What We Haven’t Learned From the Crisis

Our old theory of what to do was wrong, and we don’t have a new one.

Lehman Brothers former Chairman and CEO Richard Fuld is sworn in before testifying to the Financial Crisis Inquiry Commission about the roots and causes of the 2008 financial and banking meltdown in U.S. and worldwide markets.
Former Lehman Brothers CEO Richard Fuld is sworn in before testifying Sept. 1, 2010, to the Financial Crisis Inquiry Commission about the causes of the 2008 financial and banking meltdown. We don’t know much more now than we did then, or in 2008.

Photo by Chip Somodevilla/Getty Images

This weekend marks the fifth anniversary of Lehman Brothers’ final, chaotic descent into bankruptcy. The investment bank wasn’t the first American financial institution to drown in bad bets on mortgage-backed securities. But unlike those that had come before, Lehman wasn’t covered by the FDIC and its resolution process. And despite the scrambling efforts of the Treasury Department and Federal Reserve, there was no way to quasi-save it through the kind of shotgun marriage that was deployed to sell Bear Stearns to JPMorgan Chase. Lehman was going down, and all officials could do was wait to see what happened next.

What happened next, of course, was a full-scale financial panic—one that the Fed and the Treasury spent the next year fighting under two presidents. They wanted, desperately, to avoid the collapse of the American banking system. And contrary to loud and fashionable lines of criticism then and now, they overwhelmingly did it not out of corruption or fealty to Wall Street but out of sincere belief that ending financial panic would be critical to helping real people and the real economy. To their credit, they succeeded at stemming the disaster much better than their contemporaneous critics allowed.

But they don’t like to admit to a plain truth that’s obvious to most everyone else: that ending the financial crisis and healing the banking system turned out to be much less important than we believed at the time.

One of the most infamous documents of the Obama era is a January 2009 projection attributed to Jared Bernstein and Christina Romer making the case for the president’s stimulus plan. They forecast that with the president’s plan in place, unemployment would peak in the third quarter of 2009 at 8 percent and then fall to about 5 percent by the second quarter of 2013.


The really striking thing about the paper isn’t what they say about the stimulus. It’s what they say about a world of no stimulus. In this world unemployment peaks at 9 percent in the middle of 2010. After that it falls quite rapidly to about 5.5 percent in early 2013 and then precisely matches the no-stimulus scenario by the end of this year. Which is to say they believed then what policymakers at all levels believed—that there was simply no way to have a grinding years-long period of seemingly endless slow growth and mass unemployment. A harder recessionary fall would mean a sharper snapback. Cushioning the blow was sensible and humane, but the actual difference would be short-lived.

And yet experts knew that, at least in an academic sense, prolonged slumps were possible. That’s what happened during the Great Depression of the 1930s. Ben Bernanke summed up the conventional wisdom on this point in 2002, in his

tribute speech on Milton Friedman’s 90th birthday—back when Bernanke was a Fed governor but not yet running the show. “Regarding the Great Depression,” Bernanke said, addressing himself directly to Friedman, “you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

The embedded meaning here: The Depression occurred because the Federal Reserve of the time had allowed widespread bank failures to sharply reduce the amount of money circulating in the country. This shortage of currency led to falling prices, which became a vicious cycle. With prices headed downward, everyone wanted to defer business investments and major purchases as far into the future as possible. That only increased the excess demand for money and intensified the cycle of deflation. The lesson was clear—at all costs, prevent a spiral of bank failures, currency shortage, and falling prices. Get that done, and the system will return to equilibrium.

By this standard, the powers that be have performed quite well. Leading measures of financial system stress spiked during the crisis but rapidly returned to normal. Banks have failed, but the banking system is alive. Ordinary households and businesses have no trouble finding someplace safe to put their money, and creditworthy borrowers can get loans. There’s been no cycle of deflation.

Yet the self-correcting economy we were promised hasn’t materialized. The unemployment rate remains high, even as the share of the population looking for a job keeps shrinking. And there’s no real mystery as to why the labor market has remained sick. Despite the hype about robots and jobless recoveries, employment growth has been about as weak as you’d expect given weak overall GDP growth. This is the deepest and most frightening lesson of the financial crisis—the automatic bounce-back mechanism doesn’t actually exist. The need for some extra boost—whether from fiscal stimulus, or monetary policy aimed at deliberately increasing inflation—is deeper and more profound than the Obama administration realized at the time.

Putting the measures in place for that extra boost would be an extremely difficult political lift. But the emergency measures that saved the banking system in the fall and winter of 2008–2009 were a tough lift too. They got done because policy elites regarded them as necessary. Today, those at the helm at the time defend that judgment, but add the qualification that what was necessary was “not sufficient.” Yet the insufficiency of the banking rescue ought to raise the question of whether it really was necessary. The bailouts of financial institutions were supposed to put the country on a self-correcting long-term path, even in the absence of other pro-growth measures. If they don’t do that, then the billions spent on TARP are like any other kind of fiscal stimulus spending—just a form targeted at a segment of society that’s unusually undeserving of public assistance.   

Bailout fatigue is rampant, but there’s absolutely no consensus on what we should do when faced with the next major economic downturn. Five years ago Bernanke and others at least had the excuse that they thought they knew what to do. Today we know that bank-centered theory of depression prevention was wrong, but haven’t embraced a new one. The continued imperfections in America’s financial regulations are scary. But the lack of a plan for what to do next time those flaws come to light—that’s much scarier.