A Global Economy Held Hostage by Lehman

"Failure in market economies, while endemic, seems to go hand in hand with rapid progress." Tim Harford, Adapt: Why Success Always Starts With Failure, p. 11.

The current refunding of Greece's profligate government was presented in the mainstream media as another story of a government operating beyond its means. While this is true, the bigger, economy-retarding story behind the story is why Greece was saved.

Greece's government has since its origins in 1821 spent half of the time in arrears to creditors, and its difficulties have seemingly never merited global attention. What makes Greece, and for that matter the financially struggling governments of Ireland, Portugal and Spain newsworthy has everything to do with the identity of the creditors holding their government debt.

To put it very plainly, Greece's government isn't being bailed out as much as the banks with massive exposure to its debt are. Under more normal circumstances, the Greek government would simply give the owners of its debt a "haircut" on monies owed, and it's fair to assume that such an occurrence wouldn't engender much attention.

It does today because such a haircut would force financial institutions holding Greek debt to write down its value on their books, and that would render some of them insolvent. Given what happened in the fall of 2008 when Lehman Brothers filed for bankruptcy, there's a crippling fear of "contagion," thus making all governments "too big to fail" because banks have so much exposure to government debt.

The problem with this contagion theory is that the collapse of Lehman Brothers could never on its own have caused the market carnage in 2008 that still paralyzes and defines the actions of world leaders. In truth, the financial agony relating to Lehman was the result of market uncertainty about government policy concerning bailouts. It was not caused by the disappearance of an institution in a sector known for the ephemeral quality of its companies.

Government debt, global impact. As has been explained in this column before, government defaults or debt "haircuts" have been the historical norm. Run by fallible individuals, governments tend to overextend themselves in terms of debt much in the way that individuals do.

But as economists Carmen Reinhart and Kenneth Rogoff noted in their 2009 book, This Time Is Different, "most defaults end up being partial, not complete." More to the point, they've found that in most cases, "partial repayment is significant and not a token."

Rogoff and Reinhart point to the 1994 Mexican "Tesebono" crisis as one that would have gone largely unreported had it not been for global exposure to the Mexican debt in question. Turning to Argentina, though its government defaulted in 1982, 1989 and 2001, the '89 default did not merit international attention because it was then the country's citizens - as opposed to foreign banks - that suffered the haircut.

What's increasingly notable about modern defaults is that they are no longer errors that must be dealt with by a country's citizenry; they're global in nature. Most notably, but not very surprisingly, external defaults are highly correlative with banking crises. This also explains why external defaults on debt are such big news. While debt itself is hard to distinguish, with banking crises the frequent result of defaults, when countries fail to make good on monies owed to foreign creditors, the likelihood of damage to banks in possession of the debt grows.

Turning back to Greece, we can easily imagine a counterfactual scenario in which Greek money is still the Drachma, and most government debt is held by the country's citizenry. It's then safe to say that Greece's problems would be largely unknown. There would be little or no "contagion." That "contagion" is all the rage, and default by Greece held to be intolerable, speaks to the internationalization of the government's debt, and the implications of a default for the global financial system.

If Greece had been allowed to impose a perfectly normal haircut on those holding its debt, there exists the possibility that such a move would lead to insolvency for large financial institutions far beyond the Greek border. This of course is not permitted on the grounds that the financial system and global economy can't suffer another Lehman Brothers-style situation that would supposedly author a financial crisis.

Lehman Brothers' bankruptcy did not cause the financial crisis. As American Enterprise Institute (AEI) senior fellow Peter J. Wallison put it in a 2009 speech, "the idea that the interconnectedness of Lehman caused the financial crisis-is not well founded. The better, more realistic, explanation for the paralyzed credit situation in the aftermath of Lehman actually goes back to the spring of 2008. It was then that the Fed and Treasury, fearing "contagion" relating to Bear's demise, saved its creditors through a deal in which the Fed took Bear's debased assets on its balance sheet. Then J.P. Morgan was offered the still-functioning bank on the relative cheap, its downside covered by the federal government.

As Wallison put it, "I see the market meltdown that followed the Lehman bankruptcy as a result of the moral hazard created by the rescue of Bear Stearns six months before."

Other accounts of the time in question support Wallison's view. The fact that the federal government subsidized J.P. Morgan's acquisition of Bear Stearns created an expectation among healthy financial institutions that they too should have their downside protected in snapping up insolvent firms. As Andrew Ross Sorkin put it in his 2009 book, Too Big To Fail, acquirers wanted "Jamie" (J.P. Morgan CEO Jamie Dimon) deals whereby the government would guarantee the most toxic assets of companies being purchased.

Absent the subsidized buyout of Bear, there would have been no presumption of a government role as savior of any financial institutions, thus a more realistically priced market for banks in trouble. It should also be said that if Bear Stearns had been allowed to implode naturally, its doing so would have forced Lehman and others to act more quickly to find capital or a buyer to avoid the same fate.

According to Sorkin (p. 241) Dimon was certain that Lehman Brothers would not be bailed out, but that wasn't the general market consensus. In the days leading up to Lehman's bankruptcy, New York Fed President Timothy Geithner asked Lehman CEO Dick Fuld to resign from the New York Fed's board, and it was assumed by some that a bailout was in the works; Fuld being on the board a conflict of interest that would make Geithner's presumed actions in saving Lehman appear unseemly (Sorkin, p. 271).

The media were similarly unclear about what to expect. Though Treasury Secretary Henry Paulson had leaked his hardened stance against the venerable investment bank's bailout, media accounts the following day suggested a great deal of governmental ambiguity (p. 285). Though there was no expectation of a Bear Stearns-style bailout, it was not expected in the press that Lehman would simply be allowed to go under.

Harvey Miller, Lehman's bankruptcy lawyer at the time in question, was of the mind that a Lehman bankruptcy was "not in the forecast" (p. 307). Peter A. Cohen, Fuld's predecessor as CEO of Lehman was apparently so confident that a bailout of some form was in the works that he kept his hedge fund's assets inside the firm (p. 394). Lehman Europe alone, at the time of the firm's bankruptcy, held $40 billion in client assets which suggests once again that the markets to varying degrees expected the government to step in.

Considering all-important market signals, Wallison noted in his November 5 speech that before the brutal weekend in which Lehman Brothers filed for bankruptcy, the spreads on Lehman credit default swaps (CDS) "blew out, indicating that despite Lehman's deteriorating condition, those who were seeking to protect themselves against Lehman's failure were finding ready counterparties in the CDS market." As Wallison put it further, "Thus, when Lehman filed for bankruptcy, the markets were shocked. The result - hoarding cash and freezing lending - was the rational response to a sudden realization that the world's governments were not going to rescue all large firms."

What the episode teaches us is that while markets can ably prepare for and weather all manner of calamities, what they handle badly are opaque government policy stances whose changing nature causes information vacuums and panics like that of October 2008. Had Bear Stearns' collapse been allowed to occur absent governmental distortions, there'd quite simply be no subsequent Lehman panic resulting from investor expectations of a bailout being dashed.

Indeed, as we found in the aftermath of a Lehman bankruptcy that was painfully distorted by government ineptitude, all the talk about "interconnected" financial institutions bringing each other down through an outbreak of "contagion" was just talk. As Wallison pointed out in a May 2010 paper, within a month of Lehman's decline, "all of the CDSs specifically written on Lehman were settled through the exchange of approximately $6 billion among hundreds of counterparties." If Lehman's death didn't bring down the financial markets, that of Bear Stearns certainly couldn't have.

Hindsight is always 20/20, but the true financial crisis was not the bankruptcy of one or many investment banks. Instead, the crisis began with the bailout of an investment bank (Bear Stearns) that should have been allowed to go under. After that bailout the markets were even less prepared for what was ahead.

What Lehman wrought. The difficulty today, and one that assuredly brings with it negative global economic implications, is the sad and simple truth that Lehman's demise is still so misunderstood. Given the false consensus that Lehman was the proverbial game changer that put the global economy on its back, there's no remaining stomach to let any major financial institution fail on the part of elected officials whose jobs must be won with each election cycle.

One negative result of this is that overextended governments are protected against the positive discipline from the markets telling them to spend and borrow less. Greece's bailout is an unfortunate signal from other governments that even the government of a very small country is "too big to fail." Healthy incentives on the part of other countries teetering on the edge of default to reduce their levels of spending are chilled. This at first glance points to continued capital consumption by governments not forced to suffer the consequences of their profligate actions. Less capital is left for the private sector where true wealth creation occurs.

Failure is a necessary condition for success. As for the global financial institutions whose survival would be threatened by an allowance of government default, the economy loses there too. Taking nothing away from the impressive dynamism of the financial sector, it's apparent from the myriad bailouts of banks within it in modern times that, absent government protection, the financial world would look quite a bit different. Put simply, political unwillingness to apply market forces to the business of finance means that its long-term health and dynamism is in fact reduced.

Looking at the computer industry, it's arguably been the most vibrant of any over the last 40 years.  There we should remind ourselves that the industry has been built on constant failure. How unfortunate then that the financial industry hasn't benefited from similar churn that, if allowed, would surely make it even more profitable and useful to a world heavily reliant on finance.

Also unknown is how many individuals will never achieve their greatest wealth-creating comparative advantage in the global marketplace thanks to a financial world that is so heavily protected from the consequences of its mistakes. In this case the "unseen" must be considered, as in how much has the world's economy lost thanks to continued government support of an increasingly misshapen financial sector that presumably misuses a great deal of human capital? No doubt many individuals presently working in finance would find much more productive pursuits if their industry were allowed to benefit from the repeated creative destruction that has animated computers.

Conclusion. Recent headlines advertise a coordinated rescue of a Greek government that is unable to stay current on its debt obligations. That's a gross misreading of what's afoot.

In truth, the Greek story was a hidden bailout of large financial institutions throughout Europe and elsewhere that have exposure to Greek debt, and that would be pressed or rendered insolvent if Greece's government were allowed to default on its debt. Saving the banks is said to be justified by the market troubles that occurred in the aftermath of Lehman Brothers' bankruptcy.

What's missed is that the market troubles that occurred in concert with Lehman's demise were not a function of a change in policy that said it shouldn't be saved; rather it was the direct result of policies designed to save vulnerable financial institutions. Absent these policies, free markets would have been better prepared for Lehman's collapse. While painful for those involved, putting a poorly managed institution out of its misery would have signaled an economy on the mend.

Fear of another Lehman at present holds the world's economy hostage. Due to a broad misunderstanding among policymakers over why the Lehman Brothers bankruptcy was such an earthshaking market event, there's a growing belief inside the political class that no governments, and no major banks, can be allowed to fail.

This is terribly unfortunate. Failure is a sign of capitalism working, and it is what authors progress. The global economy will not grow as fast as it should so long as policy is in favor of saving wasteful governments, and by extension, badly managed financial institutions.

"Too Big To Fail" was a wrongheaded policy on its best day, and at present it's slowing the natural evolution of the global economy. It's well past time to move on from Lehman Brothers and other government-authored struggles of 2008 in favor of freedom both to succeed and to fail. Our economic advancement depends on just such a policy change.