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Counterfactuals are tricky things, and Wednesday Kenneth Rogoff addresses perhaps the juiciest one the recent crisis has offered economists: would things have been drastically different had the Treasury not allowed Lehman to fail? Mr Rogoff provides a definitive no:

The overwhelming consensus in the policy community is that if only the government had bailed out Lehman (OTC:LEHMQ), the whole thing would have been a hiccup and not a heart attack. Famous investors and leading policymakers alike have opined that in our ultra-interconnected global economy, a big financial institution like Lehman can never be allowed to fail. ...

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. Patch up Lehman, move on,... and nothing bad ever need have happened.

The fact is global imbalances in debt and asset prices had been building up to a crescendo for years, and ... there was no easy way out. The United States was showing all the warning signs of a deep financial crisis long in advance of Lehman...

It seems fairly clear that the world was in for a serious downturn no matter what transpired in September. A major oil price spike had already occurred. The housing crash in America had already done enough damage to bank balance sheets that the solvency of many large firms was in question, and as Mr Rogoff mentions, the continued growth in imbalances was going to keep placing pressure on the global economy and financial system.

The question is whether there might have been a less debilitating reckoning given an orderly resolution to Lehman. The financial crisis touched off by the events of last summer drove all correlations to one; good and bad assets alike fell in value, good and bad funds were forced to liquidate assets, good and bad firms experienced falling stock prices, and good and bad workers lost their jobs. The disorderly failure of Lehman sucked liquidity out of the system, placing serious pressure on solvent and insolvent alike. It stands to reason that had a panic been avoided, some unnecessary losses would not have occurred.

But there are two side issues to this hypothetical. Mr Rogoff addresses one:

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.

While many economists were in agreement by last summer that some more comprehensive banking policy was necessary, the political system was unlikely to provide the necessary resources and action without a major scare. Pre-Lehman, every rescue was ad hoc. Post-Lehman, a framework was put in place and capitalized with $800 billion from Congress. It was going to take a scare to get a real policy in place, and so the question may not have been whether but when.

The other side of the matter is the accumulation of structural imbalances. Many of those who were forecasting a financial crisis did so based on expectations of a dollar run. This never materialized; what we saw instead was Lehman and a subsequent flight-to-safety based dollar rally. But in the absence of a panic, could the system have persisted indefinitely, with no dollar run? Perhaps not. Perhaps Lehman saved America from a dollar collapse.

There was a lot of accumulated baggage in the global economy and a recession was a sure thing as of early fall last year. The pressure on financial institutions was only going to increase, and some breaking point was bound to be reached. Ideally, policymakers would have recognized the danger ahead of time and marshaled the resources necessary to identify and resolve insolvency, but in the real world this was not going to happen. A Lehman-ish meltdown does seem rather like a historical inevitability in hindsight.

This article originally appeared on The Economist.com

Source: Did Lehman Save America from a Dollar Collapse?