The State of the Economy a year after Lehman’s Collapse

Some economists ask the question did the Lehman collapse save the financial system? On a Monday morning, one year ago, Lehman Brothers collapsed, the stock market plummeted 500 points and the Panic of 2008 reached a feverish pitch. Conventional wisdom over the last year says that Fed Chair Ben Bernanke and then-Treasury Sec. Hank Paulson made the biggest mistake of their careers that weekend by failing to save the storied investment bank. But what if the conventional wisdom has it backward? What if allowing Lehman to fail was less like an unscrupulous shot to the foot and more like the prudent amputation of the foot to save the patient? Joe Nocera of the New York Times makes the case. Let's evaluate:

“Lehman's collapse, and the panic that ensued, was necessary to convince Congress to pass the $700 billions of TARP money to purchase bad assets from ailing banks, Nocera says. And even if Lehman didn't the fall, another bank, possibly with more assets, would have failed and the ripples would have been even more painful. Here's NYT DealBook summing up his argument:

Mr. Nocera says that almost everyone he's ever spoken to in Hank Paulson's old Treasury Department agrees that without the immediate panic caused by the Lehman default, the government would never have agreed to make the loans needed to save A.I.G. In effect, the Lehman bankruptcy caused the government to panic, which in turn caused it to save the firm it really had to save to prevent catastrophe.

Look at that first sentence again. "Almost everyone (Nocera's) ever spoken to in Hank Paulson's old Treasury Department agrees" ... that Hank Paulson's old Treasury Department did the right thing. I'm sure they do! But that's not exactly non-biased testimony, is it?

I'm not sure I see much evidence for Hank Paulson's old Treasury Department self-serving claim. Consider the timeline of the AIG bailout. On September 16, Moody's and Standard and Poor's downgraded AIG's credit rating. The next day, the government offered AIG a $85 billion lifeline. That sounds to me quite a lot like cause and effect. Would it have happened without Lehman's passing? I don't know. Neither does Nocera and neither, I imagine, does Hank Paulson's old Treasury Dept.

Ditto the $700 TARP plan. Again, let's look at the timeline. On September 20, Paulson introduced the bailout plan in a brief 3-page memo which initially gave the Treasury Dept. free and unlimited reign to spend. The Senate Banking Committee rejected it, even though Lehman had already failed. One week later, on Sept. 29, the House of Representatives voted down the measure, even though Lehman had already failed. That day, the Dow plummeted 777 points. Three days later, the Senate responded by voting the bailout plan into law. Was the Senate reacting to the bankruptcy filing of Lehman Brothers three weeks earlier, or the largest single-day point-drop in Dow history three days earlier? I would guess the latter, but again, I don't know. Neither does Nocera and neither, I imagine, does Hank Paulson's old Treasury Dept.

Playing with counter-factuals can be fun, even illuminating. But I think Nocera is pressing here. A year ago on this Monday was when Lehman Brothers announced its collapse and President Barack Obama celebrated the day by giving his financial regulation speech to many politicians, financial CEOs and former President Bill Clinton. Still the announcement of Lehman Brothers collapse marked the beginning of the end of the self-sustained U.S. financial system, as big banks crumbled one after the other and ultimately received $2 trillion in government money to keep existing. Still President Obama used the occasion to deliver a speech on Wall Street outlining a retreat from the government's involvement with financial institutions. So how does the economy today, and Americans views of it, compare to a year ago? According to Gallup's charts, the economy is worse, but Americans are more optimistic that it's getting better:



The measures are for percentage of Americans who say the economy is getting better/worse, percentage of Americans who say their employers are hiring/letting people go, and self-reported average daily consumer spending.

Here's a look back at how everything progressed. Note that a year ago, people were spending tons of money and thinking the economy was getting worse...and then it did: consumer spending saw sharp drops before Obama was inaugurated, then continued to decline. Now, people are more optimistic about the economy than they were on the first day of its collapse: