Primer: Lehman revisited
“The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy.”
Ben Bernanke, then chairman of the US Federal Reserve, March 2009.
With the collapse in mid-September 2008 of Lehman Brothers, the largest bankruptcy in US history, it became clear a financial crisis was imminent. Significant strains were apparent in the financial sector before the Wall Street investment bank’s demise but afterwards the existence of a systemic threat became apparent.
Ben Bernanke helped set the tone of the broader discussion with his identification of two key elements in the global financial crisis as quoted above. First, its scale was huge. Although it started in the US it rapidly became a global affair with the Europe just one of the regions hit hard.
It is widely accepted that only massive intervention by the financial authorities worldwide pre-empted a global financial crash. Measures included bail-outs of many of the leading financial institutions around the world and the advent of the quantitative easing programme.
Second, there is no doubt that the financial crisis was followed by a severe contraction of the world economy. A global downturn became apparent in the third quarter of 2008 and went on for a year.
The subsequent economic turnaround was weak in many places. For example, the euro-zone suffered almost a decade of stagnant output with its own financial crisis following the global one (see figure). However, the precise relationship between the two is a matter of debate. Adam Tooze, professor of history at Columbia University, has recently argued that the two are inextricably linked. In his view the weakness of the European banks was a central element to both crises (see panel: What to read about the Global Financial Crisis).
Bernanke’s choice of the ambiguous word “precipitated” in his description of the relationship between the financial crisis and the economic downturn is significant. Many would no doubt read it as saying that the financial crisis caused the economic crisis. However, it could alternatively be taken to mean that the financial crisis simply triggered the global downturn or perhaps accelerated it. In other words, in this second reading, the financial crisis, although important, was not the ultimate cause of the economic troubles that followed.
Indeed there is an intense debate about the causes of the crisis. However, by mid-2009 the Bank for International Settlements (BIS), the central bankers’ central bank, had already compiled a comprehensive outline of competing explanations.
On the macroeconomic side it pointed to two sets of arguments. One highlights the existence of large imbalances in the world economy. For example, the US had a substantial current account deficit while China and Germany had out-sized current account surpluses. For some experts these imbalances provided the backdrop to the crisis.
Key dates in 2008
• 15 September – Lehman Brothers files for bankruptcy protection, the largest in US history.
• 16 September – The US authorities step in to support the AIG insurance company.
• 19 September – Provisional details begin to emerge on the US Troubled Assets Relief Program (TARP).
• 8 October – Central banks around the world announce a co-ordinated round of rate cuts. The UK announces a substantial support programme for banks.
• 4 November – Barack Obama elected as US president. He was inaugurated on 20 January 2009.
• 14-15 November – First G20 summit in Washington DC. This involved the largest developing economies, as well as the developed ones, in a co-ordinated response to the crisis.
• 25 November – The US Federal Reserve announces the first steps in what subsequently became known as its quantitative easing programme. It was later extended and many other central banks adopted similar measures.
A second macroeconomic explanation was the prolonged period of low interest rates that preceded the crisis. For the critics this created the conditions for the precarious plight of many financial institutions.
On the microeconomic side the BIS outlined three alternative explanations. First, was the existence of unhealthy incentives. For example, many investment bankers received big bonuses if their institutions performed well but were not penalised in any way if they were responsible for big losses. Second, was poor risk management. The mismeasurement of risk clearly created potential problems for financial institutions. Finally, it was widely accepted that financial regulation was too lax.
It is important to recognise that these explanations are not mutually exclusive. For instance, it is possible to believe both that interest rates were too low for too long and regulation was inadequate. There are also different variations of each argument.
In any case there is no doubt that the Lehman collapse is viewed by many as a key turning point of the early 21st century. In the pages that follow we examine the story in detail.
What to read about the Global Financial Crisis
There is a huge literature on the Lehman crisis and its aftermath. Two bestsellers caught the public imagination in the immediate aftermath of the crisis.
In Andrew Ross Sorkin’s Too Big To Fail (first published in 2009) the New York Times journalist described the bail-out of the US financial system. In The Big Short (2010) Michael Lewis, the veteran financial writer, told the story of the creation of the US housing bubble including the role of derivatives. Both later received cinematic treatment.
Raghuram Rajan’s Fault Lines (2010) deserves a special mention for several reasons. The former chief economist at the International Monetary Fund was famously slapped down as a “Luddite” by Larry Summers, the former US Treasury Secretary, when in 2005 he warned of the danger of an impending financial crisis. Rajan put the crisis in a broader context including the widening of inequality in the US, trade imbalances and skewed incentives in the financial sector. He later became governor of the Reserve Bank of India.
Crashed (2018) by Adam Tooze looks set to become a defining text on the crisis. In over 700 pages the Columbia University historian argues, among other things, that the euro-zone crisis that broke in 2010 was closely linked to Lehman. The book has the advantage of a greater sense of perspective than was available to earlier accounts as well as additional information that has become available.
A Crisis of Beliefs (2018) by Nicola Gennaioli and Andrei Shleifer examines the crisis from the perspective of investor psychology and behavioural economics.
The 79th Annual Report of the Bank for International Settlements, published in 2009, is still one of the best and most comprehensive guides to the crisis.
It is available at www.bis.org