The Global Economy Hasn't Recovered Since Lehman

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As is typically the case, the government sprang into action after the worst had been done. Having eschewed all the escalating warnings for nearly two years on the advice of the “right” people, those same would be left in position to help write the history. In the spring of 2009, after three massive waves of global liquidations had shaken the world’s economy in ways it hadn’t felt in four generations, Congress was busy. Among the bills put forward was one sponsored by Senate Judiciary Chairman Pat Leahy (D). It was fitting, in a way, that this one would come from that particular Committee.

The Fraud Enforcement and Recovery Act of 2009 would link together two elements crucial to what everyone was pushed into believing was the way out – fraud and recovery. The main points of the law were twofold. First, it would expand the definitions of financial fraud by expanding the definition for “mortgage lending business” under 18 U.S.C. § 27. The next Countrywides will not be able to subprime the same way.

The second purpose of the fraud act was the creation of the Financial Crisis Inquiry Commission (FCIC). This would be the federal government’s official word on the whole devastating affair.

It has now been ten years since Lehman Brothers. I’m not sure anyone before that fateful weekend in September 2008 was aware of Lehman. I was but for very different reasons. In the days before the internet was fully populated, Lehman used to publish some very good research often worth the wait for it to arrive in the mail. Ironically, most of it was focused on fixed income markets.

In the end, it was fixed income that would be the investment bank’s downfall. Not in the way most people conceive of the bond market, of course. Things were very different in the way they happened, next to nothing of what is ever included in Economics or even Finance textbooks. These were the strange “shadow” developments that though they existed in the shadows weren’t ever so totally blacked out. Ignored is more like it.

In fact, some of the first references I ever saw to things like repo came in those Lehman research reports. More than most, they were aware of, and factored for, some of the ways funding markets had changed. And it didn’t do them any good when the time came.

The FCIC would spend an entire year investigating 2008. It would hold 19 days of public hearings, interview more than 700 witnesses, and review “millions of pages of documents.” Perhaps, but they obviously weren’t the right ones.

The final report was issued in January 2011. Six months after its publication, the crisis board was still in the news and for all the wrong reasons. At the last minute, a scheduled July 2011 meeting between Representatives and members from the FCIC was canceled. Instead, Democrats in the House released a 37-page report on how they believed Republican Commissioners were using their positions on the council to undermine Dodd-Frank.

Indeed, there had been dissent from the very beginning. No government effort will ever be free from politics. Nor will any investigation about the past be limited to the past; each inquiry will always be put together with an eye toward influencing the future. The FCIC was no different, with various political forces attempting to guide its conclusions in a specific partisan direction.

For example, these Republican Commissioners, Vice Chairman Bill Thomas and Commissioners Keith Hennessey, Douglas Holtz-Eakin, and Peter Wallison in December 2010 released what they titled a “financial crisis primer.” The first words in it were, don’t laugh, “Bubbles happen.”

The battle lines were drawn long before Lehman. The Republicans were going to defend what they saw as free markets while the Democrats were going to demonize them and use the crisis to force greater regulations. Neither side, in the end, cared all that much about what really happened.

In the published report, the one put forward by the Democrat majority, the word “Lehman” appears 556 times. That would be expected, the failure of this one particular firm was the proximate cause for the catastrophe that followed. Likewise, “Bear Stearns” shows up in 218 instances. Appropriate.

As was the 377 references to “Federal Reserve.” Only, most of these were not as harsh as you might imagine. The US central bank, we were always told, had guided the US financial system with what had been characterized before Lehman as expert skill. Alan Greenspan had been its “maestro” and his successor, Ben Bernanke, had written what many in Economics still declare the definitive book (papers) on the Great Depression.

With such monetary genius inhouse for decades, how in the world could the Federal Reserve have let something like this happen? The Commission didn’t seem all that eager to find out.

Ben Bernanke, as Chairman, testified, obviously, before the FCIC. One particular statement struck a particularly noteworthy chord. So much so, the Commission added it to the opening paragraph of what should have been a particularly interesting section of the report.

“Prospective subprime losses were clearly not large enough on their own to account for the magnitude of the crisis. Rather, the system’s vulnerabilities, together with gaps in the government’s crisis-response toolkit, were the principal explanations of why the crisis was so severe and had such devastating effects on the broader economy.”

It was an interesting bit of testimony from the man who once told Congress, paraphrasing, subprime was contained. What Bernanke was saying, if you wanted to understand him, was that he came to realize it wasn’t really about subprime at all. But only after Lehman.

This tidbit was added in the report’s segment dealing with “shadow banking.” To its credit, the FCIC at least included commercial paper and repo. In other words, even the Democrats were following along in this monetary evolution, the one where the “banking” system transformed from deposit funding to wholesale techniques.

But, and you knew this was coming, they never really grasped what that meant. Not really. In the final report, commercial paper and repo were the only shadow elements discussed, as if that was their full extent, and even then they were sort of glossed over. Yeah, it was complex stuff and different, and then it failed. The end.

There was no depth to this critical piece of the autopsy.

In attempting to defend what they saw as “free markets”, the Republican Commissioners went to some length to show that the Great Financial Crisis was not an exclusively American event. Therefore, they would conclude, what good would excessive American regulation do for the future?

“The majority says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis.”

Exactly. The panic wasn’t Wall Street, it was Lombard Street. German banks were being nationalized because of how they funded US fixed income investments, all in dollars. They were borrowing through and around Lehman, as well as Bear, and any number of others. AIG was providing many foreign institutions with credit default swaps not for hedging but regulatory capital relief.

The FCIC report spends some time on AIG, and credit default swaps, but doesn’t mention the actual way in which they were used and toward what ends.

In the official report, the one prepared by the majority, the word “eurodollar” doesn’t appear even once. Zero times in more than 660 pages (including appendices and introductions). Not even in relationship to LIBOR, which is referenced only six times; one occasion in the regular discussion, four in footnotes, and one more as an entry in the glossary.

And, believe it or not, the FCIC’s glossary definition of LIBOR doesn’t bother to mention “eurodollar”, either. It is a curious omission, and a glaring one, given both that LIBOR was central to the global aspect of the crisis and is itself a eurodollar rate. All the FCIC would officially say in its description of LIBOR’s was that it is “an interest rate at which banks are willing to lend to each other in the London interbank market.” Cute. Lend what, exactly, in London?

While it may seem like I am praising the Republican version, I am not. To be clear, it may have been a little further ahead, in the end it still meant nothing. The word “eurodollar” doesn’t appear in theirs, either. They don’t even mention LIBOR though they correctly identify the “global nature of the crisis.”

Neither one goes into the real shadows, the offshore money system. Among the more than 1,100 pages that in both versions make up the official account of the Great Financial Crisis of 2008, there are together zero instances of the words “offshore” and “eurodollar.” Pace Bernanke, how then could something like subprime turn into a massive global disruption? Without eurodollar and offshore, you have no idea.

This will continue to be our downfall. In the ten years since Lehman failed “we” don’t really know why it failed, nor does anyone really appreciate the ramifications. The official FCIC report refers to “subprime” 784 times.

As far as the public goes, the 2008 crisis was a US housing bubble propelled by greed and risky mortgages. Those were but symptoms of something else altogether, an aspect of monetary evolution Economists and politicians just will not tackle voluntarily.

For Economists, anyway, the reasons are simple. To admit the existence of the eurodollar would be to undermine the very thing they’ve spent their lives working toward. Each and every DSGE model, those that are at the heart of econometrics, would be rendered obsolete, made invalid by an unrestrained exogenous monetary input. To acknowledge eurodollar and offshore would be to put modern Economics back on Square One.

For this we suffered Lehman and all that has followed.

Of the few who have noticed, Alan Greenspan was about the only one who worried about the drastic changes. I’ve chronicled his fretting many times over the years, but it bears repeating yet again especially in this context:

"The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition."

In the same FOMC meeting all the way back in June 2000, Greenspan also said something that would’ve ten years forward saved the FCIC from the majority’s 663 pages of worthless regurgitation plus the 439 pages of dissent that only went the smallest fraction beyond useless.

"This is not to say that money is not relevant for the economy. For a central bank to say money is irrelevant is the deepest form of sin that such an institution can commit.”

But that’s exactly what the Federal Reserve did. They committed just that sin, and Lehman was the inevitable result. By being unable to define modern money, they were blind to all of its proliferations, not just into wholesale techniques way beyond commercial paper and repos, but also how it had long ago erased international boundaries.

Greenspan’s Fed had come to the uneasy conclusion that it didn’t matter; in their view they had no alternative. They would move one single wholesale rate, federal funds, a quarter point here or there thinking that was enough control such that the US central bank, the nation’s presumed monetary steward, would never have to define money at all. It all seemed to work, but only so long as the eurodollar system kept expanding offshore.

Once it stopped doing that, “…the system’s vulnerabilities, together with gaps in the government’s crisis-response toolkit, were the principal explanations of why the crisis was so severe and had such devastating effects on the broader economy.”

What’s changed since Bernanke gave that testimony? Nothing. Those vulnerabilities remain, as do the intellectual gaps responsible for the sparse toolkit.

Quantitative easing, for example, has proved one thing very well: central bankers are incapable of appreciating both what they don’t know as well as how that might cost the global economy everything. Not only did the Fed try QE four times to no effect, that they attempted it at all (particularly after Japan’s experience with it) shows this corrupt nature of modern Economics as applied in this central monetary setting.

The Federal Reserve’s correct response to Lehman’s failure, if not Bear’s, if not the commercial paper market on August 9, 2007, would have been to undertake the most exhaustive and determined investigation into the very thing Alan Greenspan had worried about years earlier. They should have charged right into the shadows, all the way in, and attempted an earnest and honest investigation so as to understand all these monetary proliferations. That was their job!

They still might not have succeeded in time, but it’s the only thing that could have.

The Financial Crisis Inquiry Commission, for its part, should have been the safety net which would have caught the Fed in these lies. How could it have been a global breakdown? How can it still be one? The most striking and strikingly visible piece of the mountain of crisis evidence was the obvious chasm between LIBOR and federal funds; offshore eurodollars and onshore. Had the FCIC really been doing its job, subprime would’ve merited zero mentions and eurodollar those 784, if not more.

Bernanke was right in his testimony about this one thing, only in linking together how it wasn’t really subprime that then devasted the broader (global) economy. The monetary system was the culprit, eurodollar and offshore, and if it was never fixed because it was never once fingered then might it still be wreaking economic devastation today?

For Republicans, the answer is, since January 20, 2017, a solid “no.” They’ve got the unemployment rate in the US under 4% and so how about a return to “decoupling?” Even Democrats are now afraid to challenge that one data point, with former President Obama recently getting into a schoolyard shoving match with current President Trump as to who created this supposedly awesome economy. They’re both wrong, deliberately blind just like both sides of the FCIC.

If only it had mentioned eurodollars. The ECB, one among a growing list, yesterday recognized what has been building all year despite this so-called US boom. The economic risks have shifted all toward the downside, reflecting what many markets have been saying for months now. Most prominent among those, the eurodollar futures curve is today even more inverted than it was at the beginning of this week despite last week’s payroll (wages) report.

And that inversion is happening at an extremely low nominal level, suggesting, still, the global economy never recovered despite a decade since Lehman showed the world what was really wrong. The only thing that has changed this year is the same thing that changes each and every time we repeat this Lehman-like direction: the dollar. The offshore eurodollar, that is.

The FCIC buried subprime. Good for them. Ten years after Lehman, that’s still the biggest fraud. 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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