The collapse of Lehman Bros. on September, 15, 2008 precipitated a global collapse in confidence among creditors and depositors alike; but whilst the heavily indebted economies of Europe and the United States were structurally unsound (with production geared against export-led growth), extreme economic slowdown was not a necessary condition for the subsequent structural adjustment. The behaviour of the US treasury during the crisis epitomized the ineffectual and indecisive policymaking deemed largely responsible for the exacerbated nature of an otherwise mild cyclical downturn.
It is now common knowledge that nearly all developed economies had become highly indebted before the winding up of Bear Stearns in March 2008. One commonly overlooked aspect however, was that this debt was largely illusory, and was a result of complex financial swaps and hedges that expanded credit, leverage, and the broader money supply. Much of the debt counted in the US economy was a result of inter-bank lending, where banks created complex chains of borrowing. For example, J.P Morgan would lend $1 to a hedge fund, which lends $1 to an investment bank, which lends $1 to a broker, which lends $1 to a mortgage bank, which lends $1 to the homeowner. The total financial leverage therefore becomes $5, but the actual indebtedness of the household (real economy) is only $1. The virtue with this structure, known as Fractional Reserve Banking, is that as long as all the links are safely capitalised and secure, debt can be quickly deleveraged without serious repercussions on the non-financial economy. The longer the chains are however, the more pronounced the effects are if one link breaks. In the US, the chains were extremely long (in some cases chains reached leverage ratios of 30:1) and the situation quickly became an untenable deleveraging nightmare.
This is exactly what happened with the bankruptcy of Lehman Bros, and the US treasury’s decision to not guarantee creditors and lenders. The chain was allowed to break, and otherwise modest losses in the financial sector matured into system-wide threats to the world financial system. But why were the banks so poorly capitalised in the first place? Was it because they expected government aid in conditions of system wide failure? Or was there some other fault line in the system? Many commentators do indeed simplistically blame “crony capitalist” relationships between congress, the Federal Reserve, and Wall Street; where an implicit promise from congress to socialise losses if they are systemic encourages the mass accumulation of tail-risk (financial jargon for risks that are rare, but catastrophic, and systemic if realised). But a more technical approach towards the problem of poorly capitalised institutions points the finger towards accounting standards stipulating transparency.
The new accounting standards (Known as “Mark to Market” accounting standards) took discretionary power away from regulators and banking officials, and handed it over to the forces of the market. Institutions were required to report their solvency as a function of the market value of their assets. During a boom period, with rapidly rising asset values, these institutions witnessed enormous profits and were able to reward large bonuses to their employers and run down their capital reserves. But when values began to fall, losses built up, and to maintain “official” solvency they were required to liquidate their assets en masse with virtually non-existent capital reserves and anxious depositors. This drove down the value of their previously profitable assets, and a positive feedback loop spiralling downwards compounded the problems yet again, and financial balance sheets did not recover until the suspension of the new accounting standards in March 15, 2009.
The relevance for both of these points is that financial sector losses were compounded by the government’s reluctance to intervene in Wall Street, and instead rely upon the efficiency of the market to allocate resources. The Federal Reserve was even forced to increase interest rates early 2008 during the deleveraging process, and winding up of Bear Stearns due to an unsubstantiated attack on commodity prices (and specifically oil) leading to an increase in cost-pushed inflation. With the monetarist paradigm stressing inflation control over demand-management the Federal Reserve hiked up interest rates, despite the contraction in the money supply as a result of deleveraging. The effects were again ruinous, as the money supply contracted rapidly as a result of monetary policy plus the necessary structural adjustment. If the treasury had instead intervened in commodity speculation directly, and regulated oil hoarding in the typical post-war Keynesian approach, the money supply could have expanded and supplementarily supported the deleveraging process, which would otherwise have been deflationary.
Yet even despite the difficulties imposed on the deleveraging process by accounting madness and artificially high interest rates, the non-financial economy was acting with typical flexibility moving employment away from the bloated domestic-demand sectors towards exporting sectors throughout the credit crunch. The trade deficit from 2006-2009 almost halved for example, whilst the current account deficit narrowed from $974 billion in 2006 to a mere $189 billion in 2009. This path had already begun before the collapse of Lehman- and the excessive output gaps experienced alongside stagnant growth could have been avoided if the US Treasury was more willing to consider its full role in the management of economic affairs.
This argument leads on to the topic of financial life-support by government which I will analyse in another piece, citing the Third World mass defaults on debt from 1982-1989, the Swedish crisis of 1992 and Japan’s lost decade.