James Surowiecki is the guy the New Yorker pays to explain the economy and the stock market to its readers. He’s also running a great blog called “The Balance Sheet” these days. And recently he decided to wade forth into the debate over Lehman Brothers.
Surowiecki takes as his starting point the paper from Stanford economist John Taylor that argues that the credit market crisis last fall was not spurred by Lehman going under so much as uncertainty about the effects of government action. Taylor’s central piece of evidence is the movement of 3-Month Libor, which didn’t go into panic mode until well after Lehman collapsed. The timing, he argues, is more closely linked to the bailout than Lehman’s collapse.
“Taylor’s assumption in his paper is that investors would have known right away how severe the repercussions of Lehman’s bankruptcy would be. But this is simply untrue—for whatever reasons (some suggest fraud, others panic), the hole in Lehman’s balance sheet was much bigger than people initially thought it would be, which meant that the losses its lenders suffered were much bigger than anticipated. (One study suggests that the chaotic nature of Lehman’s bankruptcy alone cost creditors tens of billions of dollars.) As the magnitude of the losses became clearer, so too did banks’ risk aversion, since Lehman’s failure seemed to demonstrate starkly the risks of lending to any other big financial institution.”
As regular readers know, we’ve been making the lonely argument that the government’s failure to rescue Lehman was not a disaster. We think Surowiecki’s point here actually supports our case. The only problem is that he construes the revelation of “the magnitude of the losses” too narrowly. What caused the panic was that the collapse of Lehman signalled to market participants that the magnitude of losses throughout the financial sector was far greater than had been anticipated.
Importantly, nothing about a rescue of Lehman would have avoided this outcome. Lehman’s collapse into a government rescue or bankruptcy would still have set off the alarm signals. The simultaneous collapses of AIG and Merrill Lynch were also occurring, and Citigroup was soon viewed to be in critical condition. In short, it was the desperate situation of the financial sector rather than the failure to rescue Lehman that almost destroyed the financial system.
Surowiecki seems to disagree. He writes that “thinking about what Lehman’s failure tells us about how we should deal with tottering financial institutions today,” concluding that we must stop implosions at all costs.
This debate matters because Lehman is constantly invoked by those who want to convince us that Lehman’s failure was a catastrophe and want to encourage us to avoid “No Failure” as our future policy. In other words, they are arguing that the risks of allowing failure are far greater than the damage to markets caused by propping up failed firms. We have our doubts, although we’re willing to acknowledge that this could be the correct view. In any case, Lehman’s collapse is not evidence for the No Failure policy.