The prevailing narrative is that the failure of the federal government to bail out
Lehman triggered a global financial panic. Only massive government intervention
prevented a second Great Depression.
There are important and persuasive dissents from the prevailing narrative. The most
prominent and persistent dissenter is Stanford economist John Taylor.
Taylor, in his book "Getting Off Track," painstakingly demonstrates that the
interest rate spreads between safe and riskier debt didn't actually increase after
the Lehman bankruptcy. The spreads didn't really begin to increase until Treasury
Secretary Henry Paulson and Fed Chairman Ben Bernanke began running around with
their hair on fire, claiming that unless Paulson was given hundreds of billions in
bailout funds and Bernanke cranked up the printing presses, we'd all be standing in
This alternative chronology was further documented in a Wall Street Journal column
this week by John Cochrane and Luigi Zingales, business school professors at the
University of Chicago.
The subsequent frenzied federal activity was supposedly to respond to a credit
"freeze." After the Paulson-Bernanke panic, interest rates did spike. But, for the
most part, they didn't get much, if any, higher than they were in 2006 and 2007,
when no one was running around with his hair on fire. And they quickly subsided.
Promoters of the prevailing narrative say this was because markets became confident
that the federal government would do whatever was necessary to keep finance flowing.
But that's hard to credit. At first, the federal government resembled the Keystone
Kops to the rescue.
Congress balked at giving Paulson his $700 billion. The stock market tanked. Then
Congress approved the $700 billion. The stock market tanked again.
Paulson first said he would use the money to buy distressed debt securities. Then he
said he would instead use the money to force feed capital to banks, including banks
that didn't want it and which Paulson declared to be healthy.
In any event, it's hard to see the evidence of a credit freeze. Consumer debt did
decline slightly in the 4th Quarter of 2008. Business debt, however, increased.
Consumer debt actually declined more rapidly after the Fed began pouring liquidity
into it. Businesses and consumers were retrenching primarily because of the
recession, not because no one would lend them money.
Taylor says that the Fed, which did crank up the printing press, mistook a lack of
confidence in the credit worthiness of counterparties for a liquidity crisis. That
would suggest that selected government guarantee programs would have been
sufficient, without Paulson's bailout stash and Bernanke's extraordinary monetary
The guarantee programs, for instance covering money market funds and bank borrowing,
were successful. They didn't end up costing the government a dime. In fact, the
government made money on the programs from the fees it charged for the guarantees.
The first bailout that was made post-Lehman, AIG, looks increasingly unwise. The
bailout mostly allowed its debt insurance clients, such as Goldman Sachs, to avoid
taking a haircut they deserved for imprudent investments. The government declaring
AIG a sick bird, however, caused an exodus of its traditional insurance customers,
leaving the entire company an irredeemable mess.
There's a tendency to give the rescuers the benefit of the doubt. Many very smart
people thought the economy was on the precipice. Now it isn't. So, it was better to
be safe than sorry.
But the costs of the massive federal intervention are just now coming due. The
federal government, which was always a long-term fiscal wreck, is now a short-term
fiscal wreck. Bernanke's extraordinary monetary expansion has to be unwound without
debasing the currency and unleashing inflation. Since the flight to safety and the
dollar abated around March, the dollar has lost 17 percent of its value compared to
Meanwhile, the Lehman bankruptcy proceeds. It's a protracted, painful and expensive
That would be a highly salutary lesson about the costs of excessive risk-taking.
Except that the prevailing lesson is that the government should have bailed it out