Rogoff: The Fault Lies Not in Lehman, But in Ourselves…

Well, Ken Rogoff does not do a Shakespearean turn, but he makes a badly needed observation in his latest piece at Project Syndicate, namely, that pinning a lot of blame for the crisis on the Lehman collapse is a faulty analysis. And he picks up a pet theme of ours, that patching up the system is not a viable long-term solution.

From Project Syndicate (hat tip Mark Thoma):

The overwhelming consensus in the policy community is that if only the government had bailed out Lehman, the whole thing would have been a hiccup and not a heart attack..

Yves here. If that is what the policy crowd that Rogoff hangs with really believes, the are even more deluded than I realized. Back to his article:

Unfortunately, the conventional post-mortem on Lehman is wishful thinking. It basically says that no matter how huge the housing bubble, how deep a credit hole the United States (and many other countries) had dug, and how convoluted the global financial system, we could have just grown our way out of trouble….

It was not just Lehman Brothers. The entire financial system was totally unprepared to deal with the inevitable collapse of the housing and credit bubbles. The system had reached a point where it had to be bailed out and restructured. And there is no realistic political or legal scenario where such a bailout could have been executed without some blood on the streets. Hence, the fall of a large bank or investment bank was inevitable as a catalyst to action.

The problem with letting Lehman go under was not the concept but the execution. The government should have moved in aggressively to cushion the workout of Lehman’s complex derivative book, even if this meant creative legal interpretations or pushing through new laws governing the financial system. Admittedly, it is hard to do these things overnight, but there was plenty of warning. The six months prior to Lehman saw a slow freezing up of global credit and incipient recessions in the US and Europe. Yet little was done to prepare.

So what is the game plan now? There is talk of regulating the financial sector, but governments are afraid to shake confidence. There is recognition that the housing bubble collapse has to be absorbed, but no stomach for acknowledging the years of slow growth in consumption that this will imply.

There is acknowledgement that the US China trade relationship needs to be rebalanced, but little imagination on how to proceed. Deep down, our leaders and policymakers have convinced themselves that for all its flaws, the old system was better than anything we are going to think of, and that simply restoring confidence will fix everything, at least for as long as they remain in office.

The right lesson from Lehman should be that the global financial system needs major changes in regulation and governance. The current safety net approach may work in the short term but will ultimately lead to ballooning and unsustainable government debts, particularly in the US and Europe.

Asia may be willing to sponsor the west for now, but not in perpetuity. Eventually Asia will find alternatives in part by deepening its own debt markets. Within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three. As painful as it may seem, it would be far better to start bringing fundamentals in line now. Restoring confidence has been helpful and important. But ultimately we need a system of global financial regulation and governance that merits our faith.

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  1. David Habakkuk

    One of the things Rogoff's comments bring out are the nefarious effects of the very simplistic conceptions of 'information' used by economists — and their arrogant neglect of developments in the analysis of 'information' in other disciplines.

    So for example economists might profitably learn from the use of the theory of 'speech acts' developed by philosophers including J.L. Austin and J.R. Searle in the seminal study 1999 Ritual and Religion in the Making of Humanity by the anthropologist Roy Rappaport.

    Statements by central bankers — among others — are classic examples of 'speech acts' with what in the jargon is known as 'perlocutionary force'. Such force is exercised, Rappaport explains, when 'an act or utterance persuades, threatens, cajoles (or whatever) some part into taking action.'

    Decisions on investment, saving and consumption are, obviously, influenced by 'rational' calculations based on 'real' factors and by less tangible ones, such as confidence — and 'animal spirits'. The two kinds of consideration are actually difficult to separate, particularly as what it is 'rational' to do depends upon assessments of a necessarily unpredictable future.

    Haunted by the — hardly unjustified — fears of a collapse in confidence leading to a self-reinforcing deflationary spiral, central bankers in particular, and much of the policy community, have increasingly allowed their reports on the economic situation to be shaped by the imperative of persuading people to consume and to invest.

    So, having been seduced by dogmas about the efficiency of markets into allowing a set of fundamentally unsustainable imbalances to develop, policymakers now find themselves incapable of thinking realistically about the least worst ways out of them. They have locked themselves into the world so aptly described by the former William White in his interview with Der Spiegel:

    "'Somehow everybody was hoping that it won't go down as long as you don't look at the downside,' William White told SPIEGEL. 'Similar to the comic figure Wile E. Coyote, who rushes over a cliff, keeps running and only falls when he looks into the depth. Of course, this is nonsense. One falls, because there is an abyss.'"


  2. Siggy

    The effect of the failure of Lehman is symptomatic of the disease. We can argue adnauseam as to whether the failure of Lehman was necessary or even desirable, net, we will arrive at the point that it has occurred and in its occurance we have learned that our system is flawed.

    As Yves would say, 'Quelle Surprise'; I wish the hell I really knew what that means, and in our surprise we might just reflect on the fact that CDS are really a marvelous speculation tool. In that fact alone reasonable men should be able to agree that transactions in CDS need fairly stringent regulation. Failing regulation, CDS can become uneforceable side letters much like those that AIG wrote in its reinsurance contracts affair that resulted in the termination of hank Greenberg.

    I date the onset of our disarray as being circa August 1971. Tricky Dicky led the way and Bretton Woods went poof. Curiously, in winning, DeGaulle lost in that he won. Go figure.

    What we have to examine is our fractional reserve system and the basis of our currency. The Dollar is a reserve currency because ours is the world's largest economy, it also helps that the Arabs agreed to denominate the price of oil in dollars as opposed to gold about the same time as Bretton Woods went poof.

    A further complication is that we have/had ample regulation and law available for 'prompt corrective action', however, our regulatory agencies did not act. And, critically, the body politic was too busy extracting bonuses from the system to notice that we were in a succession of easy money bubbles.

    What Rogoff is pointing to is the fact that our society is either going to work to correct its prior excesses; or, it will crumble into something far more socialistic than our current mixed, free market, controlled economy.

    Econometrics have a place and use, nonetheless, it is ultimately a political economy and the body politic is ultimately responsible. By assent or inaction, you get what you want.

  3. Anon of Ibid

    If they wanted to restore an actual, lasting confidence, then regulation, enforcement, and some real consequences visited on the perps would have done it for the public at large. A false confidence in a financial system that is terminally ill helps not at all. When the next shoe drops (CRE, major bank failure, some event that forces true valuation of assets) and all goes pear-shaped again (as I believe it will), then it will be that much harder to build again, if not impossible. Without rancour or feelings of revenge, I hope it happens while most of the enabling players are still around — only because it should happen sooner rather than later for the good of all.

  4. Hugh

    We did not have a robust financial system which the Lehman bankruptcy unaccountably put at risk. We had a house of cards, a crony capitalist financial system built on Ponzi schemes and bubblenomics. If it had not been Lehman, it would have been something else. This does not excuse how Lehman was handled. It could have been managed much better than it was, but then so could everything else that happened. We are at a classic impasse. We have a financial system that needs to be rebuilt in an entirely different way. However, those with the power and responsibility refuse to do this. By committing the resources of the country to maintaining the status quo, they are keeping the old system going, but it is difficult to see how they or the country can do this indefinitely. In the absence of any new initiatives or changes in course, I see 2010 as a year in flux with wildly countervailing forces at work. But for 2011, I see only depression.

  5. Alfred

    What Rogoff is saying is all good, only its not realistic in a system where a few executives at a firm like Goldman control the whole political apperatus. They shape capital markets and adjust rules if necessary so they will benefit from them. FAS 157-3,4 fair value accounting rules helped Goldman and others to stay profitable amidst a sea of foul mortgage assets. During the third quarter of 2008 GS apllied 6 new accounting rules to its financial statement, in the most recent quarter there were already 17 accounting changes. Former New York AG Spitzer recently declared an end to the democratization of markets. I am beginning to think he is right. In the meantime employment, stock prices are lower where they were ten years ago, all the while Wall Street executives are living it up still pretending to be the masters of the universe.

  6. Anne from Chicago

    The financial system of the United States failed. That one firm (a key rival to Henry Paulson's alma mater) was allowed to see its failure fulfilled is an interesting twist of fate for those who worked at Lehman.

    We reached a point in capitalism where the only thing that saved the entire financial system of the richest capitalist nation in the world was government intervention.

    Another interesting twist in the capitalist narrative.

    Moving forward, what do we see? Goldman's PR machine spinning a tale of unbroken health throughout all this.

    And it's equally interesting that despite what Lloyd Blankfein has publicly stated (last February and April) about compensation being connected to long term (not short term) gains, Goldman has set aside 11 billion for bonuses this year, as reward for the extraordinary profit they've seen in this year of all years.

    So if "the right lesson from Lehman should be that the global financial system needs major changes in regulation and governance," we're a far long way from reaching that goal.

  7. Francois

    "Deep down, our leaders and policymakers have convinced themselves that for all its flaws, the old system was better than anything we are going to think of, and that simply restoring confidence will fix everything, at least for as long as they remain in office."

    Isn't it the kernel of the matter? Those who most benefit personally from the system are the least willing and able to fathom the necessary actions needed to rebuild/modify said system to provide it with robustness and fairness.

    When one looks at the epic rescue of the financial system, there is one extraordinary feature that cannot pass any smell test: the top actors are still in place, their wealth barely affected (by that, I mean they still can live an extraordinary lavish life without problems), and allowed to devise even more creative ways to earn more, more and more.

    Meanwhile, ordinary people all over the country are suffering badly. This constant assault on the very fabric of basic fairness and common sense (for example, bad performers should be fired, not rewarded) in our society will trigger excessive reactions in the direction opposite to what we had for the last 2-3 decades.

    This situation cannot end nicely.

  8. Anonymous

    So where is the inflection point that we can pass so that the crimes (lack of moral turpitude) of the recent oligarchic overloards can be prosecuted?

    I can't live forever.


    word ver says – demiterm

  9. tom a taxpayer

    Who ya gonna call? TRUST BUSTERS! Teddy Roosevelt prosecuted the lawbreakers and reformed the system. We need a TR-like leader with the will and strength to prosecute and reform the corrupt financial system. Unfortunately, we don't have TR, we have PR…reform spin…reform lite…reform sound and fury signifying nothing.
    The regulatory system can use reform, even major reform, but that reform effort would be futile as long as system is run by the reckless gamblers on Wall Street and their hand-picked lackey regulators. The existing regulatory system might even be adequate if we had honest, diligent regulators and sober, prudent bankers.
    The problem is "regulators" like Geithner, then NY Fed President, requesting a waiver for the conflict of interest of Goldman Sachs Director Stephen Friedman continuing as Chairman of the Board of NY Fed that regulates Goldman Sachs.

    The problem is "regulators" like Stephen Friedman, then Chairman of the Board of NY Fed, and at same time, Goldman Sachs Director and big stockholder of Goldman Sachs, claiming he had no conflict of interest in regulating Goldman Sachs.

    The problem is "regulators" like Geithner and Friedman insuring that William Dudley, former Goldman Sachs executive, got Geithner's job of NY Fed President. Stephen "no conflict of interest" Friedman was chairman of the search committee, and Geithner lobbied the NY Fed to appoint Dudley as NY Fed President.

    The problem is "regulators" like Hank Paulson waltzing from Goldman Sachs CEO to U.S. Treasury Secretary, and then, when the opportunity presented itself, proceeding to wipe out Goldman Sachs competitors Bear Stearns and Lehman, to save GS from billions in counterparty risk at Fannie, Freddie, and AIG, and to allow the Goldman Sachs family and friends to control key positions at the U.S. Treasury and to advise him on how best to "regulate" the enrichment of Goldman Sachs.

    The problem is "regulators" like U.S. Treasury Secretary Geithner who can not be expected to investigate and prosecute NY Federal Reserve Geithner for the dirty deals he made with AIG, Bear Stearns/J.P.Morgan, Goldman Sachs, etc.

    The problem is "regulators" like U.S. Treasury Secretary Hank Paulson who can not be expected to investigate and prosecute Goldman Sachs CEO Paulson.

    The problem is "regulators" like Geithner and Paulson having bald-faced, screaming conflicts of interest which should have disqualifed both from serving as U.S. Secretary of Treasury.

    We need to replace Geithner and the rest of Wall Street's lackey regulators with a few honest men and women.

  10. Anonymous

    Remember the reaction to Greenspan's mild "irrational exhuberance" caution? Or what it took for unions to accept losses of power and money?
    Only crisis allows reform. The bigger the crisis, the bigger the reform, and we need far more than reform. Because, in addition to all the financial problems Rogoff mentions we have peak oil and environmental catastrophe approaching. What is necessary is not just reform of the present system – because the current recession has revealed its absolute dependence on unsustainable growth – but a massive slaughter of two thirds of humanity. What would it take for anyone in power to openly propose that? What kind of power would it take to accomplish such a thing without destroying all of humanity and rendering the planet uninhabitable?

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