Financial Crisis from Lehman to Europe

September 15, 2011

by Chidem Kurdas

The current financial crisis is a reverse of the 2008 disaster in key respects. Then, investment banks were seen as the main culprits while governments appeared in the guise of cavalry riding to the rescue. The trouble originated in the United States and spread to Europe. This time, the culprits are certain governments, the problem is European and how badly it will affect the American financial system is a question. How did the crisis go from US-based mortgage securities and Lehman Brothers to Italian sovereign debt and French banks? 

By conventional pundit wisdom, the 2008-2009 bust happened because of weak regulation and new complex derivatives. That is a superficial and misleading take on 2008-2009. In any event, it can not be the explanation for what’s happening now.  Increased regulation or limits on derivatives, the focus of much recent policy making, do not help in a sovereign debt crisis.

Lack of financial discipline by governments such as Greece is surely to blame, but it was government regulation of private business that was loudly demanded  to rectify financial risk in the wake of the previous emergency, not regulation of government itself. As for other policy responses that have had at best an ephemeral effect, click the highlighted text for Mario Rizzo on fiscal stimulus and Jerry O’Driscoll on the Federal Reserve.

The recession, like other recessions, reduced tax revenues and increased public spending.  This further weakened the weaker links in the European chain, that is, those governments that were heavily in debt to begin with. Greek finances were a disaster waiting to happen; any economic downturn would have caused severe problems.

The contagion to Spain, Italy and France was less predictable but facilitated by the common currency. Germany being in good shape, it became the all-around bailout source—-see Andreas Hoffman on the German experience under the euro.

Treasury Secretary Timothy Geithner reassures us that Europe will not go the way of Lehman Brothers and it is the responsibility of countries like Germany to support weaker economies. As for the US, he urged Congress to get on with President Obama’s new stimulus proposal—-or jobs package, if you prefer that way of framing it.  We’re offered the same nostrums as before, just tweaked a bit.

Meanwhile the two massive initiatives of the Obama administration, the healthcare law and the Dodd-Frank Act imposing thousands of pages of financial regulation, are if anything an incubus on economic growth and of no conceivable help if Greece were to default and set off another recession.

Back then these ambitious programs were seen as the triumphant reincarnation of Franklin D. Roosevelt’s New Deal. Now that a different crisis has come along, they look like dodo birds.

Why do such huge missteps happen? Thomas Sowell provided an answer in his study of the interventionist elite mindset — The Vision of the Anointed. Self-Congratulation as a Basis for Social Policy.   Mr. Sowell points out that those who believe in using government action to solve an ever-widening range of complex problems assume the world is a tidy, highly predictable and controllable place. But economic reality tends to be messy and unpredictable, as our current plight shows.

7 Responses to “Financial Crisis from Lehman to Europe”

  1. Lord Keynes Says:

    “The contagion to Spain, Italy and France was less predictable but facilitated by the common currency. “

    Bingo.
    The Eurozone nations have given up their monetary independence. That is the cause of debt problems on the periphery.

    Those European nations with monetary independence and adequate fiscal policy – Norway, Sweden, the UK – have no sovereign debt crisis.

    And Japan, for example, has a public debt to GDP ratio far greater than Greece, yet there is no sovereign debt crisis in Japan:

    http://en.wikipedia.org/wiki/List_of_sovereign_states_by_public_debt

    “But economic reality tends to be messy and unpredictable, as our current plight shows.”

    And fundamental uncertainty applies equally to the private sector and its investment decisions. The private sector does not escape severe problems caused by uncertainty that render the standard neoclassical market clearing mechanisms and Austrian notions of plan/pattern co-ordination nonsense.

    If one thinks austerity is the way to go, have a look at Ireland. A catastrophe.


  2. Nice post!

    It seems paradoxical to the sober:

    Many countries face a debt crisis. Their solution to the current situation is additional debt (in the US and EU). Regulation has by large failed, thus regulation helps in the future.

  3. Mario Rizzo Says:

    Perhaps if Andreas drank more champagne he would see the wisdom in the “paradox.”

    “Mr. Sowell points out that those who believe in using government action to solve an ever-widening range of complex problems assume the world is a tidy, highly predictable and controllable place.”

    There are those who believe theat complex systems demand ever more complex regulations. We must get away from this. Complex systems
    like markets must have simple predictable
    rules so that agents can concentrate on market uncertainties.

  4. Roger McKinney Says:

    The Euro Zone should take the name of Big EZ from New Orleans!

  5. chidemkurdas Says:

    Lord Keynes-
    Re “And fundamental uncertainty applies equally to the private sector and its investment decisions. ”
    Sure, uncertainty applies to all human affairs. But in the private world nobody can impose their particular view of the uncertain future on everybody else.

    By contrast, government is a coercive and imposes on the whole country policies that embody one group’s view of the future.

  6. chidemkurdas Says:

    Andreas Hoffman–
    Your paradoxes might include another one:
    The centralized EU bureaucracy having been notably ineffective in preventing the crisis, now many argue that the EU should become more centralized (as best I can understand the argument).

  7. chidemkurdas Says:

    Mario Rizzo–
    Re “simple predictable rules”
    Yes, yes, yes.


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