John Taylor took the trouble to respond to Paul Krugman's latest outrage on the sources of the financial crisis. Taylor's post -- along with the deeper analysis he points to -- is well worth reading.
Krugman's calumnies are so nonsensical I generally do not find it worth responding.
The idea that I now like stimulus is simply preposterous if you bother to read what I write about it. (Here, here and here.) The idea that I or John Taylor don't think there was a run is even more preposterous. (One of many examples here, p. 7: "Why was there such a large fall in output? For once in macroeconomics we actually have a good idea what the shock was—there was a ‘‘run’’ in the shadow banking system.")
To top it off, Krugman writes "Anyone else have the impression that something happened in the second half of September 2008?" I mean really, accusing Taylor and myself of thinking that nothing happened in September 2008? Are Krugman's readers such simpletons that they fall for such unvarnished falsehoods?
Taylor did us a service by taking the time to straighten this one out.
Yes there was a run.
Taylor's detailed work shows what many of us sensed: That the run was not triggered by Lehman's bankruptcy. Instead a good part of the run can be laid at the feet of Treasury Secretary Paulson, who showed up on national TV asking for 700 billion dollars, with three sheets of paper in front of him, no clear explanation of what he wanted to do with the money, and with a hastily-imposed short-sale ban on bank stocks. How to Cause A Run 101.
More importantly, Taylor's work also puts to rest Krugman's idea (last sentence) that Lehman caused or threatened a chain of bankruptcies. Ed Lazear puts it nicely: it wasn't dominoes, it was popcorn.
That's what a run is. When a piece of news comes out that banks may be in trouble, people pull their money out of all the banks at the same time. Krugman is being simply incoherent in first calling it a run and then a threatened chain of bankruptcies only saved by further bailouts.
In fact, the run is central to my view of the crisis and its lessons. I doubt Krugman has thought through the implications carefully, along with the distinction between dominoes and popcorn, as they run directly counter to his worldview.
Runs don't have a single cause, they have a straw that broke the camel's back. Ask yourself, would simply bailing out Lehman have avoided this whole mess? Obviously not. People saw Lehman go under -- and Paulson's speech, plus short-sale ban, plus everything else going on at the time -- and asked themselves, "gee, my bank was investing in the same things Lehman was. I wonder how they're doing? I'd better pull my money out just to be safe." ("People" here means institutional investors in the shadow-banking system, i.e. prime-brokerage customers, repo investors, derivatives counterparties, asset-backed security investors.)
In the circumstances of Fall 2008, suppose that the government had announced a big Lehman bailout, especially along with Paulson's speech. Well, you come to just about the same worries about your own bank, as if Lehman had not been rescued, don't you? If they had to rescue Lehman, they must have been in real trouble. I wonder if my bank is in similar trouble?
Actually it would have been worse. such a bailout would have also come with a howl of protest, and it was clear that the bailouts would have to end somewhere, and the next one would be bigger. AIG? Citigroup? Hmm, let's take our money out extra special fast as a big blowup is coming this way.
The insight that it was a run is central to my view of how to fix things. If it was a run, echoing, as Krugman says, Friedman and Schwartz's view of the Great Depression, then some of Friedman and Schwartz's conclusions are surely warranted! No, this was not some mysterious failure of capitalism and we need to have the Fed run everything under Dodd-Frank. No, this does not require that we save every big institution and protect them from competition and failure forever. This was one run very like the many runs and panics we've seen throughout history.
Our run was in the shadow-banking system. I recommend Darrel Duffie's "Failure mechanics of dealer banks," the article and the book Once you read these, you naturally see simple ways in which we can fix bankruptcy law and run-prone assets in place of Dodd-Frank. How, exactly? That's a subject for another post -- actually a long series -- coming up.
Yes it was a run. And that fact leads directly to some very un-Krugmanlike conclusions.
(If you want to read what I actually have written so far about this issue it's all here. I'm teaching a class this week on financial crisis -- we're going to spend a lot of time on Duffie and Gary Gorton's analysis of the run in repo markets.)