Ten years later: Are we readier to counter a Lehman-style crash?

Joshua Roberts/Reuters
Three key players in the government response to the 2008 financial crisis – (from left) former Federal Reserve Chairman Ben Bernanke, former Treasury Secretary Timothy Geithner, and former Treasury Secretary Hank Paulson – talked with New York Times columnist Andrew Ross Sorkin earlier this month in Washington.
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Ten years ago, the economy turned down much harder and faster than professional forecasts had allowed for. Today, while the field of economics isn’t transformed, it has been chastened. Economists are looking more at real-world evidence as well as amending their own theoretical models. The erosion of lender confidence in 2008, they’ve realized, was a crucial reason a bad housing bust evolved into something much worse. On the positive side, economists have greater confidence that tools like central bank stimulus and government spending can help a stressed economy recover. “Belief in the eternal efficiency of markets has been extinguished, at least for the time being,” says finance expert Daniel Alpert. And “the economics profession truly has gotten religion” regarding societal anxieties that have fueled populist politics, he adds. All this may be important at a time when some see new threats to financial stability coming into view.

Why We Wrote This

The financial crisis resulted in a deep recession. We wondered: Has it also prompted economists to change their views on how crises happen?

A decade ago, with America’s housing market crashing and credit markets in disarray, economists and leaders at the Federal Reserve predicted the US economy would keep growing.

When, instead, the United States plunged into its worst recession in seven decades, it caused not only a crisis in banking and housing, but also added to widening distrust in experts and forced economists to take a good long look in the mirror.

The result, 10 years after a mid-September Monday when the collapse of the investment firm Lehman Brothers roiled world markets: a profession that is humbler, more open to new ideas, and more sensitive to the social impacts of its prescriptions. These changes in thinking are important as numerous challenges – from trade and tariffs to income and wealth inequality – come to the fore and create potential new threats to financial stability.

Why We Wrote This

The financial crisis resulted in a deep recession. We wondered: Has it also prompted economists to change their views on how crises happen?

“The economics profession truly has gotten religion,” regarding societal anxieties, says Daniel Alpert, a finance expert who tracked the crisis and responses to it as a managing partner at Westwood Capital in New York. “Belief in the eternal efficiency of markets has been extinguished, at least for the time being.”

The crisis was also an equal opportunity slap in the face. Just as the credit chaos of 2008 shook the faith of conservative economists in the efficiency of markets in finding proper equilibrium, the Great Recession also eroded a simplistic confidence in globalization on the left, Mr. Alpert says. “I’ll say the economics profession historically was very much part and parcel of the problem. We were all tribal,” he says.

These shifts in thinking are incremental. Even before 2008, for instance, many economists offered prescriptions about social ills. And the tribes still exist, along with their fealty to particular politicians and parties. But other experts agree that new conversations and ideas have emerged.

“First, the profession has become much more empirical, increasingly emphasizing evidence and data over theoretical conjecture. Second, economists are much more concerned with inequality these days. And finally, economists are more willing to question basic assumptions, such as the premise that economic actors are perfectly rational,” economist Noah Smith wrote in a recent Bloomberg column.

Consider the keywords “inequality” and “poverty” in the titles of research papers since the crisis. They pop up more frequently in the two most recent years (ending Sept. 1, 2018) than in the two years ending Sept. 1, 2007, judging by emails that summarize papers published by the National Bureau of Economic Research.

Seeing the forest instead of trees

In some cases, whole new topics have come into focus, such as nontraditional ways for central banks to stimulate an ailing economy, and the idea that regulators ​consider risks to the whole financial system, not just the soundness of individual banking firms.  

“Macroeconomists learned that the financial sector can be a huge source of shocks and our treatment of it so far had been far too simplistic,” says Joseph Gagnon, an economist at the Peterson Institute for International Economics in Washington.

Former Federal Reserve Chairman Ben Bernanke, who had studied the contracting availability of loans during the Great Depression, said this year that even he was taken by surprise at how big a role the financial industry’s own panic played in the crisis.

All this leads to a question that’s timely today: If economists and central bankers have been learning lessons since 2008, will the system be safer going forward?

Safer, but not fool-proof

No one promises a crisis-free future. In fact, this past week of “Lehman anniversary” articles have included plenty of opining about lingering risks and new ones, from shadow banks in China to high and rising debts in America and other wealthy nations.

Many economists argue the system is safer today – not just because of new wisdom, but also because the recession’s lessons helped guide the creation of the Dodd-Frank Act in 2010, and parallel global efforts to monitor banks.

But the crisis also brought a key challenge into view: Even when economists have a useful idea, they may lack the clout or credibility to get policymakers on board. Economists broadly agree that more spending or tax cuts from Congress would have been helpful in hastening the economy’s recovery, says Mr. Gagnon, who shared his thoughts by e-mail. But Congress was only willing to go a certain distance down that path

Even policies that work may have drawbacks. It’s one thing for the government to spend if it can then pay down some debt before the next crisis. Today, however, tax cuts during good times may leave the nation in a poorer position to enact fiscal stimulus in the future.

Mail the money

Or take the central bank strategy known as “quantitative easing,” which involves buying bonds, in an effort to pull long-term interest rates lower. This extra measure “really does help,” Gagnon says, but may benefit the old and wealthy more than younger or lower-income Americans.

“Just mailing out large checks to all households is probably socially preferable but central banks cannot do that on their own,” he says.

The new perspectives shouldn’t be oversold, Timothy Taylor, a Minnesota economist who is managing editor of the Journal of Economic Perspectives, writes in an email. “For the mainstream majority of the profession, I’d say that the lack of fundamental change is the striking point.”

Still, the steps of progress, including closer regulatory watch on financial markets, are real.

“There will be future financial crises,” Mr. Taylor says. “But there is reason to hope that they might be perceived sooner and the policy reaction to them can come more quickly.” 

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