Did Lehman Save America from a Dollar Collapse?

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 (LEHMQ.PK), 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

Comments

[Leftfield:]

So, "the pressure on fincancial institutions was only going to increase" absent a Lehman-type trigger. That "the political system was unlikely to provide the necessary resources and action without a major scare."
I don't see how the necessary resources can be provided. Continued mega-failures seem imminent. Putting them all on the failing US balance sheet is a moon shot that is being attempted without change or reform of the worst of them.
Looks to me like Lehman came years/decades too late and that sanity has yet to appear in public policy.

Aug 13 07:11 AM

[morph366:]

As you say it is always difficult with counter-factuals so while it may be interesting to contemplate the idea that "Lehman saved America from a dollar collapse.", it is more likely that the massive unwinding of the carry trade and repatriation of dollars to shore up troubled US balance sheets was already in motion before Lehman collapsed and that plus the safe haven dynamics rescued the $

My own suspicion is that the events of last fall will lead to a continuing erosion of confidence in the dollar, but it will be a much more protracted event rather than a crash

Aug 13 08:02 AM

[chap08:]

"Saving America from a dollar collapse" is an oxymoron. A collapse, or long term decline, in the dollar is a necessary condition for whatever long term recovery is possible. A collapse against other currencies will be difficult to achieve, but a collapse against goods, services and hard assets (i.e. inflation) will happen.

Aug 13 08:33 AM

[Gregman2:]

What you're suggesting is that letting Lehman get broken up simply deferred the inevitable?

Aug 13 12:37 PM

[Dave Wrixon:]

As there is not going to be a collapse of other currencies against such goods then a collapse against other currencies is inevitable. Dollar Pegs are just not sustainable unless other countries wish to be dragged down to Hades as well.


On Aug 13 08:33 AM chap08 wrote:

> "Saving America from a dollar collapse" is an oxymoron. A collapse,
> or long term decline, in the dollar is a necessary condition for
> whatever long term recovery is possible. A collapse against other
> currencies will be difficult to achieve, but a collapse against goods,
> services and hard assets (i.e. inflation) will happen.

Aug 13 01:50 PM

[deskjock:]

other countries injecting their own stimulus by printing more of their own currency DELAYED the dollar's collapse. it is still coming though.

with Geithner now asking Congress to increase the debt limit, and with only a small portion of the stimulus money being printed, the dollar collapse is still in the horizon.

those who say otherwise could simply be fooling themselves.

Aug 14 02:08 AM

[deskjock:]

to add to this, Hillary's visit to China and holding a "secret" meeting with the Chinese to reassure them of their dollar/debt holdings are probably loaded with more promises of opening US markets to Chinese products which would surely inflate the trade deficit more.

so in essence, we are printing money to send it overseas again without building anything of value within the country.

printing more dollars, inflating the trade deficit, increasing taxes (Bush tax cats ends in 2010), pushing for more costly social programs....what could go wrong for the dollar?


On Aug 14 02:08 AM deskjock wrote:

> other countries injecting their own stimulus by printing more of
> their own currency DELAYED the dollar's collapse. it is still coming
> though.
>
> with Geithner now asking Congress to increase the debt limit, and
> with only a small portion of the stimulus money being printed, the
> dollar collapse is still in the horizon.
>
> those who say otherwise could simply be fooling themselves.

Aug 14 02:14 AM

[jimboy:]

Letting Lehmans go under was about the only thing the authorities did get right. If they'd had the guts to allow the lot to go down (including the sainted Goldmans, which would have failed but for the AIG bail-out) America and the World would have had a deep, cleansing recession and by now we could be looking to forward to genuinely rebuilding the economy instead of a phoney recovery.

Aug 14 05:34 AM

[Crocodilian:]

That Lehman went under was salutary, precisely because it was so scary and so painful. Following the LTCM rescue, the market drove down risk premiums to dangerous lows, based on the moral hazard of the "Greenspan put"

If investors conclude that they cannot lose money, then they will take too much risk, and increase the risk profile of the system as a whole beyond what is optimal.

Lehman induced losses effectively reintroduced the pricing of systemic risk into the system, and that's a good thing.

Aug 14 06:00 AM

[Maxe Paul:]

"Did Lehman Save America from a Dollar Collapse?"

I dont realy understand the question. The collapse of Lehman was inevitable, the rally in the US$ was inevitable.

Maybe you should ask, "Did the US$ cause the collapse of Lehman?"

Aug 14 06:25 AM

[storm999:]

Since you say post-Lehman a comprehensive policy was put in place, I the take gist of your argument to be that if Lehman had been bailed out, someone else would have been allowed to fail and comprehensive policy would have been put in place.

Aug 15 04:46 PM

[Nicola:]

Lehman didnt save America from Dollar Collapse the goverment should save lehman and let her recover again, This bank is one of the important instittution in the world
Jesus bless you all

Nicola CEO(LordMovie.com)

Aug 18 02:10 AM