6 Years Later, There Are Still Lessons To Learn!

Henry Paulson, fierce advocate for the free market, has become the most interventionist secretary of the Treasury in the history of his country.

Monday will mark the sixth anniversary of the failure of the American bank Lehman Brothers: a bankruptcy that shook the foundations of the international financial system and unleashed the worst economic crisis since the Great Depression of 1929; a crisis that also had massive repercussions, notably on the financial situation of many governments — to begin with, that of the United States.

We can draw several lessons from this singular episode of our recent economic history, three of which cannot be overlooked.

Self-Regulating Market

The capacity of the market to regulate itself comes in first place. Since the end of the 1970s and the beginning of the 1980s, we have witnessed in all industrialized countries an important reversal of the paradigm inscribed into the development of the neoliberal revolution. This revolution, installed first in Great Britain by Margaret Thatcher and pursued next in the United States by Ronald Reagan, proposed a vision in which the primacy of the market had become uncontested, and in which the retreat of the state from the economic sphere was judged indispensable to the proper functioning of the economic machine and the straightening of public finances. Concretely, a wave of privatization and the reform of social programs reveals this, but especially the various deregulations, notably in the financial sector.

However, the 2008 crisis demonstrated more than ever that the self-regulating market, particularly in the financial sphere, was a pure myth. Without the supervision of government institutions, it is capable of the worst slip-ups — even capable of becoming a menace to the stability, or even viability, of the economic system. It is for this reason that in the last few years, all governments have acted, notably within the scope of the Basel III Accords, to reinforce the regulation of the banking sector in order to better supervise its activities and avoid a repeat of the dark scenario of 2008.

‘Too Big to Fail’

In the last two decades, a sort of faith has developed that is coupled directly with the phenomenon of globalization. Thus, in a decompartmentalized market and a financial system that is more and more interconnected and interdependent, a major player gets protected de facto since [such an entity] represents a systemic risk. In other words, government institutions were going to run to its aid at the first false step because it becomes a threat to the system as a whole.

And this is what Dick Fuld, president of Lehman Brothers, believed exactly up until the end: He was convinced that the American government — and Henry Paulson, the secretary of the Treasury at the time — was going to find, and finance a buyer for his company. In his mind, if the vaults of the public treasury had been opened to organize the rescue of small players like the bank Bear Stearns, why would it be otherwise in his case? Especially because only one week before Lehman Brothers submitted its report and put itself under the protection of Chapter 11 of the American law on bankruptcy, Paulson had just completely nationalized the two major players of the American real estate market and the organizations responsible for guaranteeing mortgages, Fannie Mae and Freddie Mac.

However, things did not unfold as Dick Fuld wished, because Paulson wanted to avoid moral hazard at all costs. He held firmly to the need to send a clear message to the market: The government will not be there to pick up the broken pieces every time an “irresponsible” player entangles itself in difficulties. For him, irresponsibility must be paid for and is a part of the rules of the game, the rules of the market.

Applied Politics 101

In the end, the great and celebrated economist John Maynard Keynes affirmed: “The difficulty lies not in the new ideas, but in escaping from the old ones.” This is simply called pragmatism and is the third and last lesson to learn from the bankruptcy of Lehman Brothers.

In effect, for a while, it has been believed that a political decision had to be perfectly faithful to the ideological line of the decision-maker, a sort of superposition between action and idea. However, the conduct of public affairs is far from being so simple and linear, and one of the fundamental requirements of governance is exactly the capacity of the decision-maker to adapt himself to the context and environment in which he makes his decisions, including the resources at his disposal and the constraints he must face. This supposes that he can sometimes deviate from his customary — and very comfortable — ideological trajectory in order to be able to make the most optimal possible decision in the interest of his citizens.

This is a posture that several political decision-makers in history have decided to adopt and that Paulson favored in turn, just after the shockwave created by the bankruptcy of Lehman Brothers in the markets, in going to the aid first of AIG (American International Group) to the amount of some $180 million, and in announcing next the famous $700 million to bail out the banking system.

All of a sudden, Henry Paulson, this former president of Goldman Sachs, fierce defender of the free market and of the noninterference of the state in the economy, had become probably the most interventionist secretary of the Treasury in the history of his country — something that would make Keynes turn over in his grave (from joy)!