On Sept. 13, 2008, officials from the Federal Reserve and Treasury Department met with a who’s who of Wall Street to try to figure out a way to save the world.
Lehman Brothers, then the fourth-largest investment bank in the United States, was on the verge of going under and dragging the rest of the financial system down with it — unless the assembled policymakers and masters of the universe figured out a way to save it.
They didn’t, of course, and the result was akin to someone turning the lights out on capitalism. Global stocks, trade and output all fell faster in 2008 than they had in 1929. Policymakers stepped in with trillions of dollars in bailouts, stimulus and money-printing. It was enough to stabilize the system but not our politics. Those took an ugly turn all over the world.
But what if, at that fateful meeting, Lehman had been saved? How would the economy have fared? And, 10 years later, how different would the world’s economies — and politics — be?
Without Lehman, the “Great Recession” might have been a recession in the United States alone. ...
One thing we can say for sure is that saving Lehman wouldn’t have saved us from a recession, because we were already in one. Back then, you see, there were two related but still relatively different problems: the housing crash and the losses it was causing the banks. Bailing out Lehman would have done something about the second but not the first — and so things would have continued to deteriorate.
“This was very much a real economy story,” the Center for Economic and Policy Research’s Dean Baker told me. There had been “big construction and consumption booms driven by the housing bubble,” and it wasn’t clear “what would fill the gap” it was leaving behind, especially when households had so much debt that they couldn’t spend as much anymore.
That, according to Frederic Mishkin, a professor at Columbia Business School and Federal Reserve governor from 2006 to 2008, meant there “absolutely still would have been a nasty recession” even if Lehman had been rescued.
There’s a big difference, though, between an uppercase Great Recession and a lowercase very bad one. Namely, as Johns Hopkins Professor Laurence Ball told me, “10 years after the savings-and-loans crisis” of the early 1990s, “we weren’t doing retrospectives on it” as we are with the 2008 crash today. Which is where Lehman comes in. There’s a negative feedback loop between a bad economy and weak banks, and nothing makes it worse than a systemically important institution going under. Former Fed chair Ben Bernanke, for one, has found that it was the panic phase of the crisis much more than people’s over-indebtedness that explained why the downturn was as deep as it was.
Precise figures are impossible, but if not for that panic phase, unemployment might have peaked at 7 or 8 percent instead of the 10 percent it did.
Now, the financial system was so fragile in 2008 that it wouldn’t have been easy to avoid an all-out panic, but it wouldn’t have been impossible either. “We have centuries of experience with these things,” former treasury secretary Timothy Geithner, who at the time was the New York Fed chief, told me. Fixing them really “isn’t that complicated,” he said. It’s just a matter of having the right tools and the will to use them.
The Fed would have had to grease the wheels for a Lehman deal by buying up enough of its toxic assets that somebody would have wanted the rest of it, as well as bail out insurance giant AIG much as it did and push the other investment banks to either raise capital or sell themselves.
This wouldn’t have unfrozen credit markets, but it would have kept things on the right side of apocalyptic. Although even then “some of the big mortgage lenders and regional banks that were more directly affected by the mortgage meltdown likely wouldn’t have survived,” University of Oregon economist Tim Duy told me. Think Washington Mutual and Wachovia. That notwithstanding, the idea is that the rest of the banks would have gotten the time they needed to earn their way out of their problems without needing government help. That might sound overly optimistic, but it might have been feasible. While the banks were in a lot of trouble, it wasn’t nearly as much as the post-Lehman “fire sale dynamic,” as Geithner put it, made them look. Avoiding the panic might have let us avoid the bailouts.
So what would have happened to American politics if we had been dealing with the fallout of a great recession, not the Great Recession?
President Barack Obama’s administration, for its part, would have helped the banks by helping the economy. “Obama first proposed his stimulus over the summer of 2008,” the chair of his Council of Economic Advisers, Jason Furman, told me. And while it certainly wouldn’t have ended up being as large in this case, it might not have been that much smaller than what was needed. That’s because without Lehman there wouldn’t have been a bailout, and without a bailout, former congressman Barney Frank told me, deficit fears wouldn’t have been such a constraint. So they might have passed a $300 billion stimulus when the economy needed $700 billion of help instead of a $700 billion stimulus when, according to Obama adviser Christina Romer, it needed $1.8 trillion.
But would rescuing the banks in 2008 just have left us with a riskier banking system in 2018? In other words, would we have still fixed the financial system’s most obvious flaws if there’d merely been a scare instead of a near-death experience? Actually yes. They’d begun working on these issues, Frank told me, a few months before Lehman failed, and doing something about them would have been even more of a priority if it’d been saved and all the other banks were still teetering along. The financial overhaul, Frank said, in a world without Lehman “might not have been as far-reaching” — there might not have been a Consumer Financial Protection Bureau — but otherwise “we would have seen legislation very much like what we have now.”
... but Greece might have gotten kicked out of the euro ...
The euro crisis, meanwhile, might have unfolded a bit differently. It’s true, as London School of Economics Professor Paul De Grauwe told me, that the crisis “was inevitable,” and Lehman merely affected "the timing of it but not its existence.” Much as the United States had unsustainable flows of money into housing, Europe did into countries. At some point that was going to stop — that’s what unsustainable things do — and cause a lot of pain for the banks and countries involved.
But Lehman did more than just change when this started. It changed how it ended, too. The key here is that, as Europe’s unofficial paymaster, Germany wanted to have each country be responsible for its own problems. And yet despite that, Greece — a country that, as former Fed governor Mishkin told me, would have seemed like “a perfect test case” for this no-bailout approach, given that “it was very small, had had outrageous fiscal policy, and had lied and cheated” about it — was repeatedly given money. Why? Three words: No more Lehmans. Berlin was grudgingly convinced that it was simply too risky to let a country default at that time. There was no telling who else it might bring down.
So if the United States hadn’t had Lehman, Europe might not have had its own government bailouts. At least not at first. Instead, Europe would have slowly slid into recession — Greece, Portugal, Spain, Ireland and Italy were all shrinking at an average 2.5 percent pace in the third quarter of 2008 — until its problems became undeniable a little later. And when they did, Athens might have been on its own. That would have taught the others an admittedly expensive lesson. Greece’s government would have defaulted, its banks would have too and it would have had to leave the euro so it could print the money for its ATMs.
This would have been Europe’s own Lehman moment. The most immediate problem would have been that French and German banks, already reeling from all the subprime bonds they had bought, would have faced a fresh round of losses on the Greek debt they owned, as well. At which point, the Fed probably would have had to lend dollars to the European Central Bank to lend out in turn. This might have been politically awkward, but, Geithner told me, the fact is that “the world runs a dollar-based system. We benefit from that system, and that benefit comes with obligations.” Besides, this would have been “way cheap insurance compared to the alternative” of a European financial crisis spreading to our shores.
But the bigger threat is that markets would have started looking for the next Greece and would have had no shortage of possibilities. Countries like Ireland and Italy would have seen their borrowing costs go up because it looked as if they might default, too, and it would have looked as if they might default because their borrowing costs had gone up. The only way to stop this vicious circle would have been for the ECB to say it was willing to use its potentially unlimited supply of euros to do so.
If, that is, Germany would let it. Berlin had long opposed this sort of thing out of the misbegotten fear that it would turn into massive inflation. But seeing 60 years' worth of European integration risk disintegrating over the course of 60 hours might have focused minds. It wouldn’t have hurt that by kicking out the Greeks, who were easily lampooned as welfare cheats despite the fact that they worked the longest hours in Europe, German Chancellor Angela Merkel would have had more political cover to make a deal. So the ECB would have been allowed to intervene, Paris and Berlin would have promised to put together a big bailout fund sometime soon, and Europe’s ever-closer-union would have marched on … at the expense of Greece falling into Russia’s widening orbit.
... and a trade war with China might have started sooner
Things wouldn’t have been quite as dramatic in China. The irony is that for such an unrepresentative government, Beijing responded much more swiftly to the threat of mass unemployment than any democratically elected government did. Indeed, it tried to replace the exports it lost after Lehman by unleashing a stimulus — 19 percent of its GDP, according to Columbia historian Adam Tooze — the likes of which the United States has only seen during World War II. That’s what happens when your leaders aren’t worried about losing the next election but rather the next revolution.
Beijing’s building binge would have been a lot smaller, though, if Lehman hadn’t failed. And, as a result, its exports would have been a good deal larger. At a time when the United States and Europe would have been languishing with near-zero interest rates — the one time a country’s trade surplus does come at another’s expense — this might have proved an irresistible political target. Trade tensions would have come to the forefront much sooner.
A smaller recession would have meant a more stable world
The broad contours of the last 10 years, then, probably wouldn’t have been all that different if Lehman had been saved: a recession in the United States, a crisis in Europe, a stimulus in China. The only difference is it all would have been smaller. But that’s everything. The system can handle smaller. It was built for smaller. What it can’t handle is a slow-motion recovery from double-digit unemployment. The point is that Lehman was as much a political event as an economic one. The boom, bust and bailout cycle discredited the Establishment, and it disillusioned people about how much of a chance they had ever really had to get ahead. “Rigged” became the political epithet du jour on both the left and the right. Voters flocked to nationalist parties that promised to put them ― and, sometimes not-so-implicitly, their ethnic groups — first.
So more than anything else, what was lost when we weren’t able to avoid what needed to be avoided at that Sept. 13, 2008, meeting was the sense that the system worked, that the elites knew what they were doing, and would do the right thing even if they exhausted all the other alternatives first.
Ten years later, that’s still true.