Learning the Right Lessons From the Financial Crisis

By Harvard professor N. Gregory Mankiw.Excerpts:

"In the mid-2000s, the nation experienced a housing bubble. A combination of stupidity, negligence and malfeasance led a bunch of Wall Street firms to make excessively risky bets that the bubble would go on forever. Through mortgage-backed securities and related instruments, they extended credit to home buyers of dubious credit quality.

For a while, this credit expansion fueled the bubble. But when the bubble burst, these new homeowners defaulted in record numbers, and the Wall Street firms headed toward insolvency. The whole financial system teetered on the edge of collapse, leading to a deep recession.

Fortunately, policymakers came to the rescue. Henry M. Paulson Jr., the secretary of the Treasury, persuaded Congress to pass the Troubled Asset Relief Program, which he and his successor, Timothy F. Geithner, used to recapitalize the banks. Ben S. Bernanke, the chairman of the Federal Reserve, expanded the tools of monetary policy to support the financial system and the economy more broadly. Their bold steps saved us from another Great Depression.

In this conventional narrative, Wall Street financiers are the villains and Washington policymakers are the heroes. Certainly, the policymakers have promoted this view. Mr. Bernanke even titled his memoir “The Courage to Act.”

Yet a new book, “The Fed and Lehman Brothers,” by Laurence M. Ball, an economist at Johns Hopkins University, casts doubt on this narrative. Mr. Ball (who is a friend of mine) does not excuse the financiers from starting the trouble. But he draws attention to the policymakers who, in his view, failed to do their jobs at a crucial moment."

"A central bank can solve this liquidity problem by lending to a financial institution experiencing a run. That is why the Federal Reserve Act calls for an “elastic currency.”"

"When mortgage defaults started rising, many financial institutions experienced a run on their short-term liabilities. These liabilities were not traditional bank deposits but rather repurchase agreements, called repos. But the forces at work were much the same.In September 2008, the financial giant Lehman Brothers found itself facing a liquidity crisis. Yet the Fed, rather than acting as a lender of last resort, pushed Lehman into bankruptcy."

"Mr. Ball argues that a careful look at Lehman’s finances shows that it did have enough collateral. In addition, he examines the historical record and finds no evidence that Fed officials at the time were concerned about the insufficiency of collateral.

The claim of inadequate collateral arose weeks later when the full impact of the Lehman bankruptcy became clear. It was, Mr. Ball suggests, an attempt to cover up a policy blunder."

"the Dodd-Frank Act has increased restrictions on Fed lending, making it harder for the Fed to act as lender of last resort."