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2012 Election

The Cost of Failure

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In January 2008, the non-partisan Congressional Budget Office (CBO) presented an economic and fiscal outlook for the period 2008 to 2018. They projected that the Federal fiscal deficit in 2008 would be 1.5% of GDP, or -$220 billion. Moderate fiscal deficits (< 2% GDP) would continue through 2010, and then decline into a slight surplus as the Bush tax cuts expired and the deployments in Iraq and Afghanistan wound down. Unemployment was projected to rise to 5.5% and then fall beneath 5% again by 2010.[1]

Six months later, in the wake of the financial panic arising from the decision to let Lehman Bros fail, the projection had risen to -$1,500 billion.

 

What happened? The easy answer is “the financial crisis”. But the financial crisis involved many events unfolding over time, each with critical decision points that could have changed the course of events. The traditional model of financial crises involves five stages[2]:

  1. Displacement: some event occurs to change economic conditions, create new growth opportunities and fuel positive expectations;
  2. Boom: credit expands and the increase in the money supply creates a positive feedback loop;
  3. Overtrading: positive expectations become irrational as economic activity departs from “fundamentals” for a sustained period of time. This is described by Kindleberger as a “mania”, while Alan Greenspan famously called it “irrational exuberance”;
  4. Revulsion: a trigger event, such as a slowdown in lending or drop in prices, causing economic actors to become more conservative and reinforce a negative feedback loop. The “revulsion” phase may or may not include a panic and a crash (i.e. “hard landing” vs. “soft landing”);
  5. Tranquility: at some point after revulsion sets in, the market hits bottom: prices may have fallen far enough for investors to begin purchasing them again, or the lender of last resort may have provided sufficient liquidity to financial institutions to calm markets.

While the 2008 crisis was unique in its particulars, it conformed perfectly to the model described above. The “revulsion” phase began when the US subprime mortgage boom began to deflate in 2007, causing the most exposed issuers to fail and cascading losses across both traditional mortgage lenders as well as the securities backed by them (CMO’s and CDO’s). The institutions that were most exposed through high leverage or risky lending practices began to run into liquidity problems, as short-term paper expired and was not rolled over, inter-party lending came to a halt, and investors began to withdraw their money.

Did the pinching of the real estate bubble necessitate a financial panic and crash? Not at all. The deflation of the Japanese real estate bubble of the 1990’s was far larger in terms of household worth and GDP than in the United States – by a factor of 10. Almost every bank in Japan had negative net worth (i.e. was bankrupt), but there was not a single run on a single bank: because of the implicit guarantee of the Japanese government.[3]

 

This is a critically important point. The panic could have been avoided. The worst effects of the crisis could have been substantially mitigated. Why weren’t they? Because the Bush Administration, and Treasury Secretary Henry Paulson specifically, dropped the ball. The decision to let Lehman Brothers fail created a full-fledged run in the banking sector. Even as Paulson was uttering his famous words, “the American people can remain confident in the soundness and the resilience of our financial system,” investors whose money was frozen out of Lehman were desperately trying to get their cash out of banks like JPMorganChase, in anticipation of the next bank failure. Credit markets were frozen and businesses around the world literally began to run out of cash to fund daily operations.

Why single out Lehman Brothers? The government had already bailed out or guaranteed losses for Bear Stearns ($29 billion), Countrywide ($17 billion) and Merrill Lynch. Merrill Lynch was purchased by Bank of America on the 14th of September, the same day that Treasury Secretary Paulson refused to extend federal guarantees to cover potential Lehman Brothers losses. Mr. Paulson was being criticized in Congress and the press as “Mr. Bailout” and was undoubtedly worried about the “moral hazard” of rescuing more banks[4]. Bank of America, which had purchased Countrywide and Merrill Lynch under enormous pressure from regulators and only with the promise of federal money to cover potential losses, walked away from talks with Lehman.

The next day, the Federal government was forced to bail-out AIG at an eventual cost of $50 billion.

All governments struggle with the issue of moral hazard: if you give the bankers too much security, they will take undue risks, confident that the government will bail them out. This is a good policy, in general, but it should be applied before the crisis strikes!!! It is useless to apply moral suasion once the hazard has been incurred; and in the case of Lehman Bros, far, far worse than useless.

What should Paulson have done? It’s clear that he should have extended guarantees to Lehman, and any other major US financial institution that looked on the verge of illiquidity. A combination of liquidity injections by the Federal Reserve, Treasury guarantees, loans and investments to recapitalize losses of sufficient size to convince the market that the government would take every measure necessary to prevent a liquidity crisis.

Of course, this is what ended up happening. The government bailed out AIG; extended $130 billion in facilities to Bank of America to cover potential losses from their forced acquisitions of Countrywide and Merrill Lynch; passed the Emergency Economic Stabilization Act of 2008, which included the Troubled Asset Relief Program (TARP) of $700 billion in capital injections to distressed banks; the Federal Reserve dropped its Federal funds rate from 5% in 2007 to 2% and subsequently to 0.25% by December 2008; the Fed also agreed to purchase up to $1.25 trillion in mortgaged bank securities from private institutions.

 

Unemployment doubled from 2007 levels to 9.3% due to the systematic consequences of the liquidity crisis on the real economy. Presidents Bush and Obama tried to stimulate consumption and restart expansion through tax rebates and fiscal stimulus ($168 billion and $787 billion respectively). These efforts arguably prevented the crisis from being worse than it was, but in no way came close to overcoming the inertia of the $15 trillion economy. Consumers and companies were simply too leveraged and too afraid to go out and spend.                                          

 

Readers will say that it is easy enough to criticize Bush and Paulson with the benefit of hindsight. There is no way that they could know that letting Lehman fail would provoke a global systematic reaction, and that’s true. However, the appropriate government and central bank response to a financial “revulsion” has been known since the middle of the 19th century. The Bagehot rule[5] states that in times of crisis, the central bank should lend freely to illiquid but solvent firms, though at a penalty interest rate.

This is the doctrine of the “financial bazooka” which, once applied in the United States in late 2008, ended the worst of the credit crunch. Had the government rescued Lehman, there is no doubt that the financial crisis would have evolved far differently. Guarantees would still have been required for most major US banks; the seizures of WAMU, Freddie and Fannie, and the bail-outs of Goldman Sachs and –Morgan Stanley would still have happened. Even assuming that the full cost of TARP, much of which is recoverable, had been borne by the taxpayer, it would have been far cheaper than the subsequent crash in the real economy.

Why bring this up now? Because Republicans are blaming President Obama for a fiscal deficit and government debt for which the incompetence of Henry Paulson and the Bush Administration are responsible. The long tail of the Lehman Brothers bankruptcy still drags on the US economy.

It also has major implications for US policy going forward. Congress should also re-impose the Glass-Steagall and elements of the Bank Holding Company Acts. Given the complexity of modern financial instruments, the size of the $70 trillion in liquid global assets, and the rapidity of electronic free capital flows, these measures would not prevent a future financial crisis, but, they would provide a strong layer of insulation for deposits and “traditional” banking from riskier financial activities. It would also reduce the regulatory load and improve supervision of systematic risks.

Without a firewall between federally guaranteed retail banking and corporate and investing banking, moral hazard will continue unabated. It is absurd to expect Dodd-Frank, which has yet to be fully implemented, to prevent a future crisis. When that crisis does develop, government must be ready to intervene appropriately:

  1. Provide unlimited liquidity assurances at punitive rates;
  2. Seize and spin-off failing institutions;
  3. Wipe out management and shareholders in failed institutions;
  4. Move quickly to mitigate impacts on the real economy;
  5. Worry about moral hazard later.

It is also important in Europe, where policymakers are also facing an extended liquidity crisis in the Mediterranean members. Despite the well-predicted recession and deflation cycle, there has been no hint of deploying a “big bazooka” and the euro crisis enters its third year. Only this week has the ECB hinted at unlimited measures to support the monetary union – but hints are not enough and markets will not be convinced by words.



Sources and Notes:

[1] “The Budget and Economic Outlook:Fiscal Years 2008 to 2018”, Congressional Budget Office, 23 January 2008
[2] Kindleberger, Charles P. and Aliber, Robert Z., “Manias, Panics and Crashes: A History of Financial Crises,” 6th Edition, 27 September 2011. The five stage model described by Kindleberger is based on the work of the late Hyman Minsky.
[3] “Comparing the US and Japanese Housing  Bubbles”, Seattle Bubble, 3 November 2008
[4] Johnson, Simon and Kwak, James, “Lehman Brothers and the Persistence of Moral Hazard,” The Washington Post, 15 September 2009
[5] Named after Walter Bagehot (1826 – 1877), and English economist who described the appropriate policy for a lender of last resort in the event of a financial crisis in  1873 (“Lombard Street”).

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