Tag: Lehman Brothers

What I Saw and Did Not See About the Macroeconomic Situation Eight Years Ago: Hoisted from the Archives

Posted on by Brad DeLong

Hoisted from the Archives from June 2008J. Bradford DeLong (June 2008): The Macroeconomic Situation, with added commentary:

Looking back, what did I get right or wrong back eight years ago when I was talking about the economy? I said:

  • That the best way to think about things was that we were in a 19th-century financial crisis, and so we should look way back to understand things (RIGHT)
  • That a recession had started (RIGHT), which would probably be only a short and shallow recession (WRONG!!!!)
  • That the Federal Reserve understood (MAYBE) that it has screwed the pooch by failing to prudentially regulate shadow banks, especially in the housing sector (RIGHT), but that it would shortly fix things (MAYBE).
  • That the Federal Reserve was still trying to raise interest rates (RIGHT).
  • That the Federal Reserve should not be trying to raise interest rates (RIGHT), because the tight coupling between headline inflation today and core inflation tomorrow that it feared and expected had not been seen for 25 years (RIGHT).
  • That central bank charters are always drawn up to make financial markets confident that they are tightly bound not to give in to pressure and validate inflation (RIGHT).
  • That, nevertheless, when the rubber hit the road and financial crisis came there was ample historical precedent that central banks were not strictly bound by the terms of their charters–that they were guidelines and not rules (RIGHT).
  • That the Federal Reserve understood these historical precedents (WRONG) and would, with little hesitation, take actions ultra vires to avoid a major financial and economic collapse (WRONG).
  • That there was a long-standing tradition opposed to central banks’ taking action to stem financial crisis and depression–a Marx-Hayek-Mellon-Hoover axis, if yo will (RIGHT).
  • That this axis thought that business cycle downturns were always generated by real-side imbalances that had to be faced via pain and liquidation–could not be papered over by financial prestidigitation (RIGHT).
  • But that this axis was wrong: business cycle downturns, even those to a large degree generated by real-side imbalances, could be papered over by financial prestidigitation (RIGHT).
  • That even though the Fed and the Treasury believed that interest rates should still go up a little bit, they were also engaged in unleashing a huge tsunami of financial liquidity upon the economy (RIGHT).
  • That this liquidity tsunami was appropriate as an attempt to maintain full employment response to the collapse in construction and to the great increase in financial risk (RIGHT).
  • That this liquidity tsunami would do the job, and the recession would be short and shallow (WRONG!!!!!!!!)
  • That the runup in oil prices was not a speculative bubble that would be rapidly unwound (RIGHT).
  • That the runup in oil prices was a headwind for real growth (RIGHT).
  • That the dollar was headed for substantial depreciation (WRONG).
  • That the housing price and housing construction shocks to the economy were still ongoing (RIGHT).
  • That for those with a long time horizon equities were fairly valued, offering higher returns than other asset classes, if risky returns (RIGHT).
  • That asset prices would fluctuate (RIGHT).

But I did not, even in June 2008, understand (a) how bad the derivatives books of the major money-center banks were, and (b) how weak the commitment of central banks to doing whatever was necessary to stabilize the growth path of nominal GDP was.

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Must-read: John Plender: ‘Lehman Brothers: A Crisis of Value’ by Oonagh McDonald

Posted on by Brad DeLong

Must-Read: Either Lehman was a reasonable organization caught in a perfect storm–in which case its creditors should have been bailed out as part of its resolution–or Lehman should have been shut down and resolved while there was still enough notional equity value left in the portfolio to cover the inevitable surprises and the likely negative shock to risk tolerance. As I have come to read it, Paulson, Bernanke, and Geithner were afraid to do their job in spring and summer of 2008, and also afraid to take responsibility to do what their forbearance with Lehman in the spring and summer had made prudent in the fall.

Perhaps Paulson, Bernanke, and Geithner thought that although the way they handled Lehman was a small technocratic policy mistake, it was a political economy necessity. Perhaps they thought an uncontrolled Lehman bankruptcy that would deliver a painful shock to asset markets and economies would generate strong political benefits: constituents would feel that shock and then complain to congress, which would then give the Fed and the Treasury a free hand to keep it from happening again. Perhaps such considerations made it the right political-economy thing to do. Perhaps not.

But we have never had the debate over that. Paulson, Bernanke, and Geithner have instead claimed that they did not have legal authority to resolve Lehman in the fall. Combining with their failure to resolve it in the summer to generate the conclusion that they did not understand what their jobs were:

John Plender: ‘Lehman Brothers: A Crisis of Value’ by Oonagh McDonald: “The collapse of Lehman Brothers in 2008 was… a spectacular curtain raiser…

…Oonagh McDonald, a British financial regulation expert and former MP, brings a regulatory perspective to the story, exploring the multitude of flaws in the patchwork of rules… examines how, one weekend in September, Lehman went from being valued by the stock market at $639bn to being worth nothing at all…. Lehman… was so highly leveraged that its assets had only to fall in value by 3.6 per cent for the bank to be wiped out. The tale of how the management reached this point under the leadership of Dick Fuld is compelling. The response… to the credit crunch that began in mid-2007 was pure hubris. Having survived episodes of financial turmoil when many expected the bank to fail, Mr Fuld and his colleagues decided to take on more risk. Meanwhile, they neglected to inform the board that they were exceeding their self-imposed risk limits and excluding more racy assets from internal stress tests…. Much of the decline in the value of Lehman’s assets came from direct exposure to property….

The conclusion is a broader, provocative exploration of the concept of market value, in which McDonald tilts at the efficient market hypothesis that underlay much of the thinking in finance ministries, central banks and regulatory bodies before the crisis…. The brickbats McDonald aims at regulatory behaviour before the crisis are amply justified. More questionable is her critique of crisis management by the US Treasury and the US Federal Reserve. She thinks Lehman could and should have been bailed out in the interests of systemic stability, but does not address the question of how the troubled asset relief programme would have found its way through a hostile Congress without the extreme shock of Lehman’s collapse…