The overwhelming consensus in the policy community is that if only the government had bailed out Lehman, the whole thing would have been a hiccup and not a heart attack. Famous investors and leading policymakers alike have opined that in our ultra-interconnected global economy, a big financial institution like Lehman can never be allowed to fail. No matter how badly it mismanages its business – Lehman essentially transformed itself into a real estate holding company totally dependent on a continuing US housing bubble – the creditors of a big financial institution should always get repaid. Otherwise, confidence in the system will be undermined, and chaos will break loose.
Having reached the epiphany that financial restructuring must be avoided at all costs, the governments of the world have in turn cast a huge safety net over banks and whole countries in Eastern Europe, woven from taxpayer dollars.
Unfortunately, the conventional post-mortem on Lehman is wishful thinking. It basically says that no matter how huge the housing bubble, how deep a credit hole the United States and many other countries had dug, and how convoluted the global financial system, we could have just grown our way out of trouble. Patch up Lehman, move on, keep drafting off of China’s energy, and nothing bad ever need have happened.
The fact is global imbalances in debt and asset prices had been building up to a crescendo for years, and had reached the point where there was no easy way out. The United States was showing all the warning signs of a deep financial crisis long in advance of Lehman, as Carmen Reinhart and I document in our forthcoming book This Time is Different: Eight Centuries of Financial Folly.
Housing prices had doubled in a short period, spurring American consumers to drop any thought of saving money. Policymakers, including the US Federal Reserve, had simply let the 2000s growth party go on for too long. Drunk with profits, the banking and insurance industry had leveraged itself to the sky. Investment banks had transformed their business in ways their managers and boards clearly did not understand.
It was not just Lehman Brothers. The entire financial system was totally unprepared to deal with the inevitable collapse of the housing and credit bubbles ..
And there’s no evidence that Rogoff even understands the biggest issue of all — the utterly massive misdirection of the time structure of production across the course of the artificial boom. If Rogoff understood that, his reality check for folks like Scott Sumner would be more substantially more devastating than it already is.
(Note that Sumner’s claim is wider than those who argue that an extension of “too big to fail” to every Wall Street firm could have averted an economic bust. Sumner’s claim is that a credible expansionary Fed monetary policy during 2007 and 2008 could have averted not only a Wall Street crisis, but also any significant destruction of economic wealth and consequent unemployment due to macroeconomic discoordination requiring a system-wide restructuring of the time and relative price structure of the economy across innumerable and multivarious time streams of production, consumption, and credit.)