'The world economy is now in a very strange place. We should not forget how strange and disturbing it is.' These are the words of Martin Wolf, the Financial Times' Chief Economic Commentator.

Wolf's 'strange place' has the world economy in a 'contained depression', where only two of the six largest advanced countries have higher GDP than in 2007; where monetary policy has lost the power to stimulate; where fiscal policy has been incapacitated by excessive government debt; and where the financial sector has channeled capital flows in the wrong direction.

In short, the global economy is in a mess and we don't yet have the formula for setting it right.

Wolf's story starts with the 1997-98 Asian financial crisis.

The argument goes that the emerging economies (especially China) concluded that they should take out self-insurance against similar crises by encouraging domestic saving and accumulating foreign exchange reserves. The reserves flowed into US assets, pushing up the US dollar and opening up a current account deficit. This weakened demand for US production, encouraging expansionary policy settings in the US (low interest rates and a fiscal deficit), which led to the sub-prime crisis which triggered the wider financial crisis.

Wolf has been pushing the 'blame China' line for some time. Doubtless these factors were operating, but to give China central place in the policy narrative is misleading.

The US financial disaster was largely the home-grown product of lax prudential supervision, misguided doctrines and vested interests.

Low interest rates began as a fix for the 2001 'tech wreck'. Budget deficits reflected the doctrinally driven Bush tax cuts. The current account deficit was already more than 5% of GDP by 2004, before China's surplus became significant. Europe and the UK had their own versions of financial excesses and regulatory failure.

In 2006 (the height of the US external deficit), China accounted for little more than a quarter of the US current account deficit, with Germany, Japan and the oil producers accounting for the rest. As we now realise, the intrinsically unsustainable imbalances were in the European peripheral countries, which went unnoticed until the Greece debt debacle of 2010.

Whatever the role of external imbalances in the lead-up to the 2008 crisis, this isn't the main issue now. China's current account surplus has fallen from 10% of GDP to 2%. If any country were to be singled out, it would be Germany, although it's hard to pinpoint what Germany is doing wrong in its policy settings, other than the unalterable reality that euro membership gives Germany an uber-competitive exchange rate.

The main issues are elsewhere: how to unwind America's quantitative easing and restore normality to monetary policy without a damaging external spill-over; how to get budget deficits and debt down over time without stifling the feeble recovery; how to restructure a financial sector which failed so comprehensively over the past decade; and how to bring some order into volatile global capital flows.

Photo by Flickr user Digitalnative.