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BW Businessworld

Lessons Of The Fall

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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. Famous investors and leading policymakers have said that in our ultra-interconnected global economy, a big financial institution such as Lehman can never be allowed to fail. No matter how badly it mismanages its business, 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, woven with taxpayer’s dollars.
Unfortunately, the conventional post mortem on Lehman is wishful thinking. It says no matter how huge the housing bubble, how deep a credit hole the US (and many other countries) had dug, and how convoluted the global financial system, we could have just grown our way out of trouble. The fact is: global imbalances in debt and asset prices had been building up to a crescendo for years. That had reached a point where there was no easy way out.

The US was showing all the 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 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 did not understand.
It was not just Lehman. The entire financial system was totally unprepared to deal with the inevitable collapse. The system had reached a point where it had to be bailed out and restructured. And there is no realistic political or legal scenario where such a bailout could have been executed without some blood on the streets. Hence, the collapse of a large bank or investment bank was inevitable as a catalyst to action.
The problem with letting Lehman go under was not the concept, but the execution. The government should have moved in aggressively to cushion the workout of Lehman’s complex derivative book, even if this meant creative legal interpretations or pushing through new laws. Admittedly, it is hard to do these things overnight, but there was plenty of warning. The six months prior to Lehman saw a slow freezing up of global credit and incipient recessions in the US and Europe. Yet, little was done to prepare.
So what is the game plan now? There is talk of regulating the sector, but governments are afraid to shake confidence. There is recognition that the housing bubble collapse has to be absorbed, but no stomach for acknowledging the years of slow growth in consumption that this will imply. There is acknowledgement that the US-China trade relationship needs to be rebalanced, but little imagination on how to proceed. Deep down, our leaders and policymakers have convinced themselves that for all its flaws, the old system was better than anything we are going to think of, and that simply restoring confidence will fix everything.
The right lesson from Lehman should be that the global financial system needs major changes in regulation and governance. The current safety net approach will lead to ballooning and unsustainable government debts, particularly in the US and Europe. Asia may be willing to sponsor the West for now, but not in perpetuity. Eventually, Asia will find alternatives in part by deepening its own debt markets. Within a few years, western governments will have to sharply increase taxes, inflate, partially default, or some combination of all three. As painful as it may seem, it would be far better to start bringing fundamentals in line now. Restoring confidence has been helpful and important. But ultimately we need a system of global financial regulation and governance that merits our faith.
The author is Professor of Economics and Public Policy at Harvard University, and was chief economist at the IMF.
Copyright: Project Syndicate, 2009.
(Businessworld Issue Dated 11-17 Aug 2009)