Professor John Cochrane offers his take on the financial crisis of 2008 in the current issue of the Cato Institute’s Regulation.
His basic argument: “the signature event of this financial crisis was the ‘run,’ ‘panic,’ ‘flight to quality,’ or whatever you choose to call it, that started in late September of 2008 and receded over the winter. Short-term credit dried up, including the normally straightforward repurchase agreement, inter-bank lending, and commercial papermarkets. If that panic had not occurred, it is likely that any economic contraction following the housing bust would have been no worse than the mild 2001 recession that followed the dot-com bust.”
Was that really the source of the crisis? Maybe, although no one really knows. This is economics, after all. Certainly there’s no shortage of competing notions of about what happened. But even if you don’t agree with Cocgrane 100%, he makes a number of salient points that, at the very least, demand consideration in the months and years ahead as the powers in Washington attempt to “fix” the system.
With that in mind, here are a few points in Cochrane’s article that are worth debating…
Why was there a financial panic? There were two obvious precipitating
events: the failure of Lehman Brothers investment
bank in the context of the Bear Stearns, FannieMae, Freddie
Mac and aig bailouts; and the chaotic days inWashington surrounding
the passage of legislation establishing the TroubledAsset
Relief Program (tarp). Why would Lehman’s failure cause a panic?
Why, after seeing Lehman go to bankruptcy court, would people stop
lending to, say, Citigroup, and demandmuch higher prices for
its credit default swaps (insurance against Citi failure)?
Nothing technical in the Lehman bankruptcy caused a panic.
The usual “systemic” bankruptcy stories did not happen:We
did not see a secondary wave of creditors forced into bankruptcy
by Lehman losses.Most of Lehman’s operations were
up and running in days under new owners. Lehman credit
default swaps (cdss) paid off. Sure, there was some mess —
repos in the United Kingdomgot stuck in bankruptcy court,
somemoneymarket funds “broke the buck” and had to borrow
from the Fed — but those issues are easy to fix and they
do not explain why Lehman’s failure would cause a widespread
panic.What ismore, Lehman’s failure did not carry any news
about asset values; it was obvious already that those assets were
not worth much and illiquid anyway.
We are left with only one plausible explanation for why
Lehman’s failure could have had such wide-ranging effect:
After the Bear Stearns bailout earlier in the year, markets
came to the conclusion that investment banks and bank
holding companies were “too big to fail” and would be bailed
out. But when the government did not bail out Lehman, and
in fact said it lacked the legal authority to do so, everyone
reassessed that expectation. “Maybe the government will not,
or cannot, bail out Citigroup?” Suddenly, it made perfect
sense to run like mad.
The critical issue, Cochrane writes, is that…
Bank deposits, subject to runs, pose an externality.We all understand
that markets can fail when there are externalities. If we
need to allowbank deposits,we need a guarantee or priority in
bankruptcy, which leads tomoral hazard and puts taxpayer at
risk. Some regulation and a forced separation of these “systemic”
contracts fromarbitrary risk-taking are necessary. But this is a
veryminimal level of regulation compared to the too-big-to-fail
guarantee and extensive discretionary supervision and regulation
now being applied to the entire financial system.
The stakes, as a result, are clear, he asserts:
We are in an ever-increasing cycle of risk-taking and
too-big-to-fail bailouts, going back decades. Now we know
that bank holding companies, insurance companies, and
investment banks are too big to fail in the government’s
eyes and their activities are not going to be fundamentally
restricted in size and scope. This crisis strained the
fiscal limits of the United States to make good on
bailout expectations. The next one will be bigger. Where will
it come from? State and local government defaults? Defined
benefit pension funds? Commercial real estate? A new “Asian
bubble?” Default by Greece, Italy, or Ireland? Who knows?
We do know this: when the government no longer has the
fiscal resources to bail out its financial institutions, the crisis
will be much, much worse. Iceland can happen in the
United States if we do not get this right.