In September 2008, the collapse of Lehman Brothers triggered the worst economic crisis in the developed world since the Great Depression. Within two quarters, real GDP contracted by 3.3% in the US, by 4.7% in the Eurozone and by 7.2% in Japan. The rebound in markets and real economies started over the course of Q2 2009 after the US Fed had signalled its readiness to buy massive amounts of bonds in March 2009. Beyond the widespread misery which the crisis caused, for instance, for those people who lost their job, it turned out to be very expensive. From 2007 to 2013, the ratio of public debt to GDP surged by 41ppt in the US and 29ppt in the Eurozone.

Two US policy mistakes caused the catastrophe. First, the US Fed blew up a massive credit bubble with average annual credit growth to the private sector of 9.5% from 2004 through 2007. The Fed mistook the disinflationary impact of positive supply shocks (cheap imports from China, strong gains in productivity at home) for a potential harbinger of dangerous deflation. The Fed kept its policies too loose for too long despite healthy gains in real GDP.

Overly lax regulations and the irresponsible behaviour of many banks contributed to the credit excesses. But that is no valid excuse for the central bank. Whatever the micro issues, the central bank must employ its monetary and regulatory policy tools to steer the aggregate growth in nominal credit and money responsibly.

As the second mistake, US authorities triggered a virtual collapse of wholesale financial markets with their decision on 14 September 2008 to simply close a struggling investment bank, Lehman Brothers, instead of winding it down in an orderly fashion, as they had done with Bear Stearns six months earlier. Having started to deflate somewhat gently in mid-2007, the US credit bubble burst with devastating effect.

1) Mind the leverage. Keeping consumer price inflation close to or below 2% is not good enough for central banks. In addition, they must watch money and credit growth and other risks to financial stability. If need be, central banks should use their instruments to restrain credit growth and leverage even if inflation is on target.

2) Prevent the panic. If systemically relevant financial institutions hit trouble, they must be wound down in an orderly fashion to prevent a run on the banking system. Owners, managers and most employees of troubled institutions may well lose their entire stake and creditors may have to incur serious losses. However, the institution must remain open for long enough to honour its contractual obligations to its clients.

3) In case of a financial panic, central banks must act fast and decisively to restore confidence.

4) To combat a financial crisis, fiscal policy plays only a minor role. The huge stimulus programmes which the US passed in early 2009 did little to calm the situation. Only central banks with their ability to “do what it takes” can impress hyper-nervous investors enough to stop a panic in its tracks.

5) Unconventional times can require unconventional measures. Even the best rules for normal times must allow for exceptions under exceptional circumstances. Insisting on the dogmatic application of rules (no bailout ever, no deviation from fiscal rectitude) under all circumstances can be very costly.

6) Countries need to restore the health of their banking system fast in the wake of a crisis, as the US did after 2008, while many Eurozone members hesitated for too long.

7) Strengthen the shock absorbers. Making finance more boring through adequate regulation and higher capital requirements limits the risk of financial crisis.

8) Financial crises do not beget inflation. Instead, the cleansing of prior excesses unleashes strong deflationary tendencies. Expansionary monetary policies that were misguided during the boom can be required during and after the bust.

9) More reforms, less austerity. Countries that have lost access to funding markets may have to tighten their belts initially to reassure investors. However, pro-growth supply-side reforms are a much better way to improve the outlook for growth and fiscal sustainability than cuts in public investment coupled with tax hikes.

10) Do not waste a crisis. If a crisis lays bare the underlying weaknesses of a country (or company), it should be seized as the opportunity for fundamental pro-growth reforms.

Complacency in good times and herd behaviour in rough times are part of human nature. Swings from excessive euphoria to irrational pessimism, from boom to bust, have happened throughout history. They will happen again. The next crisis will come eventually.

However, humans rarely make the same big mistakes twice in rapid succession. The next crisis will probably not be caused by the bursting of a credit-fuelled real estate bubble. By and large, western economies have strengthened their defences against a replay of the post-Lehman or euro crisis. Aggregate credit growth remains modest across the western world despite very low interest rates. The authorities are more aware of the risks of excess leverage and have established procedures for an orderly winding down of failing financial institutions. Banks have built up bigger buffers. Central banks know that, if need be, they have to intervene fast and massively to stop contagion in its tracks.
No upswing lasts forever. Current US cyclical dynamics suggest that an economic correction that may well turn into a run-of-the mill recession in the western world may be due by 2021. But it will most likely not turn into a 2008/09-style mega crisis exacerbated by wholesale financial collapse.

In the 1930s, rampant protectionism exacerbated the financial and economic downturn and retarded the subsequent recovery. This time, the policy response to the financial crisis, once it had happened, had been much more effective. The post-Lehman fall in GDP was over after three quarters. Policy makers largely avoided the protectionist temptation. As a result, many advanced countries now enjoy full employment again. Even in the less fortunate countries, labour markets are healing. Over the past two years marked by Britain’s Brexit vote and the rise of Donald Trump, the protectionist risks have become somewhat more acute, though.

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