The Financial Crisis and the Financial Panic

by Reihan Salam

The fifth anniversary of the collapse of Lehman Brothers has prompted a wide-ranging discussion of financial regulation. Glenn Hubbard calls for “structural and organizational changes” in financial regulation, e.g., giving the Federal Reserve greater responsibility for maintaining financial stability. Kevin Roose points to various ways in which Wall Street has changed for the better since the crisis, though he warns against complacency. Matt Yglesias fears that the federal government’s approach to financial regulation hasn’t changed enough, as “the cult of consumer debt” remains firmly entrenched. And late last month, Anat Admati reiterated her call for forcing banks “to rely much more on equity, and much less on borrowing.”

Keith Hennessey and Edward Lazear, meanwhile, have released an essay, “Observations on the Financial Crisis,” which challenges a number of widely-held assumptions about the crisis and the policy responses that followed it. The following are a few of their observations:

1. Hennessey and Lazear distinguish between the financial crisis, which first showed significant signs in the summer of 2007, and what they call the financial panic of September 2008. They argue that the mild recession that began in late 2007 ought to be viewed as separate and distinct from a severe recession that began in late 2007 and ended in mid-2009.

2. The decision to put Fannie and Freddie into conservatorship likely helped avert larger shocks.

3. Though excessive leverage might have exacerbated the crisis, the deeper problem was that unprecedented capital flows into the U.S. (from the Gulf, Japan, and China) led to a dramatic fall in credit spreads between 2003 and 2005, and cheap credit made risky investments more attractive. Investors knew that they were taking on risk — but they didn’t understand the full extent of it.

4. Hennessey and Lazear contrast the domino theory of financial contagion and what they call the popcorn theory:

If large financial firms operate in a popcorn world rather than a domino world, preventing one failure will do little if anything to prevent other failures. Each institution feels the same heat, here caused by some prior action like unwise risk-taking, undercapitalization, or overinvestment in housing. It is merely a matter of time before multiple institutions are ready to explode. Just as different kernels are located closer or further from the heat, one financial institution may feel pressure before and to a greater extent than another. But the fundamental cause of the problem for other institutions cannot be alleviated by treating the first institution that fails.

5. They also offer a defense of TARP, emphasizing the fact that it allowed policymakers to shift from a case-by-case to a more systematic approach focused on common problems facing all major financial institutions while also acknowledging its downsides.

6. And not surprisingly, they question the wisdom of a number of policies pursued by the Obama administration.

I found the paper interesting and convincing in many respects.