10 Years After Lehman, What Have We Learned?
On 15 September 2008, Lehman Brothers filed for bankruptcy protection after the US Treasury refused to bail out the investment bank. The panic that seized the financial markets quickly after drained business and household credit in the United States and then in Europe and dried up international trade finance. Six months later, world trade had fallen by almost 20%. It took two years for it to return to its level of early 2008, and it still has not recovered its pre-crisis momentum. The "Great Financial Crisis", as it is now called, did not turn into the depression of the 1930s because we drew lessons from the latter. Could the same be said today? What have we learned from the 2008 crisis that could enable us to prevent or at least contain the next crisis?
I will make a clear distinction between three dimensions: the functioning of financial markets and the role of panic, fundamental macroeconomic factors and the role of credit, and, finally, financial regulation and the role of risk-taking incentives. Public and political attention focuses almost exclusively on the latter, which is understandable because we always need someone to blame. Yet this bias may lead us to dismiss much more important factors.
The role of panic and liquidity
At the time, Ben Bernanke was Chair of the United States Federal Reserve. A lucky thing because, as a professor at Princeton, he dedicated 20 years of his life to deciphering the mechanisms that led the 1929 Stock Market Crash to turn into the "Great Depression". He concluded from his research that, between Milton Friedman and John Maynard Keynes, the former had been right about the causes of depression. It was the contraction of money supply after the crash, and not an unwelcome austerity policy, as we would say today, that caused the recession, which then quickly became a depression. The lesson was learned: the Fed ensured that the money supply did not slow down after the Lehman crash, and created itself the money that the banking and financial system no longer created, haunted as it was by doubts regarding the quality of its assets. This is a crucial point, to which Ben Bernanke just dedicated an article. In his opinion, supported by a rigorous economic and statistical analysis, "the unusual severity of the Great Recession was due primarily to the panic in funding and securitization markets, which disrupted the supply of credit".
Panic can be seen as a sudden reversal of the attitude towards risk, as a switch from appetite to aversion. In a state of panic, financial intermediaries doubt the quality of all private assets, including the best, and, since there is no access to credit without a deposit of collateral, the latter’s depreciation dries up credit. Nothing new under the sun, one could say, but when the assets quoted on "wholesale" financial markets - the ones that fund financial institutions themselves - represent $11,600 billion (outstanding amount at the end of 2008), the panic is devastating. It is all the more so that it quickly spreads to the real economy, not only through credit, but also through the preference for liquidity. If world trade collapsed after Lehman, it is because industrialists, doubting the quality of their banks' assets and seeing markets close, deliberately accumulated liquidity by selling off their inventories (thus producing less), in order to avoid running the risk of going bankrupt for lack of funding. The first victim was international trade, which is usually largely driven by movements.
The role of credit and globalization
While panic did amplify the crisis once confidence in the financial system was dented, it is obviously not at the root of the imbalances that have undermined this confidence. Among the many studies dedicated to "fundamentals", I believe the research conducted by Moritz Schularick and Alan Taylor provides us with a key element. These two authors have compiled credit data from the 12 main industrialized countries since 1870. They thus showed that the overall bank assets (including loans, but also bonds, etc.) to GDP ratio experienced two phases of frenzied expansion, the first from 1920 to 1929, and the other from 1998 to 2008. The fact that credit bubbles, which are almost always linked to real estate bubbles, eventually burst, thus leading to bank failures, is nothing new. The explosive development of financial products using securitization to facilitate the financing of real estate, residential and commercial markets, on the other hand, is more unusual. Yet again, while these financial products (ABS, for asset backed securities) were instrumental in amplifying the credit bubble, they did not cause it. To move up a notch in the scale of causes, one must question the role played by the big central banks, starting with the Fed, from 1998 to 2008. Many economists have criticized Alan Greenspan and his successor for having pursued too lax a monetary policy and having thus provided the monetary fuel for real estate bubbles. The great fears of 1998 (the emerging market crisis), followed by those concerning the consequences of the Internet bubble burst in 2000, most probably prompted central banks not to raise their interest rates too much despite the world economy’s quick expansion. Yet in their defense, the inertia of long-term interest rates is what fuelled the credit bubble above all. As we have since understood, the massive purchases of US Treasury bonds by China and the Gulf countries during the first decade of this century kept long-term interest rates very low, and partially disconnected them from monetary policies. Therefore, globalization, i.e. essentially China's joining in global trade as a growth strategy, played a key role in the formation of the credit bubble, the bursting of which caused the crisis.
The role of financial regulation and incentives
Very quickly, politicians identified finance as accountable for the crisis. In Europe, the crisis was considered a 100% American product, and the fact that real estate bubbles had appeared throughout the world, and even more so in Europe (Spain, Ireland, Sweden...) than in the United States was ignored. As a result, unprecedented attention was dedicated to the behavior of financial agents and financial intermediaries in general, with the aim of understanding what had happened. Ben Bernanke himself, perhaps in order to exonerate the Fed from its share of responsibility in the credit bubble, has always argued that the crisis was first and foremost a matter of poor financial regulation. In line with this, many academic studies emphasized the harmful role of the disconnection between lender and borrower allowed by securitization. In a context of rising housing prices, housing loans granted to households with low or no income (the infamous subprime loans) were successful because they were quite easy to resell on the market, especially to enhance the yield of various financial products, in particular synthetic bonds (CDOs, for collateralized credit obligation). Feeling immune to credit risk, lenders indulged in this practice, thus fuelling the dual housing and credit bubble. The strong asymmetry in remuneration in relation to risk was also pointed out: high bonuses when everything goes well, reduced to zero but not negative when everything goes badly. Finally, other studies demonstrated that the very high degree of financial integration allowed by modern technologies turned some financial intermediaries into systemic players, which is not necessarily reflected in the sole size of their balance sheets.
Ultimately, politicians took action on financial regulation, in order to make lenders more accountable, to reduce bonuses, and to force systemic players to hold more capital. The 2,300 pages of the Dodd-Frank Act, the Basel 3 enhanced capital requirements, the creation by the G20 of the Financial Stability Board (FSB), and the imposition by the latter of even higher capital ratios for 30 international banks deemed systemic, pending similar measures for a list of insurers, all aim to reduce risk taking and to increase banks' absorption capacity in the event of a confidence shock, so as to avoid the use of public funds as far as possible. This powerful financial re-regulation pendulum swing certainly contributed to making the financial system more resilient in the event of a shock. It probably also limited the economic recovery by sterilizing capital - which could have been invested in riskier growth projects - and by constraining credit supply.
Yet one cannot help but think that, as it focused on past risks, the pendulum hardly touched upon the root causes of the structural instability of financial markets, as described by Hyman Minsky. As Charles Goodhart often said, even with the best of intentions, financial regulation calls for financial innovation, allowing to overcome the former.
So, what have we learned? First, that we should remember lessons of the past, such as using central bank’s unlimited power of monetary creation to counteract financial panics and to allow for a steady growth of money. While the Fed did follow this path, the same cannot be said of the ECB between 2010 and 2012. Secondly, that everything that strips economic and financial players, but not only, of their accountability leads to dangerous situations, be it pollution, risk taking or public debt*. Finally, that the convenient designation of scapegoats (banks, traders) is no substitute to a continuous and detailed analysis of financial risk factors, which is what the FSB is trying to do. Crises are inseparable from risk taking, which is itself at the heart of innovation and thus of prosperity. It is better to acknowledge this, accept their occurrence and, with Hyman Minsky, admit that "getting things right is a transitory situation".
*The collateral rules applied by the ECB in refinancing operations before the crisis treated the Greek and the Finnish debts in the same way, thus encouraging the Greek government to perpetually increase its debt.