Origins of the Great Recession
The collapse of Lehman Brothers five years ago exposed the rotten core of the west’s financial system, changing America, Ireland and the world
The defining event of our century thus far has been the failure of the West’s financial system. The consequences – budgetary, economic, political, social and geopolitical – continue to play out five years after that failure became fully apparent with the collapse of Lehman Brothers and the near implosion of the financial system. And they will continue to be felt for many years, if not decades to come.
The super-bubble that inflated in the developed world’s financial system and which burst half a decade ago was long in the making. By some measures, the financial services industry began to over-expand as long ago as the 1980s, after decades of being a relatively small and straightforward sector.
While Gordon Gecko types have always existed, the role played by aggressive speculators grew in the 1980s as investment banks moved away from providing big companies with financial advice and increasingly played the markets on their accounts.
Alongside the change in traditional Wall Street firms, a “shadow banking” system grew up in the 1990s which included new kinds of financial institutions, such as hedge funds. As memories of the financial collapse that led to the Great Depression of the 1930s faded, so too did the checks and balances imposed on the financial sector to protect the wider economy from out-of-control speculation. Many of the regulations of that era were repealed and the shadow banking system was left largely unrestrained.
The “financialisation” of western economies proceeded apace into the new century and, if anything, accelerated. As the rewards in finance rose over the decades relative to other professions, more and more of the brightest people in the world were drawn to it as a career.
Among other things, this allowed a belief to evolve that very sophisticated people, using very sophisticated financial models and selling very sophisticated products had removed, or greatly reduced, risk in the system.
The market for financial services, by this account, had become not only ultra-efficient, but very safe too.
The conventional wisdom turned out to be utterly wrong. The system the financiers had created was so complex that nobody fully understood it and, rather than being invulnerable to shocks, it had become ever more fragile.
As public and private debt levels underwent long-run increases in most western countries over decades, the entire system became increasingly vulnerable. That system, already teetering from the summer of 2007 when the first tremors had been felt, was hit by an earthquake exactly half a decade ago, when the largest default in world history took place. Lehman Brothers collapsed five years ago on Sunday. It owed $440 billion.
In the weeks that followed the Lehman collapse, the US and European financial systems slid towards meltdown, as the most intense financial panic since 1929 took hold. The tectonic plates of the rich world’s economy started shifting. So real and massive was the threat that governments began planning for the social disorder that would follow as even basic payments systems broke down (in developed economies banknotes and coins represent only around one per cent of the money supply, with the rest as mere entries on balance sheets).
By late October, the global financial system had begun to stabilise as a result of a series of unprecedented government interventions including bailouts, rescues, nationalisations and guarantees.
But it was too late to stop the shock spreading out to the real economy. And that happened with alarming rapidity. Consumer confidence collapsed and companies rushed to lay off workers in the hopes of surviving the upheaval.
Among the most immediate effects was a collapse in international trade on a scale and speed that had only one precedent – the Great Depression.
The parallel was brought home by a short academic paper that became one of the most-read scholarly essays in history. In April 2009, Irish economic historian Kevin O’Rourke and US co-author Barry Eichengreen published A Tale of Two Depressions. Within a week it had been read by 100,000 people.