Why the ghost of Lehman still haunts us

File photo: Federal Reserve Board chairman Jerome Powell appears on a screen on the trading floor of the New York Stock Exchange during a news conference following a Fed rate announcement, in New York City, US, on 1 February.
File photo: Federal Reserve Board chairman Jerome Powell appears on a screen on the trading floor of the New York Stock Exchange during a news conference following a Fed rate announcement, in New York City, US, on 1 February.


The great focus on deflation is the major reason why we live in a boom-and-bust world. Booms lead to busts and then central bankers go all out to avoid deflation

Mumbai: On 15 September, it will be 15 years since Lehman Brothers—the fourth largest investment bank in the world—declared bankruptcy.

To control the economic aftermath of the bankruptcy and stop many other financial institutions from getting into trouble, the US Federal Reserve, along with other central banks of the rich world, decided to print money and flood their financial systems with it.

This was originally supposed to be a temporary measure to rescue the financial institutions. But over a period of time, it became a permanent measure and much of the money printed since 2008 is still around.

Further, the behaviour of the rich-world’s central banks during an economic crisis—from the dotcom bubble burst of 2000 to the Lehman crisis to the covid pandemic—has pretty much been in line with the learnings they have drawn from the Great Depression of the 1930s.

It also explains why we live in a world where financial and asset bubbles keep reappearing every few years. In this piece, we will look at this dynamic and try to understand why we’re never far from the next big bubble.

The Great Depression

After running up for many years, the Dow Jones Industrial Average, America’s premier stock market index, reached its then all-time high of 381.17 on 3 September 1929. Post the high, stocks ran out of steam. By 13 November, the Dow was down 48% to 198.69. By 8 July 1932, the Dow was down 90% from its September 1929 peak and hit a low 41.22. Soon, the troubles of the stock market spilled over to the commodity markets as well, gradually impacting the whole economy.

Between 1929 and 1933, the US economy contracted by over 25%. This was the economic depression. The wholesale prices of non-farm products fell nearly 25%. So, the US faced a deflation—an environment of falling prices—the opposite of inflation.

In this day and age, governments and central banks would have tried to do something. But, back then, things were different. In fact, as Andrew Mellon, who was the treasury secretary of the US at that point of time, said: “Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system."

Further, the little macroeconomic theory that existed, believed that people have enough money to spend at any point of time. Hence, a huge economic contraction or a depression wasn’t possible.

The paradox of thrift

The British economist, John Maynard Keynes, published The General Theory of Employment, Interest and Money in 1936. In this book, he came up with the paradox of thrift to explain the deflation and the depression. If a single person cuts back on expenditure, it makes tremendous sense. But if a significant section of the population cuts back, there is a problem, because one person’s spending is another person’s income.

During the Great Depression, as people spent less, businesses saw a drop in revenue, leading to people being fired and prices being cut. An increase in unemployment led to a further cut in spending. Given that citizens and businesses were not willing to spend more, the only way out was for the government to spend more on public works and other programmes. This would act as a stimulus.

The banking collapse

In 1963, Milton Friedman and Anna Schwartz published A Monetary History of the United States, 1867–1960, where they said that the Fed made a mess of handling the economy post the crash, leading to a depression.

Between 1929 and 1933, more than 7,500 banks went bust, leading to depositors’ money getting stuck or being permanently lost. This led to further cutting down of expenditure, as citizens tried to rebuild savings, fuelling the contraction further. Now, if the Fed had printed and pumped money into the banking system, enough confidence would have been created among the depositors and the depression could have been avoided.

The inflation years

Over the years, the theories of Keynes and Friedman/Schwartz have been fashionable with the global economic dispensation. In the post Second World War world, Keynes was popular. Keynes believed that the government budget should run surpluses when the economy is doing well and when it’s not, the government should spend more than it earns, run a budget deficit, and stimulate economic growth.

The politicians just ran with one part of the argument. They believed in running budget deficits when times were bad or even when things were looking a little worse, making budget deficits fashionable. This government spending led to high inflation through the late 1960s and the 1970s, through much of the Western world.

The most cited paper

In 1958, Alban William Phillips published a paper, which went on to become the most cited paper in economics. As Tim Harford writes in The Undercover Economist Strikes Back: “Philips gathered data on nominal wages (a good proxy for inflation) and on unemployment... He found [that]… when nominal wages were rising strongly, unemployment would tend to be low. When nominal wages were falling or stagnant, unemployment would be high." This relationship became famous as the Phillips curve.

The lesson that central bankers drew from this was that “we can tackle unemployment by accepting higher inflation".

So, it made sense for governments to spend money on projects, put extra money in the hands of citizens, and thus, drive up prices. Rising prices would ensure that people would spend their money today than tomorrow, when it would have a much lower real value. Money spent would lead to an increase in demand for businesses, which would lead to them recruiting more people, and thus, higher inflation would create employment.

This is where Keynes met Phillips. The trouble was that through the 1960s and the 1970s, the precise relationship between inflation and unemployment broke down and most of the rich-Western world saw high inflation along with high unemployment.

The relationship broke down because the Phillips curve did not take the incentives of people into account. Like Friedman pointed out: as soon as people started to realize that the government was trying to engineer some inflation in order to get people to spend, the game would be over. As William Bonner and Addison Wiggin explain in Empire of Debt: “[People] would not mistake inflation for greater demand: they would not increase production; they would not hire more workers; they would not spend more money."

The Great Moderation

Paul Volcker took over as the chairperson of the US Fed in early August 1979. The retail inflation peaked in 1980 at 13.5%. Volcker abandoned the Phillips curve and started raising rates. By the time he left office in 1987, inflation was down to 3.7%. What followed through the US and much of the Western world was a period of low inflation and was referred to as the great moderation.

Between 1985 and 2008, the retail inflation in the US averaged 3.1% (simple average) per year. This led to a belief among central bankers that they had solved the inflation problem. Nonetheless, the possibility of deflation still existed and had to be avoided at all costs.

But there was another factor that central bankers hadn’t taken into account: globalization. As Stephen D. King writes in We Need To Talk About Inflation: “The incorporation of low-cost producers, such as China and India, into the global trading system-led to a series of windfall gains for western consumers… The price of manufactured goods tumbled."

In this scenario, the central banks had two options. First was to let prices drift lower. But this would lead to the inflation target of 2% not being met. Also, in their minds, deflation continued to be a big evil. As Ben Bernanke, who would become the chairperson of the US Fed in 2006, said in 2002: “I would like to say to Milton and Anna. Regarding the Great Depression, you’re right, we did it… But thanks to you, we won’t do it again."

Second was to follow a loose monetary policy—maintain very low interest rates—in a bid to force prices of stuff other than manufactured goods to higher levels. This again stemmed from the fear of deflation. Central banks followed this and it pushed up the prices of services.

But at lower interest rates, savings took longer to compound, pushing more people into speculating with their money. This led to the dotcom and the telecom bubbles of the 1990s.

In the aftermath of these two bubbles bursting, the feeling was that there was a small chance of deflation. As Bernanke put it in 2002: “I would be imprudent to rule out the possibility [of a deflation] altogether." So, by November 2002, the Fed had cut the federal funds rate—the rate at which commercial banks in the US lend to one another on an overnight basis—to 1.25%. These low rates ended up fuelling a housing bubble. Financial institutions bet on the bubble in a bid to make a quick buck.

The bubble started running out of steam in 2007. By September 2008, many financial institutions were in trouble. The Fed and other Western central banks had to avoid deflation and the next Great Depression. So, by December 2008, the Fed had cut the funds rate to 0-0.25%, where it would stay for the next seven years.

The Fed also started printing and pumping money. The initial idea was to help rescue financial institutions. But over a period of time, it became a permanent programme, in order to drive down long-term interest rates, to encourage people and companies to borrow and spend, to prop up economic growth.

The US Fed started this in November 2008. It started reversing in late 2014 and early 2015, but had to go back to money printing again in late 2019, even before the pandemic had become a reality. As King writes: “Fears of deflation refused to go away, partly because economies were unable to return to the growth rates of old."

The everything bubble

Once covid struck, interest rates were cut to almost 0% and money was printed and pumped all over again. The fear of deflation ruled. As King writes: “As economic activity collapsed alongside covid-induced lockdowns, central bankers feared a repeat of the 1930s Great Depression." There was no threat of inflation.

This time, the governments also handed over money directly into the hands of people. All this led to the everything bubble. As Edward Chancellor writes in The Price of Time: “Bubbles in stocks and bonds, in real estate and household wealth, in cryptocurrencies and digital art, in luxury goods (supercars and Swiss watches) and household pets (Cockapoos selling for $5,000 a pup), and in collectibles (baseball and Pokémon trading cards)."

But there was also generalized retail inflation of the kind the Western world hadn’t seen in nearly four decades. Of course, one part of it was because of the collapse in global supply chains due to lockdowns. But with more money in the hands of people, and people feeling richer because of the bubbles, once the lockdowns ended, the consumer demand came back and drove up prices.

In fact, for almost one year after inflation struck, the central bankers kept saying that the inflation was transitory. This was because in their minds inflation was a problem they had already solved.


The great focus on deflation is the major reason why we live in a boom-and-bust world. Booms lead to busts and then central bankers go all out to avoid deflation. In the process, they end up creating another bubble.

In order to get out of this doomed loop, central bankers first need to start talking about the fact that their actions lead to bubbles and incorporate that possibility in the monetary policy they make. Bubbles are also a form of inflation ultimately. As King writes: “The bias against deflation may have inadvertently created a bias in favour of inflation."

Further, the fact that high retail inflation appeared nearly after four decades should teach them another lesson: The future may not continue to be like the past even though that’s how it has been in the past. Otherwise, sooner or later, the next Lehman Brothers will come around all over again.

Vivek Kaul is the author of Bad Money.

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