On this day, seven years ago, the investment bank Lehman Brothers collapsed into bankruptcy.
The story of what happened, before and after, has been told many times. It’s about a housing bubble inflated by reckless finance, about how policy makers ignored, if not goosed, the bubble, about how the costs of the disaster—the widespread income losses associated with the Great Recession—have fallen largely on innocent bystanders, while the finance sector, at least the parts left standing, has more than recovered.
But for all that story-telling, there are a few economic lessons we’ve yet to learn, and we’re not alone—policy makers in other economies have also failed to learn these lessons.
I’m not talking about financial market oversight. The initially disorganized and inconsistent approach to the financial part of the crisis—Bear Stearns got a bailout; Lehman didn’t—along with the systematic underpricing of risk and unsustainable leveraging, led to market reforms. While we won’t know the effectiveness of the Dodd-Frank until we see them in action, the law has a lot to recommend it (full disclosure: I was an administration economist back then).
Instead, I’m talking about both the coddling of lenders—banks, investors, money markets—and the inadequacy of fiscal policy. These two issues are related.
In a recent New York Times piece, Bin Appelbaum notes that, for technical reasons having to do with how much money the Fed pumped into the credit system in the name of monetary stimulus, central bankers are now planning to use some unusual tools to raise interest rates. These tools include paying banks not to lend by raising the interest rate on the reserves member banks keep in the Fed’s vaults (or at least on its spreadsheets), and borrowing from overnight lenders (money market funds) at a slightly pumped-up rate of interest.
In other words, when the lenders recklessly lend too much and screw things up for everyone else, we bail them out. Now, we (i.e., the Fed, but it’s a public institution) are paying them not to lend. Borrowers get austerity, joblessness, and poverty. Lenders get bailouts when credit is scarce and bribes not to lend when it’s too plentiful.
You see that here and you see it in Europe. It’s not fair and people know it. It’s one reason why people believe the system is broken and why anti-establishment candidates are getting so much attention right now (never mind that Trump himself got bailed out of bankruptcy four times).
Why, then, do we treat lenders like this?
Surely, Lehman is a major reason. The government decided not to bail it out, and its collapse is often blamed for setting off the Great Recession. Other over-leveraged, weak institutions and their investors didn’t know what to think—was there a government backstop for creditors (Bear) or not (Lehman)?—and credit and equity markets freaked out, to use the technical term.
The government shifted quickly to full-on bailout mode—AIG, Citigroup, Morgan Stanley, and lots of others got “rescued.” Don’t annoy the lenders! Nobody even gets a “haircut” (where lenders to insolvent institutions get back cents on the dollar)!
Many progressives believe we’d be better off today had we taken the road less traveled, allowing more systemically important financial institutions to fail. The rationale for the bailouts is that modern economies can’t function without credit, but since the Federal Reserve is the lender of last resort, it could have taken over until the financial markets recovered.
I’m agnostic, and believe that decision should be a function of first, what’s most effective in terms of getting back to full employment most quickly, and, second, what’s least costly in terms of national resources. We do not know the answers to such questions (and frankly, risk-averse policy makers are unlikely to allow multiple failures when the economy is already fragile).
But here’s what I do know. Neither bailouts nor allowing insolvent banks to fail will work if, when private sector demand is subsequently tanking, we undercut the use of fiscal policy to make up the difference. In this regard, the clearest lesson of Lehman is not simply that we must regulate financial markets, which is true, nor is it that we must always preserve private credit flows by fully bailing out irresponsible lenders, which contributes to inequality and economic unfairness.
It’s that it takes both monetary and fiscal policy working together to get back to full employment. Restored credit flows alone won’t get people back to work. That’s pure supply-side thinking.
I hear you: “wait a minute…you’re trying to say a fundamental problem of contemporary capitalism—the bubble/bust syndrome—can be solved by government borrowing and spending? By fixing some potholes? How can that be?”
That’s not what I’m saying, but neither is it too far off. Not just potholes, and not just spending, but investments in energy-efficient public schools, in human capital, in jobs for the disadvantaged and chronically underemployed, in nutritional assistance and income support for the poor, and in world class airports, broadband, ports, and waterways.
In weak economies, these investments deliver major bang-for-the-buck. The Recovery Act–the oft-maligned stimulus–and related measures were, in fact, highly effective in this regard, but they ended too soon. For example, according to my calculations, if, instead of fiscal consolidation in 2013, we’d invested three percent of GDP in infrastructure, we might have closed the $800 billion output gap that year (the difference between actual and potential GDP). Instead, that gap, though diminished, persists to this day.
And don’t give me any of that fiscal rectitude crap, either. As a card-carrying employee of the fiscally responsible Center on Budget and Policy Priorities, I can assure you that it’s not temporary, offsetting investments of the type just noted that drive persistent budget deficits. It’s unpaid-for tax cuts and the refusal to square our long-term demands for robust social insurance with our willingness to fund them.
In a lesson learned from the disaster seven years ago, Dodd-Frank includes procedures for the demise of insolvent banks formerly deemed “too big to fail.” As I said, we’ll see if it works and if future policy makers have the spine to try it.
But the need to end the unfair treatment of lenders and recognize that credit is but half the battle when demand collapses are lessons we’ve not yet learned. And that lapse continues to be costly to the majority of Americans who neither lend nor trade money for a living.