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Wall Street as a Feeder Fund for the U.S.

Posted by: Michael Mandel on March 14

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.

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Reader Comments

Joe Cushing

March 15, 2009 01:55 AM

I'M arguing in favor of letting all the banks fail that are going to fail. There are plenty of banks that are in good shape. If we let failing banks fail, it will make more room for healthier banks. Also, if we relaxed some regulations, a deep pocketed company like Wal-Mart could do what is has wanted to for a long time and enter banking. If Wal-Mart entered banking, it would create a lot of liquidity for our economy. They can afford to lend. People would trust them with their deposits.


March 15, 2009 03:31 PM

Another thought provoking post.
Today's fragile psychology should be accounted for in "systemic risk". This is something that didn't exist when Lehman went under and has changed the content of systemic risk.

Tom e.

March 15, 2009 07:48 PM

It seems like the more Wall Street is on its back, the less our trade deficit will be and the less pressure there will be to offshore US jobs. Hmmmm, lets keep these bums down for good.


March 15, 2009 11:32 PM

As evidence mount that we should allow these institutions to fail,you continue to hesitate,Mike,why?With the latest revelations that much of the bailout money given to AIG went to foreing banks,thus having US taxpayers in effect bailing out foreign taxpayers,when are we going to bite the bullet?As you mentioned our trade deficit is getting smaller at the same time our domestic savings rate is skyrocketing,implying that we will soon be able to finance most of the budget deficit ourselves.Therefore there is no need to cowtow to the foreigners and there is no reason they should not take a major haircut on their US investments along with US investors.They were just as responsible for the mess we are in as we are,so let's share the pain!!


March 16, 2009 05:17 PM

Every single bailout could be the subject of international collaboration between goverments since legal entities from many countries are usually involved. The problem is we still think in terms of our national sovereignty (our AIG, our GM, our Lehman and so on) and our legal system is tuned to this mentality. If these inhibitions (so unsuitable in the era of globalization) are left to the side, then there is also a third option : the international taxpayer should pay. An appropriate scheme could be invented, the mechanics are not so difficult to find.


March 18, 2009 06:02 PM

The primary purpose of the FDIC is to support individuals' trust in the banking system during major disruptions. And it works. There is no corresponding firewall for the global network and its very, very large monetary balances. When Lehman failed, trust dissolved and markets came to a screeching halt. Things restarted once the US Gov't took on the role of global "FDIC". Or so it seems to me.


March 18, 2009 06:35 PM


separately or together, I think we will end up paying more in proportion to what we each have than anything else. Which probably doesn't work out that much differently.

Thank you for your interest. This blog is no longer active.



Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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