Economics of Contempt Is Very Unhappy This Morning...
Paul Krugman: Cameron and the Confidence Fairy: An Update

Paul Krugman Is Much More Polite to John Cochrane and John Taylor than Economics of Contempt Is

Paul Krugman:

It Was Lehman Wot Did It - These days the bizarre economic notions are flying so thick and fast that it’s hard to keep up. Economics of Contempt informs us that Taylor and Cochrane(pdf) are denying the importance of the Lehman shock. This is, among other things, a demonstration of just how far Chicago has run away from the legacy of Milton Friedman, who put bank runs — starting with the failure of small banks — at the heart of his account of the Great Depression. But it’s also amazing given that these events were so recent, and so clear.

Look at what happened to yields on riskier, illiquid assets. Anyone else have the impression that something happened in the second half of September 2008?

Now, I would argue that Lehman was more of a trigger than an ultimate cause, that the overhang of household debt rather that continuing disruption of the financial sector is what’s holding us back now. But trying to diminish the centrality of Lehman to the crisis with arguments to the effect that most of Lehman’s big counterparties survived — because the government bailed them out — is just amazing.

It Was Lehman Wot Did It  NYTimes com

Heh. Indeed.

As I, at least, see it, the key to Lehman was that in its aftermath not only was a great deal of liquid cash frozen but nobody was certain how big the bailout would be or who the bailout would go to or what institutions would still be surviving when the dust cleared.

The settlement of the Bear-Stearns bankruptcy had convinced everybody that the U.S. government had guaranteed the unsecured debt of practically every single commercial bank, investment bank, and shadow bank in and outside the United States--and thus that even though people felt overleveraged, it was still worthwhile for them to hold on to their risky asset positions because in the end they were not that risky.

Lehman revealed that that was not true.

And then, of course, the attempts by financial institutions to rebalance their portfolios and shed risk made their risky assets all much, much, much more risky--and diminished the willingness to hold them.

Miss that--as it appears that Taylor and Cochrane have--and you have missed practically everything important about the fall of 2008.