Learning the right lessons from financial crises is tough. The 1929 stock market crash was blamed for all the ills of the Great Depression that succeeded it and led to two decades of regulation and socialism. In 1720, the British tried to stop all new company formations while the French gave up on finance altogether and started plotting revolution. So, it is unlikely that we have learned the right lessons from 2008, but it’s worth asking what lessons we should have learned, to avoid the same mistakes again.
There are three distinct layers of lessons we should have learned but haven’t. At the narrowest, most technical level we have not learned how to manage a financial crisis without rewarding bad behavior and bailing out the wrong people. At a broader monetary policy and regulatory level, we have not learned what policies and regulations led to the crisis and how to avoid another one. Finally, at the broadest economic management level, we have not learned why our economy produces financial meltdowns at regular intervals, and what can be done about it.
All three sets of problems have the same underlying cause: misguided incentives. If bank management keeps its jobs when it makes gigantic losses and is bailed out by the state, it will have no incentive not to do so again. If asset prices are high and regulations are “flexible” in terms of how to calculate leverage, then banks will leverage themselves up to the eyeballs and invent new ways of financing overpriced assets – high asset prices will inevitably lead to high demand for loans and high leverage will lead to low lending margins, both of which increase risk. If the economy is designed with high taxes, big government, and massive incomprehensible regulations, then market participants will naturally gravitate towards tax avoidance, buying off bureaucrats and gaming the regulations. This isn’t rocket science, it’s obvious. The further you get from pure free-market capitalism on a Gold Standard, the worse the system works.
More particularly, too little thought was given before 2008 to the process of resolving bank failures, with the result that it became impossible to do so properly. If an over-leveraged bank fails, with like Lehman $600 billion of liabilities and a matching portfolio of assets that are mostly of fairly low risk, then the loss in an orderly liquidation of that bank will be nothing like $600 billion. However, the loss from the market panic resulting from a failure of a bank of Lehman’s stature, which had been founded in 1850 and had one of the best “names” in the market, proved to be a very substantial multiple of $600 billion. Indeed, over the next 8 years, including the costs of dozy monetary and fiscal policies, the cost of Lehman’s failure was probably between $10 trillion and $20 trillion worldwide.
