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Saturday 15 September 2018

The collapse of Lehman Brothers and the subsequent GFC.


10 years on we need to get the public on board with how policymakers responded.

As I’ve written before, the GFC was first and foremost an economic problem, and a moral problem second. During the initial panic, and early in the recovery, the economic problem must be dealt with first – emergency liquidity, targeted bailouts, rock bottom interest rates, fiscal stimulus. THEN, once the economy is on solid-footing again, the moral problem can be addressed – debt reduction, financial regulation and oversight, and retribution against those responsible can take place[1].
By and large, addressing the economic problem first is what the US Federal Reserve and Government did. Consequently, unemployment peaked at 10% and the actual recession was short-lived. But there were subsequent failures – both economic and moral. The fiscal support was short-lived and inadequate, so the recovery took much longer than it should have. Furthermore, financial sector reform – while things like the Dodd-Frank Act were a good start – arguably didn’t go far enough to prevent a future crisis. And importantly – and what most public opinion truly despised – virtually no one in the financial sector was held accountable for the GFC. All the public saw was bailouts, and bad people getting golden parachutes.
Consequently, despite the absolute necessity of these emergency measures to stave off a much larger crisis (Depression 2.0), public opinion now is very unfavourable to doing these things again if the occasion calls for it.
But we can see what happens if policy is impotent during such a crisis. The Great Depression was a great example – Central Banks obsessed with maintaining their exchange rates relative to the Gold Standard, resulting in higher interest rates, inadequate crisis liquidity and consequently, total financial system collapse, Depression and widespread deflation, and 25% unemployment in the US.
And following the GFC, Europe offers another case study of policy impotence. The European Central Bank was slower to react in monetary terms, more punitive measures were imposed against the banks, and governments reacted in the reverse direction in fiscal terms with austerity. Consequently, prolonged recession and deflation, and mass unemployment ensued, comparable (even worse) than the Great Depression. One of the only silver linings was Europe having a much more supportive social safety net this time around compared to the Great Depression. So the human suffering and hardship could still have been worse.
As I’ve also mentioned before, public opinion matters. It’s not enough to say that, as long as the right people are in power, they will do the right thing, regardless of what ‘Joe Public’ thinks. I mean, Ben Bernanke faced scorched-earth opposition to his crisis measures, but he still undertook them. But this is not enough. Because if ‘Joe Public’ disapproves this time around, he will vote accordingly, and during the next crisis we may see completely different types in power. And that’s what we’ve seen. Following the GFC, a global wave of populism has swept Europe, the US and even Australia. Brexit and Trump are merely the most high-profile examples of this. But one of the telling characteristics of such populism is a distrust of technical expertise – precisely the expertise that is more likely to make the right decisions even when they are unpopular.
And if another crisis comes along (look out, Australia), and these new populist powers refuse to provide the necessary (and often unpopular) support because they find it simply unacceptable to bail out the financial sector again, we are in trouble.
The public needs to be shown how these tough decisions were the right ones. Yes, a lot more could have been done to speed up the recovery (or in the case of Europe, not make things worse), reign in the financial sector and punish those responsible. But if these new populist powers encounter another crisis, and insist on addressing the morality issue before the economic one, they will literally make the situation worse, especially for those they claim to want to protect. And there will be no guarantee that those responsible for the crisis in the first place will be caught up in the downward spiral.
Policymakers need to be able to quickly do the right thing without having to justify it to politicians or the public. But once the dust settles, they need to convince the public it was the right thing – before the time comes to do the right thing again.
It’s always tempting to want to teach the bad guys a lesson – but not at the expense of the rest of us.
Also see Catherine Rampell’s piece, Heaven help us in the next financial crisis.



[1] Technically, as long as it doesn’t restart a panic and/or jeopardise the subsequent recovery, regulation, oversight and retribution may begin sooner. But not debt reduction.

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