There has been a lot said about the global financial crisis (GFC) and the subsequent recession. Some good. A lot of it quite bad. One of the better overviews of the GFC was done by Stacey & Morris. I think it’s important to directly address some of the confused arguments about the GFC and show why they’re not correct.
One commonly repeated idea is that the financial markets went in a spin because of the collapse of Lehman Brothers. This talking point generally goes on to suggest that the government should have bailed-out Lehman Brothers and should always bail-out delicate businesses otherwise you will get such a collapse. Not true.
First, it needs to be noted that it was the bail-out culture that lead Lehman Brothers (and other businesses) to not accept non-government solutions. Lehman Brothers rejected a takeover offer because they thought they could wait for a better one.
But more to the point, it is simply untrue that the Lehman collapse lead to the financial market problems. The problem is question is the rise in the money market interest rates (the Libor-OIS spread which measures risk assessment). In August 2007 this jumped from 0.1% up to about 0.8%. This was the start of the financial problems.
When Lehman collapsed (15 Sept 2008) the Libor-OIS spread ticked up to about 1%, and then shifted up to about 1.3% over the following days. Then on the 23rd of September 2008, a week after the Lehman collapse, the Libor-IOS spread suddenly shot up until it hit 3.5% in mid-October.
What happened on Tuesday 23 September that caused the change? Certainly not the Lehman collapse. Markets adjust to new information and the Lehman information was old. It is hard to believe that market players were sleeping for a week and then woke up on Tuesday morning and suddenly exclaimed “damn, Lehman collapsed, why didn’t anybody tell me?”
What did happen on that day is that Bernanke & Paulson testified at the Senate Banking Committee about their “rescue package”, asking for $700 billion and only providing a 2.5 page piece of legislation with no mention of oversight and few restrictions on the use. This seems to indicate that it was an increase in political risk that caused the financial market troubles. This is the conclusion from John Taylor, who provides further evidence in his book ‘Getting Off Track’.