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I was just reading a post by James Surowiecki where he was arguing that “Lehman’s Failure Mattered.” However, he never explained *why* Lehman’s failure was so quickly shattering to the world’s financial markets.
I think of it this way: Wall Street was a feeder fund for the U.S. economy. The massive amounts of money necessary to finance the trade deficit—$680 billion in 2007, or roughly $2 billion per day—were flowing into the country with the Wall Street firms as the main conduits. That includes Treasuries as well, since most foreign purchases of U.S. government bonds go through major banks and investment houses (the so-called ‘primary dealers’).
In other words, there was a high-pressure fire hose of money coming into the country, with most of that flowing through Wall Street on its way to mortgage-backed securities and the like. When Lehman went under, it was if that high-pressure fire hose was suddenly stopped up, with horrific consequences. Nobody wanted to run their money through Wall Street given the threat of failure and loss.
When that happened, the money instaneously backed up, and the whole global financial system came darn near breaking. Think about it. On a typical day, money was being collected by banks all around the globe, and passed back and forth by circuitous routes and in diverse currencies. However, at the end of the day, about half of all the net capital accumulation by trade surplus countries (top five: China, Germany, Japan, Saudi Arabia, Russia) was eventually sent on to the U.S.
Now, this money was flowing to the U.S. because the U.S. was thought to be a low-risk, decent return investment (see my previous post). Investments in other countries were being perceived as higher risk, or lower return (which comes to much the same thing). When Lehman went bankrupt, the low-risk U.S. investment strategy suddenly vanished. For big foreign investors--Saudi Arabia, Russian oil oligarchs, German banks--the world suddenly became a lot riskier, in a very real sense.
Now, there's an interesting implication to this analysis. If I'm right, we could let a major bank fail today without Lehman-like global consequences. The reason is two-fold: First, the trade deficit is a lot smaller, so the fire hose of money coming into the country is operating under lower pressure. The January trade deficit was $36 billion, compared to $58 billion in September 2008.
Moreover, the fire hose is now flowing through Washington rather than New York. According to CBO estimates, the federal government ran a deficit of $78 billion in January, more than twice as much as the size of the trade deficit. So government borrowing could in principle absorb all the foreign demand for U.S. securities, as long as there were enough primary dealers in Treasuries.
From that perspective, a February post on Barry Ritholtz's Big Picture blog is useful. The post argues that the number of primary dealers should be increased, going as far as allowing most banks to participate.
I'm not arguing in favor of allowing a bank to fail. The bankruptcy of a Citi or Bank of America would be extremely messy, painful, and to be avoided if possible. But it may not cause the systemic risk that Lehman does.