incredibly large. When they stopped, the demand that they were supporting also stopped and that has given prolonged position of chronically weak demand. That is shown by the fact that now for close to six years, all of the major central banks in the world are offering close to free money. That’s quite an extraordinary situation. It shows how weak demand is because the credit machines has stopped working. The debt overhang has become decisive. That’s exacerbated greatly what Larry Summers calls the secular stagnation.

I would add, and I discuss this, there is some good reason to believe that in addition to that, the underlying supply potential has been weakened. There seems to be a real productivity problem in the western world now and it’s difficult to know how much it’s a consequence of the crisis and how much it exited already before the crisis. I think it’s both, but certainly the former is important. It’s one of the reasons we had the credit bubble. Those I think are the reasons for the problem.

DV: What are the biggest mistakes policymakers have made in response to the crisis, both in the Eurozone and in the U.S.?

MW: When they confronted the crisis, they had hugely difficult policy decisions to make. The tendency I think was to think that the main problem they had was to keep the financial system afloat, which I agree was necessary. They also realized that they had to maintain demand as private sector demand collapsed. So, they were quite willing to accept in 2008 and 2009 very aggressive fiscal policy. I supported the TARP (Troubled Asset Relief Program). This is controversial, but I’m convinced that if they hadn’t taken these measures, there was a really good chance of the Great Depression II, possibly even worse than the Great Depression.

I think that by the fall of 2010, at the Pittsburgh summit, the governments got very frightened by the fiscal deficits and by the Greek crisis. There was tremendous resistance, obviously in the US but also elsewhere in the U.K., to continue these fiscal deficits and begin to shift toward austerity. I believe that was premature. It weakened the recovery, most notably in the Eurozone but also elsewhere including the US. I think it’s also arguable that that’s probably is the biggest mistake in the short run. More action should have been taken to write down the debt overhang, particularly private sector debt overhang in the US. Greater efforts should have been made to reduce outstanding mortgage debt. The same is true in Spain, in the U.K. and public debt should have been reduced in Greece and Portugal certainly. And I think also far too much public debt ended up in Ireland.

So, the core mistakes were that they did a good job in the immediate aftermath of the crisis, they shifted to austerity too soon, pretty much everywhere—notably in Europe. They didn’t restructure debt enough and finally in Europe, the ECB (European Central Bank) inevitably took far too long to adopt the most aggressive possible monetary policies given the evident signs of declines in inflation. All this was largely because people misunderstood the nature of the crisis and particularly the balance sheet recession aspect of the crisis, which I stress in the book and was already quite apparent by 2009.

DV: How can we deal with this fragility in the future?

MW: We have had a demonstration of the extreme fragility of our financial system and its vulnerability to credit bubbles. We are in no position to cope with another such crisis in the medium term. We have lost a lot of our room to maneuver. Fiscal position is obviously much worse than it was before. I think we could do it again. Certainly the U.S. could do it again, but I think it would be really quite difficult and it’s not clear that the public will tolerate another such rescue. The politics of it are terrible for obvious reasons.

The proposals I make fall into two big categories. We have to be willing to be much more radical.  The first is to try to create greater macroeconomic balance in the economy with less reliance on the creation of demand, particularly in the United States. And I think that requires quite large changes in global financial institutions, particularly the International Monetary Fund. That’s macroeconomic balance at the global level.

The second thing we need to do is to make our economies less dependent on debt and that means substituting equity type instruments for debt type instruments. Our corporations and our households have become incredibly debt dependent and that generates huge fragility because when there is a big turn down, that inevitably means there are lots and lots of bankruptcies.

The final thing is to change the financial sector to make it more robust. I discuss essentially two reforms. One is to greatly reduce the leverage of the banking system. Back in the late 19th, early 20th centuries, leverage in U.S. banking was usually in a ratio of 3-to-1 . Now leverage after the crisis is closer to 20-to-1. Institutions with such little equity have very little loss-bearing capacity and that means in a crisis, when losses are obviously out there, it’s going to create panic.

The alternative proposal is 100 percent reserve banking. Bank deposits would be backed by government deposits of an equivalent duration. So you wouldn’t have a situation in which you have long-term risky assets on one side and short-term liabilities on the other side. And then there will be a question of what you do with the riskier assets and there are various proposal which are being considered here. The most extreme one is that all other institutions become essentially investment funds. A more moderate version is that other institutions would have capital requirements that are relatively liberated from regulations. People would be made clear that their assets are at risk if they put their money in these institutions.

But I come back to the beginning point: We should not think the system has been solved. We should not think that just by saying we’ll never bail out banks again, that we’ve resolved it. That’s not a credible promise. We really can’t afford another such crisis. We would all be in tremendous difficulty if anything like this were to happen again. But what I see around the world is everybody trying to persuade banks to lend more and accumulate more credit, to generate more credit in the economy in order to get it going. That’s right back to the disease we had before. That’s very, very undesirable. I am very concerned about the potential for further instability.