Lehman’s Lessons

The tenth anniversary this past September of the collapse of Lehman Brothers inspired a blizzard of commentary, including some deeply misguided observations. One misunderstanding is that Lehman’s demise caused the Great Recession. In fact, the downturn started months earlier in the US, as NBER’s recession dates show. But there’s room for debate on the question of whether the government’s decision to let economic gravity have its way with Lehman turned what might have been a moderate downturn into the deepest contraction since the Great Depression.

Some pundits argue that letting Lehman fail was prudent and necessary to send a signal for inspiring a more responsible style of banking. Yet a new book on financial crises by a pair of experts on the subject reminds us that applying free-market rules to banks is usually short-sighted – especially during a severe banking crisis.

Another bit of confusion about the last crisis is that it was different because the financial instruments were unique relative to financial history. But ultimately, every financial crisis is about short-term debt. They come in varying forms and are constantly evolving through time, ranging from private banknotes to demand deposits, money market funds and asset-backed commercial paper. But the underlying infrastructure is always the same: short-term debt backed by long-term debt — the basis for bank runs under certain conditions.

In any case, “a financial crisis is a systemic event,” Gary Gorton (a finance professor at Yale) and Ellis Tallman (director of research at the Cleveland Fed) write in their recently published book Fighting Financial Crises: Learning from the Past.

In a banking panic all banks are at risk, and the financial system is about to collapse. For example, during the 2007-8 crises [Fed Chairman] Ben Bernanke in his testimony before the US Financial Crisis Inquiry Commission said that of the thirteen most important financial institutions in the United States, “12 were on the verge of failure within a week or two [after Lehman].”

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