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September 13, 2013 12:59 pm
This time is different. Lehman Brothers has been in the history books for five years now. Its crash sparked the greatest financial crisis in at least eight decades. Financial history offered great insights into what would happen next, which I relied on – unfortunately. One instant judgment I made at the time was proved almost instantly wrong.
The decision by the then US Treasury secretary Hank Paulson to allow Lehman to fail was an attempt to crush “moral hazard” – the tendency for people to take more risks when they know they have insurance. After several bailouts for other stricken financial institutions over the preceding decade, it appeared that traders and executives believed there would always be a rescue from the government if they needed it. Mr Paulson thought it was necessary to show that failure could happen. This is what happened after previous bubbles – moral hazard is resolved for a decade or two when markets fall, people lose their jobs, and a new generation learns that failure is possible.
I therefore proclaimed that Lehman heralded the “end of the decade of moral hazard”. And the next day, the government announced an $85bn bailout for the insurer AIG.
Mr Paulson wanted to end moral hazard. But the near-total seizure of the world financial system that followed Lehman had the opposite effect. It showed the market – and the government – that no institution of that size could possibly be allowed to fail. Thus, if anything, moral hazard has grown since then. Bankers have faced down attempts to re-regulate them and large institutions have bulked up even more. The world would have been a safer place today if such decisive action had been taken.
Then, look at markets. Again history offered a clear template. The chart compares the market responses after the Great Crash (following a peak in September 1929), the crash of Japan’s stock market from New Year’s eve 1989, and the bursting of the Nasdaq bubble in 2000.
Each time, after the crash, stocks found a level, and enjoyed a few rallies, while moving crab-like, sideways for many years. That is the pattern I expected for the five years post-Lehman.
But this crash bears no similarity to any of these previous incidents. A different dynamic is plainly at work. The extra ingredient has come from the Federal Reserve, and also the US government.
The S&P500 hit bottom in March 2009 when it became clear that the Tarp (Troubled Assets Relief Program – the US government’s single most contentious act that requisitioned $800bn in public money to shore up the banks) was beginning to work. This was when Citigroup and Bank of America, the focus of the greatest concern, announced that they were trading profitably.
Rises in the S&P500 have correlated almost perfectly with injections of money from the Federal Reserve, which has stimulated markets by buying bonds in a policy now universally known as QE. Lulls in the stock market’s recovery overlap with lulls in QE.
If the pattern of markets after previous crises has been breached, the pattern of economies has not
Whatever else can be said for Ben Bernanke, the Fed’s chairman, he has not made the same mistake again. Thanks to the time he has bought the US with the QE money, many good things have happened: banks have recapitalised; house prices have hit a floor and begun to recover; inflation never reared its ugly head; unemployment is less bad than it was.
But here, things grow problematic. The hit to the world economy has, in the event, fallen far short of a replay of the 1930s Great Depression. This is thanks to China and the emerging markets. After falling by less than 1 per cent in 2009, world gross domestic product has grown at an annual clip of 3 per cent or more ever since.
But in the western world, this recovery is still anaemic. If the pattern of markets after previous crises has been breached, the pattern of economies has not. Outside Germany, unemployment remains at politically unacceptable levels throughout the western world. But at some point, the monetary stimulus must end – and the Fed has signalled that it will at least begin to taper off that stimulus at its meeting next week.
Is the economy strong enough to survive QE’s removal? And can market gains remain intact?
US experience suggests that markets should be fine. Bond yields have been rising since July last year, anticipating the end of QE. Those yields have not pushed stocks down.
Emerging markets suggest otherwise. Their growth has slowed significantly, and the onset of tapering speculation drove a sharp fall in stocks and currencies, particularly for countries with big current account deficits such as India or Turkey. Those falls have been arrested in the last week or so, but that may only be due to hopes that next week the Fed may not taper, or not taper very much, after all.
The great post-Lehman rally is facing its critical test. If markets take the end of QE in their stride, then maybe this time really is different. But that remains a big if.
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