Five years after the Lehmann incident : Part 1

For most people the collapse of the American investment bank, Lehmann Brothers, in September 2008 was the start of the North-Atlantic financial crisis owing to the highly visible impact it has had on financial markets. In actual fact the crisis started in 2007, although initially it was of low intensity, which at first made it go by unnoticed.

During the past month we celebrated the fifth anniversary of the Lehmann bankruptcy and it is therefore an opportune time to ask ourselves what the legacy of the crisis has been. In the first part of this two-part article we review some aspects of the situation in the crisis countries, while the second part will focus on the impact of the crisis on South Africa.

The first obvious issue is that we still do not have a single, integrated, generally accepted storyline of the events of 2007 to 2009 and the causes thereof. It is understandable that people will seek a simple answer amid so much complexity, but simplicity should not stand in the way of the truth, otherwise the solutions offered will not be in line with the root causes of the crisis.

Unfortunately, people’s ideological blinkers cause them to be selective in that they choose the storyline that fits their ideological position and close their eyes to what does not suit them. Too little attention is given to the difference in the causes of the crises in various countries, resulting in gross generalisations. As the saying goes: Why let the facts spoil a good story!

The proponents of a leading role for government in the economy see the failure of markets and the misconduct of market participants as the exclusive causes of the crisis. For them the solution therefore lies in more and stricter regulations, with the implicit assumption that regulators will fulfil their task with due diligence, while apparently they are not too concerned about the risk of unintended consequences.

However, they forget that market participants are not puppets that respond mechanically when their masters pull the strings. Market participants will respond rationally to changed incentives, e.g. by ceasing all activities that are no longer profitable, regardless of the wider implications for the economy, or they can move their business to institutions and locations that are not regulated as strictly (so-called regulatory arbitrage). It should be noted that shadow banking, which was at the heart of the crisis, has grown exponentially over the past five years, setting new challenges for regulators.

On the other hand, the proponents of a free-market economy seek the causes in regulators who did not do their job, political meddling in the allocation of capital (specifically the promotion of home ownership among low-income groups), macro-economic imbalances caused by government policy in more than one country, and an irresponsible slack monetary policy with continued low interest rates that compelled investors to seek higher returns elsewhere, with the result that risk was priced too cheaply. These proponents are looking for the solution in the recovery of market forces that should be allowed to take their course once stability has been reestablished.

The truth is that both parties have a point. The causes of the crisis are to be found in a variety of convergent factors, with financial institutions, regulators and politicians all contributing to the development of the crisis. The common factor is the reaction of people to relevant incentives and their inability to keep pace with a rapidly changing financial environment. This requires an integrated storyline that will inevitably be very complex.

People react to incentives, and it is not only the incentives for market participants that should be questioned, but also those for politicians and regulators. For example, investors have been accused of focusing too much on short-term results, but what about politicians who make policy decisions in order to improve their chances of re-election? And who will supervise the regulators to ensure they perform their duties, given their proven laxity in enforcing regulations in the past?

However, the spate of new regulations that have already been introduced is an indication that the anti-market supporters are winning the battle so far. Resistance to the so-called financialisation of the economy continues and we have yet to see how it all ends.

The second problem that has not yet been resolved is that of financial institutions that are too large to be allowed to fail. In fact, this problem has been exacerbated by the take-over of weak institutions by profitable ones, often at the insistence of the authorities. The obligation imposed on large, systemically important institutions to draw up a so-called living will in which they set out how they plan to systematically terminate their activities in the event of bankruptcy, without disrupting the financial system, has not yet been put to test.

It is an open question whether an institution that is indemnified against bankruptcy belongs in the private sector – after all, market discipline is an integral part of the functioning of capitalism. Breaking up large institutions into smaller units is not necessarily the right answer. An enormous, integrated, growing global economy requires large, complex institutions to support it, while in any event systemic risk will not necessarily be reduced. A better solution might be to internalise the potential cost of state aid by collecting from institutions an appropriate premium for the insurance they enjoy. Otherwise the moral hazard problem will continue to haunt policymakers.

A third issue is the inability of policymakers in the crisis countries to bring about a sustainable recovery in economic growth and employment. To a large extent dysfunctional political systems can be blamed for this inability, but it is also a reflection of how long it takes balance sheets distorted by excessive debt to recover. Long standing structural problems which were neglected in the past have also come back to haunt the policy establishment.

Steps to lower debt levels can put a dampener on demand in the economy for a long time, as can the lengthy process of getting rid of surplus capacity caused by overinvestment. It is ironic that while excessive credit extension was one of the causes of the crisis, efforts to stimulate the economy put so much emphasis on the recovery of credit flows at a time when the demand for credit is muted.

There is also still uncertainty about whether the central banks concerned will succeed in terminating their so-called quantitative easing policies in an orderly manner. We recently had a foretaste of this with increased volatility in markets. A continued slow recovery therefore probably lies in store for the crisis countries, with negative implications for the rest of the world.