Historians and laypeople will argue about the causes and effects of the great financial debacle of 2007-2010 for decades, just as they continue to debate the Great Depression.
Looking back, people will ask “What if the Fed had intervened to keep Lehman Brothers from collapsing as it had with Bear Stearns six months earlier?” Right now, a majority of analysts argue that letting Lehman collapse caused financial markets to swoon and the economy to collapse into the most serious recession since World War II.
This view can be found at both ends of the political and economic philosophy spectrum. Keynesian Democrats such as Princeton’s Alan Blinder and San Francisco Fed President Janet Yellen argue that allowing Lehman to collapse was a mistake, as does Republican Allan Meltzer from Carnegie Mellon, who has assumed Milton Friedman’s mantle as the chief guru of monetarism.
To these critics, it seems that if the government had intervened only to prop up Lehman until a new owner could wind most of it down, as with Bear Stearns, total national output, consumer confidence and the prices of stocks would have fallen much less and unemployment would not have spiked as it did.
I am not convinced, for a variety of reasons.
First, this argument implicitly assumes that the overall problem was one of liquidity in a few key firms. Save those and everything would be hunky dory. But the problems in the U.S. economy and financial markets were far more profound.
The housing bubble was the largest in U.S. history, and nearly as bad as the one that brought Japan to a decade of economic stagnation after 1989. Large financial institutions had taken on leverage and devised new, complex and misvalued financial instruments to unprecedented degrees. Households had doubled their indebtedness in a little over a decade and the government was financing a growing national debt largely by borrowing abroad.
Lehman itself was not the problem. Rather, it was a symptom of broader and deeper underlying problems, of unsustainable trends that had persisted for too long and that had to end one way or another.
There is no nation in modern history in which both households and financial firms dug themselves into deep financial holes as we had by 2007 that managed to escape without a severe financial market crisis and subsequent harsh recession. It was far too late in the game to reverse an inevitable correction.
If the government had intervened in Lehman and succeeded to the extent it had with Bear Stearns, many other shaky institutions waited in the wings. AIG, which did get Fed support a few days later, was in even worse shape. Bank of America and Citigroup teetered. If not Lehman, the Fed and Treasury would have had to let some other equally important firm go sooner or later.
Remember the political context. The Fed-Treasury team had taken over Fannie Mae and Freddie Mac just days earlier. Doing so engendered a wave of protest from Congress, the media and the general public. If it had then gone on to prop up Lehman, such criticism would have turned into a firestorm and made intervening in even more crucial AIG impossible. Sooner or later the bubble had to pop. Lehman just happened to be where it did. The fact that the New York Times, the Washington Post and the Wall Street Journal immediately concurred in lauding the decision shows where national opinion was.
Critics can carp, but future historians will look back and say that the Fed in particular did a marvelous job of avoiding a complete financial collapse as bad as the Great Depression. Staving off all financial-firm failures and any recession was simply impossible. And this was true well before September 2008.
A harsh reaction already was inevitable more than a year earlier, when European markets for commercial paper locked up in August 2007, because of fears about the safety of commercial paper issued by U.S. financial firms that were deeply invested in dodgy mortgage-backed securities. Indeed, it may have been inevitable even a year before that, when the orgy of refinancing and issuance of high-risk mortgages reached its peak. There was no safe way to climb down after that point.
The purpose of the interventions that did take place was not to protect shareholders in these firms, the jobs of their employees or, ultimately, even the mutual funds and pension plans to which they owed money. It was to prevent a systemic financial meltdown. The interventions were necessarily extemporaneous and messy. The mess left to clean up is enormous. Keeping every single major financial institution alive was not important. Ensuring that all of them did not collapse was. The Fed and Treasury succeeded.
Looking forward, in September 2008, it was important that the majority of firms like Morgan Stanley, Goldman Sachs, Bank of America and Citigroup did not all go down in flames at once. It is of no importance at all that such firms be healthy and profitable in their current forms a decade from now. Indeed, it would probably be good for the U.S. economy if we proceeded to systematically dismember many of them over the next few years.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.