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Tuesday, February 21, 2012

Getting Off Track and the Panic of 2008 Revisited

In a recent blog Paul Krugman, borrowing from the Economics of Contempt, takes on John Cochrane and me for our interpretations of the events leading up to the panic of 2008, and in particular my point that it was not the Lehman bankruptcy per se that was the underlying cause of the panic but rather the ad hoc and unpredictable policy leading up to and following the bankruptcy. The only evidence Krugman gives against my point is a plot of the “B of A Merrill Lynch US High Yield Master II Effective Yield” over a two year interval in which the crucial timings of the day to day movements are barely visible.

I first wrote about the panic of 2008 (including the Lehman bankruptcy, the AIG bailout, and the rollout of the TARP) in my book Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis, published three years ago in February 2009, which in celebration of the three year anniversary is now available as an e-book for only $2.40.

If you look at the charts in that book you will see a detailed consideration of the daily data. I focused on the spread between Libor and the overnight index swap (OIS), and showed that the major upward movements in this measure of stress occurred at the time of the TARP rollout. Moreover, this measure of risk peaked as soon as it was clarified that the TARP would be used for equity injections, suggesting that confusion about the TARP was a large source of the uncertainty and panic.

I wrote that the surprise of the bankruptcy (a consequence of the ad hoc nature of the policy) made things worse. Due to the careful work of Kimberly Summe we know that many creditors of Lehman did not have to go into bankruptcy, and while I referenced that fact it was not a major part of my argument and not even mentioned in Getting Off Track. That reference is now criticized under the claim that all those creditors were in turn bailed out, but that claim needs to be verified empirically.

To bolster the original case I also looked at daily movements in the S&P 500, as shown in this chart (drawn from my introductory economics text). Note that the S&P 500 was higher on the Friday after Lehman than the Friday before Lehman. Note also that the panic ends on Oct 13 when the operations of the TARP were clarified.