Lehman Brothers Former Global Chief Economist On The 2008 Financial Crisis: Lessons Learned, Lessons Missed
Lehman Brothers Global Chief Economist in 2008 Paul Sheard reflects on the lessons learned and missed from the Financial Crisis.
Why do financial crises happen? What exactly is a financial crisis? Can financial crises be prevented and, if not, can the risks of their occurring and their adverse impacts be reduced? These are important questions to ponder on the tenth anniversary of the global financial crisis.
Financial crises happen because there are two economies, one a mirror of the other: the real economy – of production, investment and consumption; and the monetary or financial economy – of money and financial claims and obligations. Most of the time the financial system is a godsend, facilitating economic activity and growth, and underpinning the high living standards the human race increasingly enjoys.
But the financial economy is an amorphous thing, what Yuval Noah Harari terms an “imagined order”, and sometimes it can become untethered from the real economy.
Main Street, Wall Street, And Liquidity
If the financial system generates too much debt and credit and asset prices get way out of line with real economy ‘fundamentals’, it can lose its normal calm and can become chaotic and dysfunctional, plunging the real economy into recession or depression. At a high level, that describes a financial crisis.
The national accounting identity yields important insights into this. For simplicity, assume there is no government sector (or a balanced budget): then, for the world as a whole, Savings equals Investment (both terms being used in their national accounting sense). This makes intuitive sense: the only way that we can transfer purchasing power from today into the future (save) is by augmenting our capacity to produce more when that future comes (investing). The real economy is the world of investing, the financial economy of saving.
Here’s the rub: the real economy—the world of investment in productive assets or embodied ones (such as human, technological, social and institutional capital)—is inherently illiquid, but the financial system is all about making the associated claims liquid (tradable or redeemable).
Financial innovation is largely an alchemic process of making increasingly liquid claims out of those underlying illiquid assets.
Think home equity finance or securitised products.
Herein lies the source of financial crises: claims in the financial system always being more liquid than underlying assets, and ‘money’ being the most liquid asset, when investors (confusing term: really ‘savers’) sense that their financial claims (like equities, bonds, repurchase agreements, bank deposits) are valued more highly than the underlying assets, they have an incentive to move into more liquid claims. Borrowers struggle to obtain finance because financial intermediaries fear that they will be left holding the bag of non-performing assets, as other creditors pull their money out. The ‘financing’ of the real economy is wont to dry up suddenly.
There is a fallacy of composition: used to dealing in liquid markets or being able to withdraw bank deposits at will, individual investors think they can move their risky financial claims into safe liquid assets and, when financial stress occur, they try to do so. But, in aggregate, the illiquid assets of society have to be held.
A run on the financial system, the hallmark of a crisis, which is so rational for individuals, is doomed to fail, and bring down the financial system and the real economy in the process.
The Central Bank Backstop
There is one savior waiting in the wings, however. The central bank, and in extremis only the central bank, can be a lender of last resort, standing ready to staunch the self-destructive impulses of a financial crisis, by exchanging financial claims on illiquid assets for central bank liquidity (‘money’) and helping to restore their value in the process.
Reflecting on the global financial crisis and the Great Recession ten years on, I see two overarching lessons for policy-makers:
- Do everything possible to prevent a financial crisis from developing in the first place because crises can be very damaging events; but,
- Given that the possibility of a crisis is a design feature of the modern financial system rather than a ‘bug’ or something that careful design can banish forever, have at the ready a well-crafted lender-of-last-resort function and be prepared to deploy it quickly and forcefully.
The first lesson was learned and policy-makers responded with gusto, implementing measures on both sides of the banking system’s balance sheet. They figured correctly that financial crises happen when banks create too much credit (either directly or indirectly through ‘shadow banks’) and fuel asset price bubbles (on the asset side) matched by ostensibly safe debt securities and deposits (on the liability side), and the holders of those ‘safe’ claims lose confidence in them and run for the door.
The response of policymakers has had four pillars:
- One, pay more attention to macroeconomic and macro-financial conditions with a view to heading off a financial crisis at the pass (the ‘Greenspan doctrine’, that asset price bubbles cannot be identified or addressed in advance but only cleaned up after the event, has given way to macro-prudential policy).
- Two, require banks to hold more capital – that way they will be able to withstand greater losses on their assets without creditors and depositors losing confidence in them and triggering a run.
- Three, require them to hold more liquid assets – that way they will be better able to withstand a run on their liabilities if there is one.
- And, four, put in place institutional mechanisms for ‘resolving’, in an ‘orderly’ fashion, systemically important financial institutions that are deemed to be insolvent.
Such ‘orderly resolution’ or ‘orderly liquidation’ mechanisms serve two purposes, a preventive and remedial one.
By being prepared to impose losses on shareholders and creditors in insolvent financial institutions, rather than bailing them out under the banner of ‘too big to fail’, it is hoped to curb moral hazard and the kind of reckless behavior that sows the seeds of financial crises; but, if a crisis does threaten, the balance sheet damage can be managed in a way that avoids the panic and contagion of a crisis.
Consumed by the somewhat wishful thinking associated with the idea of consigning ‘bail-outs’ and ‘too big to fail’ to the dustbin of financial history, there has been much less recognition of the second lesson: the need for a robust lender of last resort. What recognition there has been, has tended to draw the wrong lesson, conflating fire safety efforts and fire-fighting ones, in effect blaming the fire brigade for the fire! Outlawing fire brigades will raise the costs for the careless and the malign and lead to fewer fires as a result, but will impose much higher costs on the innocent when they do occur.
A word here on the relationship between liquidity and solvency (having positive net equity). In many discussions, a bright line is drawn:
A central bank should act as a lender of last resort, quelling financial distress by converting illiquid claims into liquid ones, when the distressed entity is solvent but experiencing liquidity issues, but if the institution is insolvent it should be subject to ‘orderly liquidation’.
Such a distinction was at the heart of the 2008 crisis and the Great Recession that ensued, the Federal Reserve deeming that it could use its Section 13(3) “unusual and exigent circumstances” lending powers to cast a lifeline to Bear Sterns, AIG, Citigroup, and Bank of America but not to Lehman Brothers. While an overhaul was certainly overdue, in a retrograde step, Dodd-Frank placed significant restrictions on the Fed’s Section 13(3) powers.
In a crisis, such a distinction is largely moot. One reason is that a liquidity crisis (almost) always has its roots in fears that the institution is, in fact, insolvent, and, left unchecked, liquidity crises naturally morph into insolvency crises.
The second, more subtle but fundamental, point is that whether a financial institution is solvent or not depends on the trajectory of the economy and financial markets, and the central bank and the government have it in their power, or should have, to alter that trajectory to a substantive degree, in particular— to make it a much better one by mobilising macroeconomic and macro-prudential policy tools (including lender-of-last-resort ones).
Not only the actions of the central bank and the government but also the fate of borrowers, lenders, and the wider economy are thoroughly endogenous.
There is another kind of ‘lender of last resort’ besides the traditional ‘Bagehotian’ central bank: the government providing equity capital to financial institutions teetering in the treacherous grey zone between solvency and insolvency.
At the time of the U.S. and global financial system suffering its massive cardiac arrest, following Fannie Mae and Freddie Mac being put into ‘conservatorship’ (a form of bankruptcy) on Sept. 7, 2008 and Lehman Brothers filing for bankruptcy on Sept. 15, 2008, the U.S. government had no mechanism by which to inject capital into the banking system to stave off a financial collapse.
Less than a month later, by Oct. 3, Congress had passed and the President had signed into law legislation authorising the Treasury to recapitalise the U.S. banking system to the tune of $700 billion, using a scheme known as the Troubled Assets Relief Program. Funds were quickly disbursed, and the TARP, together with the Fed’s multiple Section 13(3) actions, became the ‘killer app’ in quelling a full-fledged financial meltdown and reprise of the Great Depression.
As further evidence that the second big lesson of the financial crisis was not learned, the Congress and the Obama Administration allowed the TARP to lapse in October 2010, removing it from the government’s financial crisis-fighting tool-kit.
The contrast with Japan is instructive.
It took Japanese politicians and policymakers until 1998 (a little) or 1999 (a lot) to put in place a bank recapitalisation facility, long after the bubble started to burst (1990) and the banking crisis erupted in full force (1995).
But, in a case of ‘once bitten twice shy’, the government put in place a permanent crisis management framework that allows it to recapitalise banks if it judges it needs to.
Thanks in large part to the codification in policy institutions of the lessons learned of the first type, another U.S.-sourced crisis akin to the 2007-2009 one looks highly unlikely anytime soon (what might happen in the Euro area or in China is another matter). But this favorable assessment needs to be set against the more sobering judgment that, should a crisis occur, the failure to internalise the second lesson may have left the U.S. in particular in a more vulnerable position, in terms of having readily deployable lender-of-last-resort tools, than it was in 2008.
Paul Sheard is a former Vice Chairman of S&P Global and was Global Chief Economist of Lehman Brothers, based in New York, at the time of its bankruptcy.
The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.