The Danger of Developing Then Dashing Expectations: The Lesson from Lehman?

Abstract

In the economy expectations exercise enormous effects. Indeed, in finance prices and yields predominantly reflect current expectations about future cash flows and future interest rates. Change those expectations, prices and yields change as well. Change expectations radically enough, the change in prices and yields may be large enough to impact financial markets and the economy at large.

The failure of Lehman in September 2008 is a case in point. Prior to its bankruptcy on 15 September 15, 2008, the economy was treading water. Thereafter it sank like a stone, until the massive stimulus programs put in place by governments and central banks began to pull the economy up again.

This paper suggests that what made the Great Recession great was the entry of Lehman into bankruptcy. This suddenly swung market expectations concerning government policy from “too big to fail” to “let the chips fall where they may”. Following Lehman’s declaration of bankruptcy, panic ensued, as market participants rushed to adjust to the new situation. This set off a downward debt-deflation spiral that caused the world economy contract rapidly. Only massive monetary and fiscal stimulus, together with explicit government support to systemically important financial institutions (SIFIs) arrested the decline and turned what might have become the Great(er) Depression into the Great Recession. This weakened economies around the world, leading to further crises and changing the political landscape.

In concept therefore, allowing implicit guarantees such as “too big to fail” to develop generates not only moral hazard but also creates what might be called public hazard. This is the risk to financial stability and the economy at large, if the government fails to fulfil the implicit guarantee, when called upon to do so. This is a lesson that governments would do well to bear in mind as they wrestle with how to taper off the massive support that they are currently giving to firms and individuals to enable them to offset the economic consequences of COVID-19.

Keywords: Banking, financial crises, regulation, expectations, Lehmans, resolution, COVID-19, liquidity, capital, CCPs

JEL Classification: E02, E32, E58, G18, G20, G28, G33