Who suffered most and least from the Lehman crash
Andrew Sheng says a full measure of the costs of the crisis points to the regulatory gap to be closed
As we approach the fifth anniversary of the Lehman Brothers crash in September 2008, we might well ask: have we fixed the problems?
Last month, the Federal Reserve Bank of Dallas published a staff paper estimating the costs of the 2007-2009 financial crisis. The conservative estimate came up to 40 to 90 per cent of the United States' 2007 output, roughly US$6 trillion to US$14 trillion.
The Dallas Fed paper argued that it is important to measure the costs of the past crisis in order to weigh it against the cost of policies intended to prevent similar episodes in the future. After all, the running cost of financial regulation is like the price of an insurance premium against future disaster.
If the premium is too high, you might not want to insure against the risks of an uncertain future cost. But if the future costs of crisis are disastrous, then you might be willing to pay a high insurance premium. The only problem with more complex regulations today is that they may also slow down the whole economy tomorrow, which is a "lost opportunity".
The Dallas Fed researchers estimated the costs of the crisis by adding lost output, cost of national trauma and lost opportunity, and cost of the government support required.
Lost output is the common "output gap": how much goods and services were not produced due to the crisis. The 2007 output loss was estimated at between 40 and 90 per cent of gross domestic product.
The second estimate was the cost of reduced wealth. From the third quarter of 2007 to the first quarter of 2009, US household net wealth dropped by US$16 trillion. However, the Dallas researchers wanted to look at the loss of human capital due to unemployment, which rose to a peak of 10 per cent during the crisis and is still high now. This cost was estimated at 90 per cent of 2007 output.
The third estimate was the unintended consequences of government intervention. How big was the unprecedented stimulus? The federal Troubled Asset Relief Programme in 2009 disbursed US$418 billion, but including guarantees and liquidity support, the potential exposure from the financial rescue was estimated to reach US$23.7 trillion in 2009. In 2012, the federal debt was US$11.3 trillion, higher than expected.
Of course, not all the federal debt increase was attributable to the financial crisis, but there was no doubt that by 2012, the US gross national debt was already around 105 per cent of GDP, higher than the debt-to- GDP threshold considered safe.
The above study supplemented Fed data that revealed the changes in net worth by sector. The household sector lost US$12.7 trillion in 2008, mostly through the decline in share prices and real estate value. The business sector lost US$1.6 trillion in 2008 and US$6.1 trillion in 2009. The government sector went into deficit by US$0.7 trillion in 2008, and lost roughly US$1.3-1.5 trillion yearly since then.
How much did the financial business sector lose? Its net worth rose US$1.6 trillion in 2008, lost US$0.7 trillion in 2009 and US$0.5 trillion in 2010 and was in the black again by 2011. In sum, almost everyone lost during the financial crisis, especially the household, but Wall Street lost least. The reason is that its losses were covered by capital injection by the corporate and household sectors and there was huge government support. No wonder there was an Occupy Wall Street movement.
No discussion of the costs of the crisis can ignore the role of central banks in bailing out the financial sector. The Fed's balance sheet has more than tripled since 2007, with major changes in its composition. Instead of holding mostly short-dated Treasury paper, today the bulk of Fed holdings are long-dated Treasuries, mortgage-backed and agency securities and other support. This means that the Fed will be exposed to capital losses if and when interest rates rise.
All of this research suggests that the true costs of the current crises are significant, but their damage is not immediately apparent. The Dallas paper implied that unemployment may be extended longer than before and the ability of the government and the central bank to respond to future downturns may be impaired.
One reason why the Dallas Fed has been so bold in its research may be the stance of its president, Richard Fisher, an outspoken advocate of financial regulatory reform. In important congressional testimony, he said the Dodd-Franks Act that toughened financial market regulation post-Lehman was, "despite its best intentions, ineffective, burdensome, imposes a prohibitive cost burden on the non-[too-big-to-fail] banking institutions and needs to be amended. It is an example of the triumph of hope over experience."
Five years after Lehman, the world is still working on hope over experience. I'm reminded of the famous paper by Columbia economist Carlos Diaz-Alejandro on the Latin American experience in the 1980s, "Goodbye Financial Repression, Hello Financial Crash".
Andrew Sheng is president of the Fung Global Institute