So if nothing had been done, almost every major bank would have collapsed, and otherwise solvent companies wouldn’t have been able to borrow the money they needed to meet payrolls or manage the rest of their day-to-day operations. The Fed, then, would have had to go from being the lender of last resort to the lender of only resort — replacing these parts of the financial system itself — just so that we could have continued to have an economy. As it was, simply flirting with this possibility was enough to send the world economy into a free fall.
As economists Barry Eichengreen and Kevin O’Rourke have shown, global stocks, trade and output actually all fell faster in 2008 than they had in 1929. Maybe the best example, though, of how quickly things turned was that South Korea, which didn’t have any exposure to subprime mortgages but did have banks that depended on borrowing the money they needed from markets, went from growing at a 3.5 percent pace right before the Lehman Bros. collapse to shrinking at a 12.7 percent pace right after.
The beating heart of the economy — the financial system — had stopped worldwide.
Now, in the years since, there has been a debate between people who think policymakers deserve credit for doing enough to stop this from turning into a Second Great Depression, and those who say policymakers didn’t do enough to stop this from being far worse than it needed to be. They both have a point. On the one hand, Bernanke is probably correct, as he argues in a new paper, that it was more the panic the housing crash caused than the housing crash itself that explains why the downturn was initially as deep as it was.
The economy, after all, went from losing an average of 185,000 jobs a month in the six months before Lehman failed to losing an average of 646,000 jobs a month in the six months after. This wasn’t just a matter of households and companies being cut off from credit — although it certainly was that — but also of their being so scarred by the experience that they cut back their spending even more than you might have thought. It was a psychological crisis, in other words, that lasted even after the financial part was over.
On the other hand, though, the fact is that the economy was already in recession when Lehman went under, and it would have continued to be even if the company had been saved. The simple story is that falling housing prices and rising unemployment rates would have fed on each other for a while. At first, unemployment had been going up because housing prices were going down, as construction workers lost their jobs and consumers lost their access to home equity lines of credit, but eventually housing prices were going down because unemployment was going up, as people who had lost their jobs could no longer afford their mortgages. It didn’t help that households had run up so much debt during the boom years that they had to cut back substantially during the bust. This was going to be a nasty, brutish and long recession, even if the financial system hadn’t been hit by a panic that made the Great Depression look relatively tame by comparison.
All of which is to say that saving the banks was necessary, but not a sufficient condition for recovery. A modern economy just can’t function without a financial system to move money where it’s needed. The thing is, it can’t grow very much either if households are weighed down by debt. Policymakers were justifiably willing to do whatever it took about that first problem, bad politics be damned, but not the second. Yes, there was a stimulus, and yes, there were programs to help homeowners refinance their mortgages, but neither was anywhere near the scale needed. Indeed, the stimulus was a mere $700 billion when Christina Romer, an adviser to President Barack Obama, estimated that the economy needed $1.8 trillion of help.
The painful lesson we’ve learned is that it’s impossible to do too much when you’re facing a Great Depression, but that it’s all too easy to do too little.