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Why Are We Still in a Recession? The Shape of the Crisis and "Too-Big-to-Fail"

Jim Hamilton sends us to John Cochrane, who makes a number of good points. Cochrane agrees with the conventional wisdom that it was not any fundamental change or news about preferences, technologies, or the risks of undertaking production and hiring workers but rather the bankruptcy of Lehman Brothers that turned us from being in a small recession to being in the deepest recession since the Great Depression--to perhaps being in a (little) depression of our own:

John Cochrane: The signature event of this financial crisis was the... whatever you choose to call it... in late September of 2008.... Short-term credit dried up, including the normally straightforward repurchase agreement, inter-bank lending, and commercial paper markets.... Why would Lehman's failure cause a panic? Why, after seeing Lehman go to bankruptcy court, would people stop lending to, say, Citigroup, and demand much higher prices for its credit default swaps (insurance against Citi failure)?... We did not see a secondary wave of creditors forced into bankruptcy by Lehman losses.... Sure, there was some mess-- repos in the United Kingdom got stuck in bankruptcy court, some money market funds "broke the buck" and had to borrow from the Fed--but those issues are easy to fix and they do not explain why Lehman's failure would cause a widespread panic. What is more, Lehman's failure did not carry any news about asset values; it was obvious already that those assets were not worth much and illiquid anyway.

Cochrane makes the true and obvious but understressed point on the origins of our macroeconomic crisis that mortgage defaults in the desert between Los Angeles and Albuquerque are simply not large enough to justify the $25 trillion global fall in the value of financial assets that has hit our economies:

The underlying decline in wealth from the housing bust was not that large.... Most estimates put subprime losses around $400 billion. The stock market absorbs losses like that in days...

Indeed, relative to the size of the economy the losses during the crash of the dot-com bubble were four times as large. But the collapse of the dot-com bubble did not drive unemployment up above 10% even with extraordinary government interventions to create a liquidity tsunami to try to float the markets.

Cochrane makes the true and obvious point that what is special about our current situation is not that there were losses, or that those losses were the result of the unwinding of irrational exuberance, but rather how those losses hit overleveraged and overexuberant banking and shadow banking systems:

[M]ortgages were held in very fragile financial structures. An extreme example: many mortgages were pooled into securities, and the securities were held in special purpose vehicles (SPVs), funded by rolling over short term commercial paper with an off-the-books credit guarantee from a large bank. Less extreme: when Bear Stearns failed, it was holding a large portfolio of mortgage-backed securities (MBSs) funded at 30-to-1 leverage by overnight debt. In both cases, when the mortgages lose value, the debt-holders refuse to renew their loans and the whole thing blows up...

But then it seems to me that his argument starts to jump the tracks here:

We are left with only one plausible explanation for why Lehman's failure could have had such wide-ranging effect: After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were "too big to fail" and would be bailed out. But when the government did not bail out Lehman, and in fact said it lacked the legal authority to do so, everyone reassessed that expectation. "Maybe the government will not, or cannot, bail out Citigroup?" Suddenly, it made perfect sense to run like mad...

And it goes off the rails, crashes, and burns here:

[T]he central problem is how to escape the bailout expectations trap. To do this, we have to finally define what “systemic” means. And then, we must define clearly what is not systemic, and thus should and will be left to fail next time—we really mean it! This limit must be written in law or in regulation. We cannot rely on the good intentions of powerful administrators; Odysseus knew he had to tie himself to the mast. The only way to limit expectations of a bailout is for the government to give up the legal authority to do it. Lehman is actually a great example: it went to bankruptcy because the government could not save it. We need more of that. If everybody had known that ahead of time, rather than have it emerge from the usual weekend conclave in Washington, there likely would have been no panic because Lehman’s failure would not have signaled anything about the government’s commitments to Citigroup...

To see what is wrong Cochrane's story, let's start by summarizing it: It is that (i) the failure to rescue Lehman caused fears that the government would not rescue anybody, and so (ii) it was rational for everyone to panic and try to dump their risky assets. In Cochrane's view, the problem is that asset prices collapsed when financiers realized that the government's promise to bail-out too-big-to-fail banks was empty. That shock sent the real economy into a tailspin. And the solution is never to make any bail-out promises to begin with: if the promises aren't made, then people cannot fear that the promises are empty, that fear cannot generate a sudden collapse in asset prices, and so the economy cannot be sent into a tailspin.

But remember what happened in the immediate aftermath of Lehman: the U.S. government nationalized AIG and settled its liabilities at 100¢ on the $; Hank Paulson got down on his knees before Nancy Pelosi; the Treasury was given $700 billion to spend to make sure that there were no more Lehmans. After the creation of the TARP, we were all much surer that the U.S. government would rescue Citi if it needed rescue than we had been in the months between Bear-Stearns and Lehman. In point of fact, the government's promises to rescue too-big-to-fail banks weren't empty: the government has lived up to them.

The logic of Cochrane's argument implies that the passage of the TARP should have fixed the problem: the aftermath of Lehman saw "[no] secondary wave of creditors forced into bankruptcy by Lehman losses... [some] issues... easy to fix... Lehman's failure did not carry any news about asset values..." and the passage of the TARP is good news for the likelihood of bailouts. So, Cochrane's story leads us to think, everything should have been completely fine in the aftermath of the TARP: asset prices should have immediately bounced themselves back up to their pre-Lehman levels, and the storm clouds should have dissipated.

So why are we still in a deep recession?

And why were the flashpoints of the ovespeculation crash found not among institutions that were too-big-to-fail and were bailed out (Citigroup, Goldman-Sachs, JPMorgan Chase) but instead among institutions that were definitely not too-big-to-fail--and have failed--like Bear Stearns, Lehman Brothers, WaMu, Wachovia, and Countrywide?

A crisis that was caused by excessive confidence in the government's implicit guarantee of too-big-to-fail financial institutions would have had a very, very different shape than the crisis we are now in.