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On Krugman, Lehman, banks and bailouts


In a recent column Paul Krugman expressed his astonishment about a message spread by Economics of Contempt that John Taylor from Stanford University and John H. Cochrane from the University of Chicago “are denying the importance of the Lehman shock”. If this is true it is not really news – the Cochrane text is of winter 2009/2010, the Taylor interview was conducted in December 2009, so the question is why our attention should be drawn to these two right now.

In the Economics of Contempt piece, there is a lot of ranting about fictitious analysis, ridiculous claims, bizarre attempts, genuine fright  and the authors’ prominence as finance professors which make the motives hard to judge for an outsider.

Studying texts and interview I got the impression that both Taylor and Cochrane had a point which refers to the TBTF problem. In order to show you what I mean I would like to quote a few examples:

After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman … everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad. (Cochrane)

… the central financial problem revolves around the expectation that banks will be bailed out. (Cochrane)

… there is nothing inherently “systemic” about the behavior of Lehman Brothers or other large banks.What is systemic is the expectation of a bailout. The policy question is simply how to escape this horrible moral-hazard trap. (Cochrane)

… if there had been a clear policy put forth whereby people could have expected the possibility at least of Lehman being put through bankruptcy, then there could have been some preparation. (Taylor)

.. there is at least as much evidence that the panic was caused by the response as distinct from that particular event at Lehman Brothers. (Taylor)

… the responsibility of Wall Street in this crisis, and it still hasn’t been resolved is the dependence of the financial institutions on the government for bailouts and interventions. (Taylor)

… government needs to find a way for it to get out of this bailout business. (Taylor)

The only way to limit expectations of a bailout is for the government to give up the legal authority to do it. (Cochrane)

To give government officials the power to bail out firms at their discretion, especially if those officials are elected or political appointees (my emphasis), is practically to guarantee a bailout. In a crisis, everything looks systemic. … (Cochrane)

If I got it right I see these authors’ views  as support and endorsement of a claim for damage control instead of bank bailout I made not long ago elsewhere in another context. To me they seem neither bizarre nor ridiculous. But maybe my interpretation is wrong. Since the topic is too important to pass unnoticed decide for yourself. Here are the links again:

Paul Krugman

Economics of Contempt

John Taylor

John H. Cochrane



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