What have we learned from the collapse of Lehman Brothers? Kohler

Today is not the anniversary of the financial crisis, but of its turning point and the beginnings of the most important economic debate of our time.

The collapse of Lehman Brothers on the weekend of September 13th-14th last year did not start the crisis, it definitely began the end of it and more importantly it began a debate that is now redefining economics.

Without the banking panic and financial seizure that Lehman caused, world governments would not have come to the fiscal rescue of the economy to the extent they did and the global economy would not now be so firmly in recovery.

Merrill Lynch might not have been taken over by Bank of America and might itself have collapsed, with more devastating consequences than Lehman, and US Treasury Secretary Henry Paulson would not have got his $US700 billion TARP through Congress.

I’m not arguing that the Lehman default was a good thing, and I don’t agree that “Lehman had to die so that Wall Street might live”, as Joe Nocera wrote in The New York Times last week. It was definitely, entirely bad – but was it simply a mistake?

Hank Paulson said then, and since, that he never once considered that Lehman should have been bailed out. And can you imagine the moral hazard involved in using taxpayers’ money to rescue a Wall Street trading house in that way? It’s one thing to put Fannie Mae and Freddie Mac into conservatorship and bail out AIG, but Lehman?

The convulsions of last September were the inevitable result of 20 years of unrestrained credit growth and regulatory neglect.

These grew out of a complacency encouraged by the death of inflation in the 1980s, and by the ascendancy of the “efficient markets theory” and the associated idea that small government and light regulation is best.

In a 6,700 word essay in The New York Times last week, Paul Krugman argued that the economics professions fell too much in love with the efficient markets hypothesis – that stocks and other assets were always priced just right.

“The story of economics over the past half century is … the story of a retreat from Keynesianism and a return to neoclassicism,” he wrote. He was even critical of that holy of holies, the capital asset pricing model, which assumes “that every investor rationally balances risk against reward”.

“In short, the belief in efficient financial markets blinded many, if not most, economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.”

The debate that’s now taking place among economists about these issues – about the whole basis of their science, in fact – is the main hope that meaningful lessons will be learned from this crisis.

Certainly progress towards systemic change in banking and the regulation of the sector is hesitant at this stage.

But perhaps that’s not surprising. Economists provided the intellectual underpinning for the hands-off approach to regulation and to the credit bubble itself by arguing that the economy is a frictionless, self-correcting machine.

Theoretical science always provides the foundations of real world effects, whether it’s physics or genetics. Likewise economics.

Macro-economists have suffered a terrible blow to their confidence, but they have to get their act together now.

The collapse of Lehman was neither the end of capitalism nor the end of economics; the capitalists have bounced back and it’s imperative that economists do the same and come up with a new theory that accepts that economies are run by flawed humans and that they are buffeted by a financial system that is subject to the madness of crowds.

This article first appeared on Business Spectator.