• Nassim Nicholas Taleb
Moderated by • Michael J. Elliott
Wednesday 28 January
36 Hours in September: What Went Wrong?
The failure of Lehman Brothers – followed, in short order, by a US government takeover of AIG and a hasty merger between Bank of America and Merrill Lynch – marked a major inflection point in the current economic crisis. Since those traumatic September days, market participants have debated whether a deeper crisis could have been avoided if Lehman had been saved, or whether a major collapse was inevitable at some point, given the mountain of bad debt left behind by the collapse of the credit bubble. This session provided a diverse range of perspectives from Wall Street insiders and some of the industry’s leading critics.
Key points
• A sizable majority of participants – including several economists and analysts who could fairly claim to have predicted the collapse of the bubble in advance – agreed that a major systemic crisis was inevitable, even if Lehman had been saved. One economist called efforts to blame the Lehman failure for the severity of the crisis a “revisionist myth”, designed to deflect blame from those actually responsible for the debacle, such as the lenders and brokers who created and package securitized credit products, collecting huge fees in the process.
• One Wall Street critic even argued that the events of last September were actually a blessing in disguise, since a Lehman rescue would have only allowed bank balance sheets to deteriorate further while policy-makers deluded themselves into thinking the problem had been contained.
• A minority of participants contended the US financial system and economy had, in fact, gradually been stabilizing in autumn 2008 as investment banks, hedge funds and other counterparties gradually wound down their counterparty exposures in the derivatives markets. Once Lehman failed, however, panic spread through the system, making it impossible for market participants to complete these trades, which would have reduced system risk and ultimately eased the economic impact of credit losses.
• While the current economic slump resembles the Great Depression in that both were triggered by financial panics and ensuing bank failures (Austria’s Credit-Anstalt in 1931; Lehman and a host of others last year) it is unlikely to rival the Great Depression in depth or duration. The fiscal and monetary policy measures being adopted in the current crisis dwarf those implemented during the New Deal, as the ideologically opposed remedies of economists John Maynard Keynes and Milton Friedman are both being implemented simultaneously.
• Still, any recovery is likely to be slow and feeble, with a Japanese style “lost decade” perhaps the most optimistic scenario for the United States. Although the parallel is not exact, this crisis may mark the onset of the twilight of US financial hegemony, much as the post-World War II sterling crisis coincided with the dismantling of the British Empire. The potential for international conflict and domestic political instability is high.
• Participants argued heatedly over the degree of culpability for the crisis that should be born by Wall Street, with one economist posing the question: How could the banks have been so stupid? This prompted one industry insider to ask the same question about regulators, borrowers, the credit rating agencies, politicians and central bankers – all of whom accepted the premises that the bubble was based chiefly on the notion that “great moderation” in inflation and economic volatility had drastically reduced credit risk.
• Participants offered a variety of answers to this question, with several economists and regulators citing the warped incentive systems used to compensate lenders. These encouraged individuals to ignore growing systemic risk on the assumption that their own financial fortunes would not be affected. Such behaviour may be destructive, but it is not necessarily irrational, one regulator cautioned. Others, however, cited the findings of behavioural economics, which suggest that market actors are influenced by deep psychological biases, including an innate tendency towards overconfidence.
• Ultimately, the very structure of the financial markets – and perhaps of capitalism as a whole – may have become unstable, both because they include a built-in preference for fragility (such as ever-increasing use of leverage) and because of their extreme complexity, which dramatically increases the risk of extreme “fat tail” outcomes. This may require a total rethinking of the use of price or return volatility as the standard measure of financial risk, since extended periods of low volatility may actually signal an increasing risk of an extreme event.