Metaphors shape understanding of the narrative of events (Reinhart, 2009). For example, the received wisdom in the years following the Great Crash of 1929 and the attendant crushing economic contraction was that it had resulted from excesses of speculation and competition. Some of the policy lessons drawn in the 1930s were that cartelization of industry could promote growth, that restrictions on financial firms and transactions in the financial sector were a preferred way to dampen volatility, that flexible exchange rates were destabilizing, and that fiscal policy could stimulate expansion. It took decades for the economics profession to revise this narrative, beginning with the efforts of Friedman and Schwartz (1963), to put the effect of the supply of money and credit at the center of the story of the Depression. It took longer still to pare back the institutional edifice of banking and financial regulation erected as a consequence of the initial misreading of the events of the 1920s and 1930s.
In this paper, I argue that the evolving narrative of the events of 2008 represents a similar error in our understanding. The current metaphor seems to be that the global economy was hit by a "perfect storm" of disruptive forces late in 2008. A prime-time example of this interpretation came in a nationally televised broadcast in July 2009, when Federal Reserve Chairman Ben Bernanke answered questions about the economy and monetary policy in a town-hall format. Interspersed with the give-and-take was footage of vast waves battering ship and shore. This metaphor suggests that the economy was lashed by events in 2008, while key financial authorities in yellow slickers--a sort of Corps of Financial Engineers--fought the elements and made decisions about which flood waters to divert, which levees to reinforce, and which sluice gates to open.
A more appropriate narrative of the financial crisis that exploded in September 2008 would begin with how the Corps of Financial Engineers-- comprising chiefly the Secretary of the Treasury, the Chairman of the Federal Reserve, and the President of the Federal Reserve Bank of New York--inserted the government into the resolution of the investment bank Bear Stearns in March 2008. The financial authorities interpreted the death throes of the mid-sized investment bank as a problem of systemic importance and, with an ill-considered and unprecedented decision, intervened in a way that protected the uninsured creditors of Bear Stearns and raised the expectations of future bailouts. When the same Corps of Financial Engineers then failed to intervene in September 2008, Lehman Brothers entered bankruptcy. The resulting market seizure was in large part a counter-reaction based on the prior official decision just six months earlier to protect Bear Stearns.
Many observers, including the Secretary of the Treasury at that time Hank Paulson (2010) and Federal Reserve Chairman Ben Bernanke (2010), have looked back at the decision to let Lehman slip into bankruptcy on September 14, 2008, with regret and bemoaned the lack of tools available to them at the time to prevent the outcome. I will argue that Lehman's failure had widespread consequences because of the false hopes engendered by Fed support to Bear Stearns. Instead of asking "Why not save Lehman?" a more useful and consequential question is "Why save Bear Stearns?"
In this essay, I will not seek to offer a comprehensive review of official actions during the financial crisis. There have already been popular renderings (including Ross-Sorkin, 2009; Wessel, 2009) and more academic treatments (Cochrane, 2009; Levine, 2010; Swagel, 2009). Nor will I offer a theoretical explanation of how financial crises emerge: useful starting points to this literature are the articles by Brunnermeier (2009) and Shin (2009) in this journal. I will also not seek to list the litany of governmental failures that contributed to the housing excesses, along with potential reforms; that ground has been covered, respectively, by Wallison and Calomiris (2009) and Kashyap, Rajan, and Stein (2008).
Instead, I will focus here on the fork in the river in March 2008 when the government intervened in the resolution of Bear Stearns. I will review enough of the region upstream and downstream to demonstrate the consequence of the decision. I begin with a review of events leading up to the Bear Stearns bailout and some key details of that event. I then draw on the celebrated Diamond-Dybvig (1983) model to provide a framework for thinking about what engendered the financial crisis in September 2008. The Diamond-Dybvig model is often referenced to emphasize one of its implications: that there might be self-fulfilling crises of confidence. I will emphasize that the same model also suggests more relevant messages, including that the prices creditors expect to receive in the future are critical in determining their behavior.
The conclusion considers a course not taken in March 2008: that is, prompt recognition of economic losses and forced markdowns. But this policy choice has implications that go beyond events at Bear Stearns in March 2008 and Lehman Brothers in September 2008. In Reinhart and Rogoff's (2009) chronicling of the economic crises over the past eight centuries, one theme is that while countries and crises differ considerably, no country has avoided financial crisis. This universality suggests that financial crises will recur, despite the promises of legislation and enlightened oversight. If financial crises will be ever with us, it is important to have a strategy concerning how they will be managed. Among the areas where progress can be made is in identifying the inherent tensions and uncertainties that hinder decision making (for example, Claessens, Klingebiel, and Laeven, 2005, offer a systematic effort to learn lessons). Thus, I will discuss why the path of recognizing losses and forced markdowns might not have been taken in March 2008 and describe the biases inherent in crisis management that make similar mistakes likely in the future.
Vincent Reinhart is a resident scholar at AEI.