Was the Financial Crisis Wasted?
While financial regulation has been materially strengthened since the 2008 crisis, its implementation remains in the hands of a patchwork quilt of national agencies. The resulting structural diversity of post-crisis reforms does not help ensure consistency in the implementation of global standards.
LONDON – As the tenth anniversary of the start of the global financial crisis approaches, a wave of retrospective reviews is bearing down on us. Many of them will try to answer the Big Question: Has the financial system been fundamentally reformed, so that we can be confident of preventing a repeat of the dismal and destructive events of 2008-2009, or has the crisis been allowed to go to waste?
There will be no consensus answer to that question. Some will argue that the post-crisis reforms, especially those concerning banks’ capital requirements, have gone too far, and that the costs in terms of output have been too high. Others will argue that far more must be done, that banks need far higher capital, and possibly, as the proponents of a recent Swiss referendum argued, that banks should lose their ability to create money.
But any reasonable observer must acknowledge that there has been a very significant change. Most large banks now have 3-4 times as much capital, and of far higher quality, than they had in 2007. Additional buffers are now required in systemic institutions. Risk management has been greatly strengthened. And regulatory intervention powers are far more robust. Political support for tough regulation remains strong, at least everywhere except the United States, and even there the Trump administration’s measures have mainly benefited community banks, not Wall Street.
There is one area, however, where far less has been achieved. As former US Federal Reserve board chair Paul Volcker has observed, “virtually every post-mortem of the financial crisis cites the convoluted regulatory system [in the US] as a contributory factor in the financial meltdown.”
Yet the 2010 Dodd-Frank legislation, which sought to address the shortcomings exposed by the financial crisis, made very few changes. It abolished only one small agency, the unlamented Office of Thrift Supervision, and added another, the Consumer Financial Protection Bureau, a body so little loved by the current administration that one wonders about its longevity.
The convolution highlighted by Volcker was not addressed. His verdict today is that “the system for regulating financial institutions in the US is highly fragmented, outdated, and ineffective.” Aside from that, all is well!
The US is undoubtedly an outlier. What of the rest of the world? There have been a few changes, perhaps most notably in the United Kingdom, where we enjoy rearranging institutional deck chairs. The functions of the fully integrated Financial Services Authority (of which I was the first chair) have been returned to the Bank of England or reallocated to the Financial Conduct Authority.
A recent study by the Financial Stability Institute, established by the Bank for International Settlements and the Basel Committee on Banking Supervision, concludes that 11 of the 79 countries assessed have made some changes. Interestingly, despite the UK reform, the weak international trend remains toward integrated regulation, and away from the traditional model whereby different agencies regulate insurance and securities, while the central bank oversees the banking system.
But there remains a remarkable diversity of practice worldwide. Of the 79 countries, 39 still operate a three-way sectoral breakdown, and 23 have integrated agencies (nine of which double up as the monetary authority). Nine others have two agencies divided along sectoral lines, and eight have chosen a so-called Twin Peaks system, with one agency handling capital-market regulation and the other overseeing business conduct.
One might have expected that some degree of agreement would have emerged from an analysis of what did, and did not, work in the crisis. But there is little sign of it.
The conclusions of what analysis there has been are somewhat ambiguous. It is hard to say that one structure worked better than another in every place. But there are some suggestive assessments. An International Monetary Fund study of pre-crisis regulation concluded that “countries with integrated supervisory agencies [at that time generally outside the central bank] enjoy greater consistency in quality of supervision.” In other words, their compliance with Basel-set standards was more rigorous. Yet, where changes have been made since the crisis, central banks have typically been given greater powers.
This structural diversity of post-crisis reforms does not help ensure consistency in the implementation of global standards. It is particularly problematic in the European Union. There is now a banking union in the eurozone, but supervisors in around half of the member states are in the central bank, while they are outside it in the other half.
Is there not a job here for the Financial Stability Board? Could the FSB not review practices and point to a preferred structure, or at least some non-preferred ones?
There is, unfortunately, no appetite there for picking up that thistle. National supervisors have no interest in criticizing their own systems. The Financial Stability Institute’s review showed a bit more courage. Reading between the lines, the authors think little of the sectoral model, but their anticlimactic conclusion is only that “it looks worthwhile to regularly conduct assessments of the functioning of the supervisory architecture in each jurisdiction in the light of prevailing objectives.”
Who could disagree with that? The authors were clearly mindful that every academic paper worth its salt ends with a plea for more research.
So we seem set to limp along with a highly diverse system. Even the 2008 financial crisis did not dislodge the vested interests in many countries. So while financial regulation has been materially strengthened, which is clearly the most important thing, its implementation remains in the hands of a patchwork quilt of national agencies.
The Depth of the Next US Recession
Whatever the immediate trigger of the next US recession, the consequences are likely to be severe. With the US government committed to pro-cyclical fiscal, macro-prudential, and even monetary policies, the authorities are in a weak position to manage the next inevitable shock.
ASPEN, COLORADO – The United States economy is doing well. But the next recession – and there is always another recession – could be very bad.
The US Bureau of Economic Analysis estimates that GDP growth in the second quarter of 2018 reached 4.1% – the highest since the 4.9% seen under President Barack Obama in 2014. Another year of growth will match the record ten-year expansion of the 1990s. Add to that low unemployment, and things are looking good.
But this cannot continue forever. Given massive global corporate debt and a soaring US stock market – the cyclically adjusted price-to-earnings ratio is high by historical standards – one possible trigger for a downturn in the coming years is a negative shock that could send securities tumbling.
That shock could be homegrown, coming in the form, say, of renewed inflation or of the continued escalation of the trade war that US President Donald Trump has started. The shock could also come from abroad. For example, the current financial and currency crisis in Turkey could spread to other emerging markets. The euro crisis is not truly over, despite the completion of Greece’s bailout program, with Italy, in particular, representing a major source of risk. Even China is vulnerable to slowing growth and high levels of debt.
Whatever the immediate trigger, the consequences for the US are likely to be severe, for a simple reason: the US government continues to pursue pro-cyclical fiscal, macro-prudential, and even monetary policies. While it is hard to get counter-cyclical timing exactly right, that is no excuse for pro-cyclical policy, an approach that puts the US in a weak position to manage the next inevitable shock.
During economic upswings, the budget deficit usually falls, at least as a share of GDP. But with the US now undertaking its most radically pro-cyclical fiscal expansion since the late 1960s, and perhaps since World War II, the Congressional Budget Office projects that the federal government’s fast-growing deficit will exceed $1 trillion this year.
America’s deficit is being blown up on both the revenue and expenditure sides. Although a reduction in the corporate tax rate was needed, the tax bill that Congressional Republicans enacted last December was nowhere near revenue-neutral, as it should have been. Like the Republican-led governments of Ronald Reagan and George W. Bush, the Trump administration claims to favor small government, but is actually highly profligate. As a result, when the next recession comes, the US will lack fiscal space to respond.
The Trump administration’s embrace of financial deregulation is also pro-cyclical and intensifies market swings. The Trump administration and the Republican-controlled Congress have gutted Obama’s fiduciary rule, which would have required professional financial advisers to put their clients’ interests first when advising them on assets invested through retirement plans. They have also rolled back sensible regulations of housing finance, including risk-retention rules, which force mortgage originators to keep some “skin in the game,” and requirements that borrowers make substantial down payments, which work to ensure ability to pay.
The White House and Congress have also been acting to gut the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act, which strengthened the financial system in several ways, including by imposing higher capital requirements on banks, identifying “systemically important financial institutions,” and requiring more transparency in derivatives. The Consumer Financial Protection Bureau – established by Dodd-Frank to protect borrowers with payday, student, and car loans – is also now being curtailed.
Like most major legislation, Dodd-Frank could be improved. Compliance costs were excessive, especially for small banks, and the original threshold for stress-testing “too big to fail” institutions – $50 billion in assets – was too low. But the current US leadership is going too far in the other direction, including by raising the threshold for stress tests to $250 billion and letting non-banks off the hook, which increases the risk of an eventual recurrence of the 2007-2008 financial crisis.
Now is the right point in the cycle to raise banks’ capital requirements as called for under Dodd-Frank. The cushion would minimize the risk of a future banking crisis.
Other countries do macro-prudential policy better. Europeans have applied the counter-cyclical capital buffer to their banks. Some Asian countries raise banks’ reserve requirements and homeowners’ loan-to-value ceilings during booms, and lower them during financial downturns.
When it comes to monetary policy, the US Federal Reserve has been doing a good job; but its independence is increasingly under attack from Republican politicians. If this assault succeeds, counter-cyclical monetary policy would be impaired.
In the past, the Fed has moderated recessions by cutting short-term interest rates by around 500 basis points. But, with those rates currently standing at only 2%, such a move is impossible. That is why, as Martin Feldstein recently pointed out, the Fed should be “raising the rate when the economy is strong,” thereby giving “the Fed room to respond in the next economic downturn with a significant reduction.”
Most Fed critics disagree. In 2010, they attacked the Fed for its monetary easing, even though unemployment was still above 9%. Now Trump says he is “not thrilled” about the Fed raising interest rates, even though unemployment is below 4%. This is tantamount to advocating pro-cyclical monetary policy.
As we approach the tenth anniversary of the global financial crisis, we should recall how we got there. In 2003-2007, the US government pursued fiscal expansion and financial deregulation – an approach that, even at the time, was recognized as likely to constrain the government’s ability to respond to a recession. If the US continues on its current path, no one should be surprised if history repeats itself.
The Global Economy’s Fundamental Weakness
Over the course of the past decade, the global economy has recovered from the 2008 financial crisis by riding a wave of debt and liquidity injections from the major central banks. Yet in the absence of steady wage growth and productive investments in the real economy, the only direction left to go is down.
GENEVA – When Lehman Brothers declared bankruptcy ten years ago, it suddenly became unclear who owed what to whom, who couldn’t pay their debts, and who would go down next. The result was that interbank credit markets froze, Wall Street panicked, and businesses went under, not just in the United States but around the world. With politicians struggling to respond to the crisis, economic pundits were left wondering whether the “Great Moderation” of low business-cycle volatility since the 1980s was turning into another Great Depression.
In hindsight, the complacency in the run-up to the crisis was clearly unconscionable. And yet little has changed in its aftermath. To be sure, we are told that the financial system is simpler, safer, and fairer. But the banks that benefited from public money are now bigger than ever; opaque financial instruments are once again de rigueur; and bankers’ bonus pools are overflowing. At the same time, un- or under-regulated “shadow banking” has grown into a $160 trillion business. That is twice the size of the global economy.
Thanks to the trillions of dollars of liquidity that major central banks have pumped in to the global economy over the past decade, asset markets have rebounded, company mergers have gone into overdrive, and stock buybacks have become a benchmark of managerial acumen. By contrast, the real economy has spluttered along through ephemeral bouts of optimism and intermittent talk of downside risks. And while policymakers tell themselves that high stock prices and exports will boost average incomes, the fact is that most of the gains have already been captured by those at the very top of the pyramid.
These trends point to an even larger danger: a loss of trust in the system. Adam Smith recognized long ago that perceptions of rigging will eventually undermine the legitimacy of any rules-based system. The sense that those who caused the crisis not only got away with it, but also profited from it has been a growing source of discontent since 2008, weakening public trust in the political institutions that bind citizens, communities, and countries together.
During the synchronized global upswing last year, many in the economic establishment spoke too soon when they began to forecast sunnier times. With the exception of the US, recent growth estimates have fallen short of previous projections, and some economies have even slowed. While China and India remain on track, the number of emerging economies under financial stress has increased. As the major central banks talk up monetary-policy normalization, the threats of capital flight and currency depreciation are keeping these countries’ policymakers up at night.
The main problem is not just that growth is tepid, but that it is driven largely by debt. By early 2018, the volume of global debt had risen to nearly $250 trillion – three times higher than annual global output – from $142 trillion a decade earlier. Emerging markets’ share of the global debt stock rose from 7% in 2007 to 26% in 2017, and credit to non-financial corporations in these countries increased from 56% of GDP in 2008 to 105% in 2017.
Moreover, the negative consequences of tightening monetary conditions in developed countries will likely become more severe, given the disconnect between asset bubbles and recoveries in the real economy. While stock markets are booming, wages have remained stuck. And despite the post-crisis debt expansion, the ratio of investment-to-GDP has been falling in the advanced economies and plateauing in most developing countries.
There is a very big “known unknown” hanging over this fragile state of affairs. US President Donald Trump’s trade war will neither reduce America’s trade deficit nor turn back the technological clock on China. What it will do is fuel global uncertainty if tit-for-tat responses escalate. Even worse, this is occurring just when confidence in the global economy is beginning to falter. For those countries that are already threatened by heightened financial instability, the collateral damage from a disruption to the global trading system would be significant and unavoidable.
Yet, contrary to conventional wisdom, this is not the beginning of the end of the postwar liberal order. After all, the unraveling of that order started long ago, with the rise of footloose capital, the abandonment of full employment as a policy goal, the delinking of wages from productivity, and the intertwining of corporate and political power. In this context, trade wars are best understood as a symptom of unhealthy hyper-globalization.
By the same token, emerging economies are not the problem. China’s determination to assert its right to economic development has been greeted with a sense of disquiet, if not outright hostility, in many Western capitals. But China has drawn from the same standard playbook that developed countries used when they climbed the economic ladder.
In fact, China’s success is exactly what was envisioned at the 1947 United Nations Conference on Trade and Employment in Havana, where the international community laid the groundwork for what would become the global trading system. The difference in discourse between then and now attests to how far the current multilateral order has moved from its original aims.
At first, the Lehman crisis did trigger a revival of the post-war multilateral spirit; but it proved fleeting. The tragedy of our times is that just when bolder cooperation is needed to address the inequities of hyper-globalization, the drums of “free trade” have drowned out the voices of those calling for a restoration of trust, fairness, and justice in the system. Without trust, there can be no cooperation.
Recovery is Not Resolution
Last week, the IMF revised upward its growth projections for the eurozone and Asia’s advanced economies, including Japan, with the US Federal Reserve’s ongoing exit from ultra-easy post-crisis monetary policy adding to the growing sense that normal times are returning. But are they?
CAMBRIDGE – Earlier this year, the consensus view among economists was that the United States would outstrip its advanced-economy rivals. The expected US growth spurt would be driven by the economic stimulus package described in President Donald Trump’s election campaign. But the most notable positive economic news of 2017 among the developed countries has been coming from Europe.
Last week, the International Monetary Fund revised upward its growth projections for the eurozone, with the more favorable outlook extending broadly across member countries and including the Big Four: Germany, France, Italy, and Spain. IMF Chief Economist Maurice Obstfeld characterized recent developments in the global economy as a “firming recovery.” Growth is also expected to pick up in Asia’s advanced economies, including Japan.
As I noted in a previous commentary, Iceland, where the financial crisis dates to 2007, has already been dealing with a fresh wave of capital inflows for some time, leading to concerns about potential overheating. A few days ago, Greece, the most battered of Europe’s crisis countries, was able to tap global financial markets for the first time in years. With a yield of more than 4.6%, Greece’s bonds were enthusiastically snapped up by institutional investors.
Greek and European officials hailed the bond sale as a milestone for a country that had lost access to global capital markets back in 2010. Greek Prime Minister Alexis Tsipras said the debt issue was a sign that his country is on the path to a definitive end to its prolonged crisis.
In the US, the Federal Reserve’s ongoing exit from ultra-easy post-crisis monetary policy adds to the sense among market participants and other countries’ policymakers that normal times are returning.
But are they? Do recent positive developments in the advanced countries, which were at the epicenter of the global financial crisis of 2008, mean that the brutal aftermath of that crisis is finally over?
Good news notwithstanding, declaring victory at this stage (even a decade later) appears premature. Recovery is not the same as resolution. It may be instructive to recall that in other protracted post-crisis episodes, including the Great Depression of the 1930s, economic recovery without resolution of the fundamental problems of excessive leverage and weak banks usually proved shallow and difficult to sustain.
During the “lost decade” of the Latin American debt crisis in the 1980s, Brazil and Mexico had a significant and promising growth pickup in 1984-1985 – before serious problems in the banking sector, an unresolved external debt overhang, and several ill-advised domestic policy initiatives cut those recoveries short. The post-crisis legacy was finally shaken off only several years later with the restoration of fiscal sustainability, debt write-offs under the so-called Brady Plan, and a variety of domestic structural reforms.
Since its 1992 banking crisis, Japan has suffered several false starts. There were recoveries in 1995-1996 and again in 2000 and 2010; but they tended to be cut short by the failure to write down bad debt (the so-called zombie loans), several premature policy reversals, and an increasingly unsustainable accumulation of government debt.
The eurozone emerged from the financial crisis in 2008-2009 with some economic momentum. Unlike the Federal Reserve, however, the European Central Bank hiked interest rates in early 2011, which contributed to the region’s descent into a deeper crisis.
History, therefore, suggests caution before concluding that the current recovery has the makings of a more sustainable and broad-based variety. Many of the economic problems created or exacerbated by the crisis remain unresolved.
All of the advanced economies (to varying degrees) have significant legacy debts (public and private) from the excesses that set the stage for the financial crisis, as well as from the prolonged impact of the crisis on the real economy. Low interest rates have eased the burden of those debts (in effect, negative real interest rates are a tax on bondholders), but rates are on the rise.
Political polarization in the US and the United Kingdom is at or near historic highs, depending on the measure used. As a result, many critical but politically sensitive policies to ensure future fiscal sustainability remain unresolved in both countries.
The UK’s withdrawal from the European Union – and Brexit’s medium-term impact on the British economy – is another source of risk that has yet to be tackled. How Japan will resolve its public and private debt overhang is yet to be determined. I have argued elsewhere that inflation will likely be part of that resolution, as it is improbable that an aging population will vote to raise its tax burden and reduce its benefits sufficiently to put Japan’s debt trajectory on a sustainable path.
In Europe, the high level of non-performing loans continues to act as a drag on economic growth, by inhibiting new credit creation. Furthermore, these bad assets pose a substantial contingent liability for some governments. Target2, the euro’s real-time gross settlement system, has emerged as the eurozone’s mechanism for financing the emergence of widening structural balance-of-payments gaps, whereby capital flows out of southern Europe into Germany. For Greece, Italy, Portugal, and Spain, public-sector debt must now also include the central bank’s sharply rising debts.
Perhaps the main lesson is that even more caution is warranted in deciding whether the time is ripe to “normalize” monetary policy. Even in the best of recovery scenarios, policymakers would be ill-advised to kick the can down the road on structural reforms and fiscal measures needed to mitigate risk premia.
The Global Economy Ten Years After
In the decade since the collapse of Lehman Brothers and the start of the global financial crisis, the world economy has registered stronger growth than many realize, owing in large part to China. But in the years ahead, global economic imbalances and troubling trends in the business world will continue to pose economic as well as political risks.
LONDON – Much will be said about the tenth anniversary of the 2008 financial crisis, so I will focus on the global economy, which has not been nearly as weak as many seem to think.
According to the International Monetary Fund, the rate of real (inflation-adjusted) world GDP growth averaged 3.7% in 2000-2010, and would have been close to 4% if not for the so-called Great Recession. By comparison, the average annual growth rate so far this decade has been 3.5%, which is slightly lower than the average rate in the 2000s, but above the 3.3% rate in the 1980s and 1990s.
By my reckoning, China has contributed an even larger share of global growth in this decade than it did in the last, with its GDP having almost tripled from $4.6 trillion at the end of 2008 to around $13 trillion today. That additional $8 trillion accounts for more than half of the increase in global GDP over the past decade.
I have long attributed the financial crisis to imbalances within and between the United States and China, the world’s two largest economies. While the US’s current-account deficit was close to 5% of GDP in 2008 (and closer to 7% in some quarters of 2007), China was maintaining a whopping current-account surplus of 9% or higher.
Following the crisis, I predicted that the US and China would have to swap places to some extent over the course of the next decade. China needed to save less and spend more; and the US needed to save more and spend less. Judging by their current accounts today, both countries appear to have made significant progress. In 2018, China’s surplus will have fallen to around .5-1% of GDP, which is remarkable considering that its GDP has more than doubled since 2008. Equally remarkable, the US will register a deficit of 2-2.5% of GDP, which is within the 2-3% range that many economists consider sustainable.
Other global indicators, however, are not as encouraging. Back in 2008, the eurozone ran a current-account deficit of 1.5% of GDP, with Germany recording a surplus of around 5.5%. But Germany’s large surplus owed much to large deficits in other eurozone countries, and that imbalance gave rise to the euro crisis after 2009. Worryingly, Germany’s surplus has since ballooned to around 8% of GDP. As a result, the eurozone now has a surplus close to 3.5%, despite, and probably because of, years of weak domestic demand in the Mediterranean member states. This is surely a sign of further instability ahead. In fact, the slow-brewing crisis in Italy may be a harbinger of what awaits the bloc.
A central feature of the economy prior to the financial crisis was the US housing bubble, which itself resulted from the financial sector’s invention of increasingly intricate (and dubious) methods of recycling global savings. A decade on, it bears mentioning that many “global cities” like London, New York, Sydney, and Hong Kong now have home prices that only a very small minority of their permanent residents can afford, owing to the growing demand from wealthy investors abroad.
But as of this year, there are growing signs that housing prices in these and other cities may be undergoing a reversal. This may simply reflect actions taken by municipal governments to provide more affordable housing to their residents; but it also could indicate that marginally affluent new buyers are becoming scarcer.
To be sure, a gradual decline in house prices in these cities would be a welcome development in terms of economic and social equality. But one would search in vain for a time when declining home prices did not produce damaging side effects.
Having now assumed the chairmanship at Chatham House, I am eager to encourage more research into how factors such as housing costs relate to larger issues of income and wealth inequality. To my mind, the world needs much better metrics for tracing these interconnections.
For example, it is clear that wealth inequality has increased much more than income inequality over the past decade, with the rapid rise in urban housing prices playing a central role. In many developed countries, including the United Kingdom, economic inequality is a serious problem. Yet in terms of income, the latest data show that inequality has actually fallen back to the (still-too-high) levels of the 1980s.
If common perceptions about inequality tend to inflate what is actually happening, that is because many companies’ top executives are earning increasingly massive sums relative to the workers under them. Such compensation packages can be rationalized in the context of share-price performance, but that hardly makes them justifiable.
This is another issue that I hope we will be studying at Chatham House. The strange equity-market rally that has been proceeding almost uninterrupted since 2009 has been fueled in large part by major corporations’ stock buybacks. In some important cases, companies have even issued debt to finance the repurchase of their shares.
Does the growing prevalence of buybacks explain why fixed investment and productivity have remained so weak across the West? And might those macroeconomic factors explain some of the political upheavals in Western democracies such as the UK and the US in recent years?
On both counts, I suspect that the answer is yes. Unless we can recover a world in which business profits actually serve a purpose, the likelihood of more economic, political, and social shocks will remain intolerably high.
What Lehman Brothers’ Failure Means Today
The standard story about the September 2008 collapse of Lehman Brothers is that it led to a deeper understanding of the risks of financial complexity and free-wheeling capitalism. In fact, the ensuing crises in the US, Europe, and elsewhere were more a product of broader changes in twenty-first-century politics and society.
PRINCETON – So far this year, the world has marked the 50th anniversary of the Prague Spring (and its suppression), the centennial of the end of World War I, and the bicentennial of Karl Marx’s birth. Against that backdrop, should one really care about the tenth anniversary of the collapse of Lehman Brothers?
Yes, we should. Lehman may not have been a particularly large bank, and it probably was not even insolvent when it failed. Nonetheless, it nearly took down the global financial system and triggered the Great Recession. Lehman was transformative because it fundamentally altered people’s understanding of the world around them.
After September 15, 2008, the fear of “another Lehman” and a deeper financial catastrophe put the United States on the path toward wide-ranging reform. And Lehman was constantly invoked during the European financial crisis that erupted after 2010, highlighting fears of a “death spiral” stemming from state bankruptcies and defaults. Since then, the scare story seems to have lost its effectiveness. In the US, banking reforms are now being undone; and in the European Union, government debt-to-GDP ratios are well above where they were in 2008.
Still, for policymakers and opinion-shapers, the 2008 financial crisis produced three new grand narratives. First, after Lehman, the American economist Charles Kindleberger’s 1978 masterful book Manias, Panics, and Crashes met with a newfound popularity. Kindleberger had drawn explicitly from the American economist Hyman Minsky’s work on financial cycles, and his arguments were read as a warning against “market fundamentalism.”
The second narrative was that Lehman’s failure had made the Wall Street crash of 1929 and the Great Depression newly relevant. Policymakers drew lessons from the interwar years, and successfully avoided a full repeat of that period. During the Great Depression, especially in Germany and the US, the prevailing attitude was that of then-US Secretary of the Treasury Andrew Mellon: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” By contrast, the response during the Great Recession was to use public debt to replace insecure private debt – an intervention that would prove sustainable only as long as interest rates remained low.
The third narrative held that Lehman’s collapse augured the end of American capitalism. This butterfly-effect story was popular in every country that was tired of being bossed around by the US. As Germany’s then-finance minister, Peer Steinbrück, explained in September 2008: “The US will lose its status as the superpower of the global financial system, not abruptly but it will erode.”
At first, the 2008 crisis was widely regarded as a quintessentially American disaster, owing to the country’s mix of testosterone-driven finance and penchant for promoting home ownership even for those who cannot afford it. Only gradually was it recognized as a truly transatlantic affair. As the economists Hyun Song Shin and Tamim Bayoumi subsequently show, badly regulated, oversized European banks played a key role in the build-up of risk throughout the financial system.
Neither of the first two popular narratives is really correct. The crisis was not a market failure, but rather the product of opaque, dysfunctional non-market institutions that had become perversely intertwined. It exposed the problem of complexity – not of markets as such.
Specifically, the reason that Lehman was such a problem was that it was not really a single corporation. It comprised some 7,000 separate entities in over 40 countries, all of which would need to go through a complex and costly valuation and bankruptcy process. This opacity, which was hardly unique to the US, created the sense that the world was close to another Great Depression when it really wasn’t.
The crisis was the product of escalating short-termism in financial markets. While banks wanted to offload securitized products before they became toxic, other market participants were looking to win on short-term bets, paying little mind to the longer-term viability of the investment. In this sense, volatility was desirable, as it created new opportunities for gain.
After Lehman collapsed, the twin narratives about “market failure” and “another Great Depression” had a massive effect on public perceptions, and fueled the third narrative, which actually happens to be true. America’s financial and political preeminence has in fact waned.
The global primacy of the US was based on economic and political power, but it also depended on something more fundamental: trust in America’s capacity to deliver on its promises over the long term. The crisis undermined that trust, even though US economic and political power remained only slightly diminished. The deeper contagion was intellectual, not financial.
Financial behavior does not occur in a vacuum. The same kind of short-term, hyperactive mindset that felled Lehman was also taking root in the rest of society at the time. Tellingly, the iPhone was introduced in June 2007, just as early signs of the impending crisis were coming into view.
With the smartphone came all kinds of new possibilities. It added dynamism to inchoate social-media platforms like Facebook and Twitter. And it provided the basis for Tinder and other apps which have transformed the social life of millions, pushing dating further in the direction of short-termism and away from longer-term commitment.
The new digital devices and platforms encouraged hyper-individualism. But they also affected political outlooks and behavior, by making it easier than ever to reinforce one’s own views while avoiding alternative opinions. One result, little wonder, is the online culture of demonization, abuse, harassment, and manipulation we see today.
Much of today’s political volatility is a consequence of these new ways of thinking and communicating. Technology and finance adopted the same ethos: destroy continuity and glorify disruption.
Lehman Brothers’ collapse revealed a flaw not just in finance, but in twenty-first-century politics and society. The irony is that, rather than forestalling an era of technologically driven short-termism, the subsequent crisis seems to have accelerated it.