Thursday, October 1, 2009

Did The Lehman Failure Really Matter?

Economist Mark Thoma discusses whether Lehman's failure significantly worsened the economic condition at the time. While some would argue that it would have been better to have let the troubled financial institutions fail, they often have trouble supporting this claim with data, as the following from Economist's View explains.

There's a lot of revisionism going on over the consequences of the Lehman's collapse. The standard view is that allowing Lehman to fail was a mistake, and hence government intervention could have lessened the severity of the crisis. Government intervention wouldn't have avoided problems altogether, but the problems wouldn't have been as bad as what we experienced.

However, a few people are now pushing the idea that the failure of Lehman wasn't a primary contributor to the problems that financial markets and the economy experienced. According to the revisionist view, government intervention would not have made any difference, the problems would have been just as bad either way. The notion that government intervention would not have helped is, of course, the main point that this group wishes to emphasize. However, the revisionist view does not hold up to closer examination:

Why the Lehman failure did change everything, by Richard Robb, Economists' Forum: For anyone who was engaged in the financial markets during the week of September 15, 2008, Lehman changed everything. It was obvious. So what could be more tempting to finance professors than to overturn this conventional wisdom? Descartes described the man of letters who takes more pride in his speculations “the more they are removed from common sense,” and so showing that the Lehman collapse was inconsequential has spawned a minor literature.

The latest contribution by John Cochrane and Luigi Zingales, like others before them, rests partly on misunderstanding of the data. The authors deduce that Lehman wasn’t the main cause of last autumn’s turmoil by inspecting the daily movements in the spread between Overnight Interest Rate Swaps and three-month Libor, which they define as “the rate at which banks can borrow unsecured for three months.”

But a better definition of Libor under the circumstances was “the rate at which banks said they can borrow”. Libor is the result of a survey, not a measure of actual transactions. In the week of September 15 last year, big banks refused to settle foreign exchange with each other. They were not lending interbank for three month terms, so Libor during that week tells us little.

We could say the same thing for OIS. Volume was light to nonexistent in the week of September 15 last year. What we do know is that three-month T-bills traded at 0.04 per cent on September 17, down from 1.47 per cent on Friday September 12. These are real data that ought to impress the professors that the market was breaking down as fast as it knows how.

John Taylor, the father of the Lehman-was-no-big-deal thesis, wrote in a Wall Street Journal op-ed last year that spreads between T-bills and Libor “remained in that range [of the previous year] through the rest of the week” after Lehman’s demise. In fact, in the year prior to Lehman’s collapse, the peak spread was 2.05 per cent; on September 17, 2009 it reached 3.00 per cent. (Of course, any conclusions based on Libor that week are equally unreliable.)

The other principal mistake of the Lehman deniers is their assumption that the incident unfolded entirely on September 15, 2008 and any effect had to be observable by that morning. But during the final two weeks of September, the market still had to absorb the news that the Securities and Exchange Commission had no plan for an orderly transfer of client assets in the US, while Lehman Brothers International Europe would be handed over to an administration process designed for liquidating grocery stores. ...

There is plenty of room to debate the larger counterfactual: if the government had never bailed out Bear Stearns and other too-big-to-fail firms that followed, would Lehman have mattered? If the government had never bailed out anyone at all, would we be better off? But given the bailouts that preceded the Lehman failure, the Lehman failure did in fact change everything. Sometimes things that are obvious turn out to be true.

This post has been republished from Mark Thoma's blog, Economist's View.


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