today’s U.S. economy in perspective (before and after Lehman)

In the 1990s, the U.S. economy experienced both rapid GDP growth and rapid productivity growth.  As economic cycle moved towards contraction, the Federal Reserve lowered interest rates, as usual, so as to mitigate the downturn.  Normally, the Fed would have been concerned about keeping interest rates too low for too long because of the risk of stoking inflation, but inflation was mitigated by a number of factors, most notably the continued opening up of the economies of China and India.

Lacking the usual signals and concerns regarding inflation, the Fed kept interest rates low enough for long enough to create an unprecedented climate for borrowing and investing.  With the inherent baseline for interest rates unusually low, it became unusually difficult to earn a given rate of return, so investors needed to become more aggressive to achieve the same results.  And while borrowing was so cheap, many investments became temporarily less risky, because otherwise shaky companies, consumers and investment vehicles could borrow money cheaply to keep them solvent.

The cheap money lasted long enough to reorganize much of the way the financial sector invests.  Leverage, always a factor, became that much more enticing as the cost of borrowing went down.  Investments that were not long ago consider exotic, such as sub-prime mortgages and emerging market debt, because popular choices.  (The rapid growth of Fannie Mae and Freddie Mac exacerbated the problem within the mortgage market by using their extra-low cost of borrowing to dominate the market for mainstream mortgages, pushing banks towards ones that didn’t meet the lending criteria for Fannie and Freddie.)

The availability of ever more powerful computers made increasingly sophisticated risk analysis possible.  In additional to providing a false sense of security, this drove the creation of ever more complex financial instruments, often designed to allow very specific types of risk to be bought or sold.  Many trillions of dollars of new assets types were created and sold.

Between the unprecedented economic conditions and the new types of financial instruments, even the most sophisticated computer models lacked the raw data to make accurate risk assessments.  Meanwhile, shareholders and other investors demanded high returns.  A bank, hedge fund, or other investment entity that underperformed its peers because it took a more conservative investment approach would be punished.  So the whole industry moved towards riskier assets without the ability to make meaningful assessments of the risks.

Inevitably, this brought us back to one of the most classic risks in the economic system — bank runs.  Fundamentally, banks are based on confidence, and backed by a relatively small cushion.  A bank is never too far from a vicious cycle in which reduced confidence causes depositors (and/or other creditors) to pull money out which reduces the cushion, which in turn reduces confidence further.  Given the relatively small percentage of assets kept as a cushion, investment losses or high levels of loan defaults can quickly deplete the cushion enough to start this cycle if new capital is not raised quickly.

Mostly because of deposit insurance, everyday consumer depositors are among the less likely triggers of bank run (in the United States — the weaker deposit insurance in the United Kingdom was a large factor in the Northern Rock bank run).  While investment banks don’t necessarily have the extra risk of short-term liabilities (i.e., deposits that can be withdrawn at any time) against long-term assets (loans they can’t call back in quickly) which retail banks do, they’re still similarly vulnerable.  They have ample short-term liabilities, and selling assets under duress is bound to reduce their value.  So both conventional and investment banks are vulnerable.  Indeed, any highly leveraged investor (which includes hedge funds and many insurance companies) is similarly vulnerable.

When the credit crunch started to bite, it was because banks and other players in the investment community realized that not only are there lots of vulnerable parties, but it’s fiendishly difficult to figure out how vulnerable another party is to a bank run (or equivalent) — risk analysis under these circumstances is inadequate enough when you have all of the data; it’s nearly impossible from just public disclosures.  That caused a drop in interbank lending, with intermittent much larger drops whenever there’s news that makes investors nervous.

As losses continue to climb, and show up in ever more places, more and more parties are vulnerable to the vicious cycle of collapsing confidence and cushion.  Even though the Fed’s policy interest rates are still low, borrowing is difficult and expensive.  The Fed keeps taking further steps to make money more available, but as confidence collapses, money becomes less available to many players throughout the system faster than the Fed can compensate.

What makes the bankruptcy of Lehman Brothers such a significant event in all this?  In addition to being a larger player than Bear Stearns, the Fed reacted differently.  In the case of Bear, the Fed facilitated the sale by effectively guaranteeing the value of $30 billion of Bear’s less liquid assets.  No such action was taken for Lehman.  While it was never realistic to assume that the Fed would (or even could) find ways to prevent the collapse of every large insolvent investment bank, the fact that the Fed allowed Lehman to collapse significantly widened the set of entities that are now perceived as risky.

What happens next?  The unwinding of Lehman will cause some pain, but will probably not be too dramatic outside of the financial industry.  Many other institutions facing losses will seek to do what Merrill Lynch did and find a buyer, but given how few large financial institutions have healthy balance sheets most will not find one.  There will be more high-profile bankruptcies.  Failures of banks and insurance companies with large numbers of retail customers will be messier.  The Fed will try harder, in those cases, to broker deals that prevent collapse — both to mitigate the impact (psychological as well as economic) on consumers and to reduce the stress on the FDIC’s pool of assets.  But it is highly likely that some failures directly which affect millions of consumers will occur.  Those kinds of failures are likely to impact consumer spending, which will deepen the recession.

The risk of a high-drama freeze-up of the financial system is real, though probably not very likely.  The risk of a deep and memorable recession, however, is high.  And the dollar will weaken, and inflation will rise.  The turmoil may have a permanent impact on the way we think about banks, the stock market, retirement savings and other financial matters.  There are guaranteed to be new challenges for the next president.  But beyond those vague statements, the details are too murky to guess.