"Did Lehman Brothers’s Failure Matter?"

James Surowiecki takes on John Taylor:

Did Lehman Brothers’s Failure Matter?, The Financial Page: By this point, it’s become conventional wisdom that the failure of Lehman Brothers last September was the catalyst for a massive selloff in the credit and stock markets and a general flight to safety from which the markets have yet to recover. ...

In the past few days, though, a new meme has started circulating through the economics blogosphere, suggesting that Lehman’s failure actually did not wreak the havoc that everyone who lived through last September thought it wreaked. This argument ... is based on a paper ... by the Stanford economist John Taylor, which purports to show (pdf) that the credit markets actually did not react all that badly to Lehman going under, and that the crisis was really the product of market uncertainty about the effects of government action. Taylor’s conclusion is based on one piece of evidence: a graph of the 3-Month LIBOR...

The problem is that the graph that Taylor relies on as his only piece of evidence (it’s on p. 16 of his paper) doesn’t demonstrate what he thinks it does. In fact, LIBOR rose sharply in the days just before Lehman failed—evidence that even the prospect of Lehman going under had people worried. It then dropped a little when AIG was rescued, but then went straight up again, so that in the seven days leading up to and just after Lehman’s failure, LIBOR nearly doubled. That’s hardly a sign of the market shrugging off the incident.

More important, Taylor’s assumption in his paper is that investors would have known right away how severe the repercussions of Lehman’s bankruptcy would be. But this is simply untrue—for whatever reasons (some suggest fraud, others panic), the hole in Lehman’s balance sheet was much bigger than people initially thought... As the magnitude of the losses became clearer, so too did banks’ risk aversion, since Lehman’s failure seemed to demonstrate starkly the risks of lending to any other big financial institution.

In any case, no one is arguing that Lehman’s failure alone was responsible for investors’ flight from risk... But it was the first, and crucial, moment in last fall’s market panic... In this case, then, conventional wisdom seems to be right. And in thinking about what Lehman’s failure tells us about how we should deal with tottering financial institutions today, I think Paul Krugman put it well a couple of weeks ago: “The collapse of Lehman Brothers almost destroyed the world financial system, and we can’t risk letting much bigger institutions like Citigroup or Bank of America implode.”

This may seem like an academic debate. But it’s not, because those who want to convince us that Lehman’s failure was not a big deal are doing so in order to shape future policy. In other words, they are arguing that when it comes to institutions like, say, Citigroup, the government can, in fact, let them implode ... without any disastrous effects. Maybe they’re right, but it’s an awful big gamble to take on the basis of a single, dubiously-interpreted graph.

I'm with those who believe that letting Lehman fail was a big mistake.