The Telegraph
May 26, 2010
It’s Lehman the sequel, with Merkel as Bush
The big lesson of the financial crisis was that no bank must be allowed to fail. The same applies now to Greece. As the Queen’s Speech yesterday was overshadowed by yet another meltdown in global financial markets, I was reminded of Her Majesty’s faux-naif remark to the learned professors of the London School of Economics shortly after the failure of Lehman Brothers in the autumn of 2008: why did no one see this crisis coming?
The economists’ official answer, conveyed after another six months of deep cogitation in a three-page letter to Buckingham Palace, was that the economics profession did, of course, see it coming and had warned all along about global imbalances, excessive borrowing and so on. The problem was that politicians, bankers and overpaid financiers did not pay enough attention to the professional economists’ warnings.
The reason I have disinterred this episode is that the learned professors were wrong in their diagnosis of the disaster. The Queen’s question, taken in the context, was not about long-term issues such as mortgage debts and risk-management models. It was about the failure of politicians and economists to foresee the catastrophic consequences of allowing the failure of this one middle-sized bank.
The question of how the failure of Lehman turned a more-or-less normal boom-bust cycle into the greatest financial crisis of all has still not been satisfactorily answered by politicians, establishment economists and central bankers. And now, almost unbelievably, there is a serious risk that the world’s failure to understand the true lessons of Lehman will precipitate another financial disaster.
The key lesson from the failure of Lehman was that, in the midst of a systemic financial crisis, no significant bank should ever be allowed to fail. When an entire financial system is in peril, the cost of offering unlimited government guarantees and taxpayer bailouts will always be much smaller than the losses from allowing any significant bank to collapse. Such bailouts and guarantees may, in the long run, encourage excessive lending and other irresponsible behaviour, but that is an issue to be addressed by regulation after the crisis is over. In dealing with systemic financial crises, the risks of increasing moral hazard are irrelevant in comparison with the certainty of disaster triggered by the failure of any significant bank.
Today exactly the same analysis has to be applied to the risk of Greece or any other European government defaulting on its debts or dropping out of the eurozone. If any such default were to occur, it could trigger a global financial catastrophe even larger than Lehman. Yet the possibility of a Greek debt default or restructuring is being positively promoted by many of the world’s most respected economic and financial commentators. The German Finance Minister has repeatedly suggested temporary suspension from the eurozone as a punishment for the Greek Government’s transgressions. The German representative on the European Central Bank has stated publicly that he voted against the bank buying Greek government bonds. And the leader column of the Financial Times demanded yesterday that Greece must be made “safe to fail”, by preparing the ground for orderly restructuring. Such a restructuring, the FT went on to argue, would punish the German and French banks that were imprudent enough to lend Greece too much money and “whose governments inexcusably prefer to bail them out on the sly via Greece”.
These were exactly the sort of veiled threats, in some cases from the same authorities, heard before Lehman was allowed to collapse. It is hardly surprising that investors are starting to question the solidity of the guarantees against any kind of default that were supposedly provided two weeks ago by eurozone governments and the European Central Bank.
What is truly alarming about the present situation is that the world has so recently seen the catastrophic consequences of using debt defaults in the midst of a financial crisis to punish imprudent lenders. Yet some of the key policymakers and opinion formers seem, like the Bourbons, to have learnt nothing from the Lehman experience and to have forgotten none of their prejudices.
The fact is that if Greece were allowed to renege on its debts, the foreign banks that held €338 billion of Greek debt at the end of 2009 would immediately move to dump their additional €333 billion of Portuguese debt and probably their €1,500 billion of Spanish debt. And who knows how well over two trillion euros of Italian debt would be treated? The plunging value of Greek and Iberian bonds would immediately threaten several of the main French and German banks with insolvency, requiring government guarantees that would run into trillions of euros.
If Greece or any other member of the eurozone were temporarily suspended, as suggested by the German Finance Minister, the consequences would probably be even more catastrophic. The euro would immediately be revealed not as a genuine single currency but merely as a foreign exchange arrangement of the kind that has frequently collapsed under market pressures, for example in Argentina, Thailand and, not least, in the British experience of the ERM.
The citizens of Southern European countries would quickly understand this and would transfer their savings to banks in Germany and the Netherlands, leading to a collapse of the euro project within weeks and the probable failure of every Southern European bank.
Any such upheavals would dash hopes of global recovery from the 2008 crisis and would cause irreparable damage to public finances already on the brink of catastrophe. It is obvious that such calamities must be avoided, almost regardless of cost or whether it sets a bad example to improvident governments or bankers.
Astonishingly, however, the Greek tragedy in Europe is looking more and more like a revival of the Lehman drama. The €750 billion bailout package announced two weeks ago by EU governments is being hedged about with so many conditions and qualifications that it resembles the original $700 billion Bush bailout plan. The 16 bickering leaders of the eurozone seem to be emulating the confusion of the US political establishment and multiplying it by 16. And the starring role of the ideologically blinkered and incompetent President Bush, out of his depth and flailing helplessly in matters of high finance, is played by Angela Merkel.
Even as a long-time sceptic about the euro project, I find it almost impossible to believe that, just two years after Lehman, Europe would make the same blunders as the Bush Administration. But, as we have learnt again and again in this long period of turmoil, the impossible can become inevitable without even passing through improbable.
