The real reason for the 2008 financial collapse

COMMENTARY Jobs and Labor

The real reason for the 2008 financial collapse

Sep 15, 2013 2 min read

Former Director, Center for Data Analysis

Norbert Michel studied and wrote about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

Sept. 15 marks the five-year anniversary of the Lehman Brothers bankruptcy, the supposed spark that set off the financial crisis of 2008. Conventional wisdom holds that it was the federal government's decision against bailing out this investment bank that froze credit markets and sent the economy into the "great recession."

A Wall Street Journal story about the Lehman collapse was titled "The Weekend That Wall Street Died." Much like Mark Twain, though, the reports of Wall Street's demise were greatly exaggerated. The truth is, Lehman Brothers should not have been bailed out and its bankruptcy was far from the cause of the crisis.

For some reason, we're supposed to believe that if only the government had kept this "systemically important" institution from failing, we'd have been spared from the disastrous crisis and the so-called "great recession." This is false.

The key policy failure was most likely regulators' decision in favor of bailing out Bear Sterns, a (smaller) competing investment bank, rather than their decision against saving Lehman. The Bear Sterns bailout set the expectation that Lehman would also be bailed out. Going forward, investors and creditors surely expected, at the very least, the government to minimize their losses.

In fact, two potential buyers of Lehman walked away from negotiations when they were unable to secure the same government promises given to JPMorgan Chase in their acquisition of Bear Sterns. It was the inconsistent treatment of the two investment banks — not simply the act of letting Lehman file bankruptcy — that was the main problem.

The decision to allow Lehman to enter into bankruptcy did not set off an economic nuclear reaction. And it was nothing compared to the government's incoherent response to market turmoil. Going before Congress, Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson basically said: We need $700 billion to fix the problem, but we can't tell you why, and we can't tell you what we're going to do with the money.

It's not much of surprise, then, that economist John Taylor (former undersecretary of the Treasury) found the market reacted more harshly to this request than to Lehman's failure. There's also ample evidence the economy was in trouble long before Lehman filed bankruptcy.

It's well documented that various interest rate spreads — measures of perceived risk in the markets — were heightened during the last half of 2007, nearly one full year before the Lehman collapse. Defaults on subprime mortgages had risen to a four-year high by the first quarter of 2007. Both personal consumption expenditures and civilian employment began downward trends by the last quarter of 2007.

There's no doubt that the Federal Reserve saw these dangers well before Lehman failed. In an effort to head off an economic downturn, the Fed moved aggressively (by lowering its key interest rate target) from September 2007 to January 2008.

Contrary to conventional wisdom, the decision to let Lehman Brothers fail did not cause the financial crisis and the so-called great recession. It's likely that the government's decision to bail out Bear Sterns upset markets more than Lehman's bankruptcy. Lehman's failure was caused by the main driver behind the whole financial crisis: investing an enormous sum of borrowed money in worthless securities.

The notion that allowing Lehman to file bankruptcy caused the financial crisis is both wrong and dangerous. The danger in this myth is that it perpetuates the policy of bailing out financial institutions with taxpayer money. Plus, it allows policymakers who contributed to the crisis to escape responsibility for their actions.

If congressional leaders want to calm markets, they should end the too-big-to-fail doctrine once and for all.

- Norbert J. Michel is a research fellow in financial regulations at The Heritage Foundation.

Originally distributed by the McClatchy-Tribune wire service.