It’s about the “right” counterfactual

In a recent post, Mark Calabria from the Cato Institute took aim at the idea that the Lehman Brothers crisis was the “trigger” for a big crisis.

Now I do not disagree that there was, and would have been, a recession without Lehman Brothers – and even without the uncertainty caused by the lack of clarity around insurance of the shadow banking system which grew post August 2007.  However, these issues, and in turn the failure of Lehman Brothers did make the crisis significantly more severe than it would have been.

He appears to say that the failure of Lehman Brothers was a good thing (Note:  There is nothing wrong with wiping out the company – but the way it was handled, was a big driver of the global slowdown that was to come), and that the US was on the road to recovery post this.  So here we are focusing just on the US, not the contagion to other countries.  His evidence is the following graph:

Employment and consumption stopped declining not long after Lehman Brothers failed, and although the largest declines occurred WHEN Lehman Brothers failed this doesn’t mean the failure caused them – in fact, employment tends to lag the cycle and the drop may well have been the result of prior economic weakness … and the amazingly high fuel prices through the first half of 2008.

Now I agree that there were factors driving a recession prior to the failure of Lehman Brothers – but the impact of Lehman Brothers as an event is captured by asking what would have happened in the absence of the Global Financial Crisis that stemmed from it, and the full blown “bank run” on wholesale financial markets that had been building pressure from the start of 2008.  Going to FRED, grabbing consumption and population, and running a basic time regression in excel no less (so it’s easy to copy) we can get an idea of what the “trend” rate of consumption per capita was during the 1952-2012 period.  Armed with that, we can ask what the percentage difference is between this trend and actual consumption per capita outcomes.  This is:

Something is broken here – I will try to fix that up tonight.  The strange thing is that I can see the graph when editing the post … but it then wont let me do anything with it

Now we can start arguing that consumption per person was too high and a whole bunch of other things if we want to here.  However, this basic analysis clearly shows that the gap between trend consumption and actual consumption, something that should have a tendancy to head back to zero after a recession, actually deterioarted further … and has continued to deteroriate.  We look at business cycles “around trends” not “around levels” given that our counterfactual involves growth – and this makes this post by the Cato institute a bit misleading.

Saying that the downturn, or even the crisis, started with Lehman Brothers is wrong, I agree with the author here – however Lehman Brothers failure started a new dangerous stage of the crisis which, when combined with the persistent institutional failure in Europe, has made sure that the US economy has remained below potential.  A market monetarist would say that the Fed is truly responsible for this in terms of policy action, but even if we were to accept this it is undeniable that it is the “shocks” that have occurred in financial markets are the very things the Fed needs to respond to by “loosening policy”.

It’s failure is indicative of what was underlying the crisis, and the evidence shown in no way suggests that allowing its failure and initially ignoring the quiet, and then full scale, bank runs in wholesale financial markets was good policy.