Lehman's Legacy?

The collapse of Lehman accelerated and exacerbated a pre-existing trend; it did not create it.

Foreword

Late afternoon on Friday 12 September 2008, I cleared my desk at 25 Bank Street in London’s Canary Wharf and headed with my wife, Clare, to Heathrow to fly to Botswana on vacation. My last two substantive actions before I left my booth were to send out an update of my then signature publication, Issues which keep me awake at night, and to follow that up with an email to my clients advising them that I would be away for nearly a fortnight, that I would sleep soundly during my break, but that I was not at all sure I would have a job on my return or, if I did, for whom. As you will no doubt have determined by now (if you didn’t know already), I was, of course, working for Lehman Brothers at the time.

The collapse of Lehman on 15 September 2008 is something about which I have deliberately avoided writing (other than en passant) in the years since. Many have written about it — some well-informed, some less so and some somewhat self-indulgently (my favourite being a couple of newspaper articles by one of my former colleagues, who was by no means a major player, which basically argued ‘if only Dick Fuld had listened to me’!). And it had not been my intention to write about it now, at the tenth anniversary, as I stand firmly by my long-held view that, probably, no-one really has the complete picture of what happened in the months leading up to Lehman’s demise and that such ‘insights’ as some of us do have are very likely to be disputed by others.

For example, from the perspective of at least some of us in London, the game appeared to be up even in early February when, as I understand it, immediately after a board meeting in New York, a London-based senior executive of the firm resigned and a second tendered his resignation but agreed to stay on for a while. If you read into this an implication that I believe a plan developed in London which could have saved the firm to have been rejected by our senior colleagues in New York, you are correct. But I am absolutely sure that no-one among the latter group would agree with me!

However, I have been spurred into changing my mind (probably self-indulgently!) by one of my journalist contacts who sent me a series of questions about the consequences of Lehman’s collapse earlier this week. The substantive part of this article, which follows, is an elaboration of the answers I sent her — and I am grateful to her for encouraging me to pull together various strands which I have been exploring in articles for The Global Lead in particular over the past year or so.

But before I come to that, allow me to return briefly to September 2008. Notwithstanding my observation earlier about the sense in at least some parts of the London office as early as February, I doubt anyone remotely anticipated how events would play out. The — in retrospect, highly wishful — thinking on the trading floors in London on the 12 September was that, over the forthcoming weekend, either Bank of America or Merrill Lynch (which, as it turned out, were effectively merged that same weekend) would be arm-twisted by the US authorities into acquiring Lehman, ie in much the same manner as JP Morgan Chase had acquired Bear Sterns back in March.

What actually happened was, of course, much more traumatic, both at the time and, certainly, in its consequences. Over the weekend of 13/14 September, a deal was struck in the US for Barclays to acquire Lehman’s assets in North America.

In common with then US Treasury Secretary Hank Paulson, most Americans to whom I have spoken about this since put the blame firmly on the UK for the fact that the deal was geographically limited. But I am convinced that the regulators in the UK were right to take the course they did, given the very limited amount of time available. Indeed — and now I am going to be not only self-indulgent but probably partial (with apologies to my friends and former colleagues working for Lehman in the US at the time, at least some of whom are still with Barclays there) — many of us in Europe and Asia were, rightly or wrongly, left feeling ‘sold out’ by the US, especially as our part of the business was very healthy still indeed when the collapse occurred.

Be that as it may, Clare and I were in one respect very fortunate indeed. In Botswana’s beautiful Okavango Delta we had no phone signal (let alone internet) and little of the outside world reached us during our vacation. Indeed, it wasn’t until we were about to return to London that I received a call from a colleague which allowed me to catch up with the news — and reassured me that I did indeed have a job to go back to as I had effectively been ‘acquired’ by Nomura! But what I can only describe as the state of ‘shell shock’ clearly evident on the face of my colleagues when I got back to my desk on 26 September remains with me to this day.

But it simply isn’t all about Lehman!

“The great Wall Street meltdown is a huge economic and financial event. But might it also signal a historic shift in global politics – a moment that marks and accelerates the decline of American power?”

Gideon Rachman, Financial Times, 30 September 2008

On 16 October 2008, speaking at the Royal Institute of International Affairs (better known as Chatham House) in London, I gave the first of what turned out to be many presentations on the implications of the collapse of Lehman.

My starting point was something about which I had been speaking and writing since early 2008, ie the rapid shift from west to east of the global economic centre of gravity, drawing on the work of my friend and sometime collaborator, Professor Danny Quah (more of whom later in this article). I linked this to another, related, theme I had been developing in the preceding months as follows:

“I am confident that historians looking back on the [then] current decade will view the second half of 2001 as something of a watershed moment in global affairs. I support that view. But the date I have principally in mind as the ‘moment’ is not 9/11; it is 1 December 2001.

That was the date when China joined the World Trade Organisation. This was an event which I believe we shall come to see as much more important in the broad than the events of 11 September 2001, as it marked a major watershed in China’s ongoing quest for ‘comprehensive national power’….”

I went on to quote from a book from which I have drawn extensively over the years (including in my 18 March article on the recent paradigm shift in US foreign policy), ie Ronald Findlay and Kevin O’Rourke’s Power and Plenty, published in late 2007, as follows:

“...the gradual rise of India and China to their natural roles as major economic and political superpowers [is] not only the best news for global human welfare in a generation, but [promises] to raise a variety of geopolitical challenges which as yet remain unpredictable. Indeed, history suggests that this could turn out to be the greatest geopolitical challenge facing the international system in the twenty-first century.”

The key point here is that this all predates the collapse of Lehman Brothers, supporting my view that Mr Rachman is spot on in the quote at the start of this section in suggesting that that event should be seen as “… a moment that…accelerates the decline of American power”.

In other words, as I suspect we can all agree ten years on, Lehman’s demise has undoubtedly contributed to the challenges we face today. But it was certainly not, of itself, the cause so much as an accelerator and exacerbater.

Keeping a sense of proportion

All of which brings me to an ‘editor’s note’ entitled The American Crisis’ by Jeffrey Goldberg from the October issue of The Atlantic, in which he asks:

“Amid assaults against the press and the rise of technology, democracy is in a fragile state. Can it overcome the challenges it faces?”

Mr Goldberg sets out a persuasive series of arguments to support his crisis thesis, an assessment in which he is, of course, far from alone. I found this quote from Jeffrey Rosen, President of America’s National Constitution Center particularly telling:

“The goal in America today is to resurrect the primacy of reason over passion — what we are watching now is the struggle between logos and pathos. The central question in our democratic age is this: Is it possible to slow down the direct expression of popular passion? The answer to this question is not obvious.”

Nevertheless, replying to the questions posed by my journalist friend earlier this week, which were premised on there being a crisis confronting not only liberal democracy but also globalisation, I began as follows.

“There is no question other than that the world in general and 'the West' in particular are facing some daunting challenges today. Furthermore, the collapse of Lehman Brothers and its aftermath have undoubtedly contributed. But it is, I think, important to keep things in proportion.”

The end of the democratic era?…

I turned first to liberal democracy, recalling that, after the collapse of the Berlin Wall in 1989, liberal democracy expanded in an unprecedented manner. As an example, I pointed my journalist contact to her own country, Chile, where, admittedly, the process which led up to the restoration of democracy had begun in 1981 but where the consolidation of such owed much to the end of the Cold War.

However, and with all due respect to Francis Fukuyama, history is never, in my view, linear and setbacks are inevitable. Nevertheless, to write off liberal democracy as a spent force— as, for one, China’s President Xi Jinping appears to be trying to do — is, in my view, seriously overstating the ‘crisis', as any reading of the history of the 20th century should make clear. Citizens, perhaps especially the young through social media, are demanding their say and their 'rights' the world over...and will continue to do so, in my view, even though there will be inevitably be setbacks, some major (eg the 'Arab Spring’). This is, of course, the other (positive) side of the coin relative to Mr Goldberg’s legitimate concerns about the role of technology in democracies and it should not be dismissed.

In the presentation I gave at Chatham House in October 2008 I offered five main conclusions, the first of which was that the international community would fail to fix the financial system — just as it had after the Asian Financial Crisis and the Global Economic Crisis of 1997-98. To be fair, since its 2 April 2009 summit, the G20 has done considerably more in this respect than the G7 managed to achieve a decade or so earlier (which was, in fact, tantamount to nothing, as is underlined by the clear overlap between what the G7 had said it was going to address and what the G20 later committed to). Nevertheless, I am far from alone in considering that, overall, this forecast has stood the test of time.

Where we stand today was neatly summed up in a 13 September article by Karishma Vaswani, writing for the BBC, about how, to date, the collapse of Lehman drove big shifts in Asia, as follows:

“The last 10 years have seen strong growth in Asia and China and that's helped this region weather the storm during the global financial crisis.

For better or for worse, it shifted Asia away from a heavy reliance on the West.

But now with Asia's biggest economy — China — slowing down, the big fear is that another crisis could be brewing.

No-one's quite sure where it would start this time — and how badly we could all be affected.”

[Note: For what it’s worth, because of the shift in the global economic centre of gravity, my sense back in 2008 (and for some years thereafter) was that the next financial crisis would kick off not in New York, London or Frankfurt but in Dubai, Mumbai or Shanghai. As, eg, Professor Ken Rogoff believes, China still seems a likely candidate for this dubious honour. However, a combination of US President Donald Trump’s regulatory 'reform' agenda, fiscal incontinence, and protectionism has caused me to reconsider more recently and to conclude that the next financial crisis could, just as easily and to quote a phrase, be made in America. In short, we don’t know where the next crisis is going to come from; but coming it certainly is.]

The failure to fix the system — and, indeed, the rolling back of some key measures which were put in place by the US — is clearly a very big issue. But arguably even bigger has been the fact that — in part as a consequence of this — economic imbalances in society in the UK and US in particular have not been addressed, thereby fuelling the rise of populism.

Just as telling, no-one went to jail over the collapse of Lehman. If not just bankers but also culpable regulators and politicians had suffered meaningful punishment for the smoke and mirrors of subprime (at the heart of the crisis), the West and liberal democracy would undoubtedly still face challenges but probably not on anything like the same scale as it does today. My personal view is that there is a very direct link between this failure and both the electoral success of Mr Trump and (albeit probably somewhat less so) the outcome of the 2016 Brexit referendum.

[Note: Some time around the end of the first quarter of 2007, ie just a few weeks before the crumbling of the edifice became readily apparent in July, I took two of my then colleagues at Lehman to meet representatives of a major Middle Eastern client who had asked for an explanation of sub-prime. They made no bones about their belief that the whole principle of tiering subprime debt with the top x% designated AAA was highly questionable, drawing as an analogy a penthouse at the top of a tower block with inadequate foundations. This must surely have been as apparent to governments and regulators as it was to the proverbial ‘smartest guys in the room’.]

…and the reversal of globalisation?

This takes me to the aforementioned issue of the end of the US hegemony — or, if you prefer, the 'unipolar moment'. As I have already argued, America’s relative decline began before the collapse of Lehman Brothers, albeit barely noticed as China was still pursuing Deng Xiaoping's injunction to "hide and bide". But, as Messrs Findlay and O’Rourke confirm, it was clear even by the middle of the last decade to those who chose to look carefully that we were moving to a multipolar world.

Mr Trump’s main campaign slogan, “Make America Great Again”, was therefore as resonant as it was timely relative to the trend since around the start of the century.

Although I have had a fair number of doubts expressed to me in the past over papers I wrote two years ago warning of Mr Trump’s trade agenda, it would be fair to say that it is now totally clear that he is a protectionist at heart. He clearly deeply believes that free trade has not been good for America and that he can bring back manufacturing jobs and eliminate bilateral trade deficits by tariffs and/or picking off trade partners one at a time with bilateral deals.

Nevertheless, so far, no other major economy is following the US into protectionism (other than retaliatory measures). Furthermore, the EU and Japan may have persuaded Mr Trump to back off hitting them in favour of an alliance against China's state-controlled mercantilism — which is very largely justified in my opinion. Tom Mitchell, writing in the 11 September edition of the Financial Times (subscriber access only), is in no doubt that this prospect is causing Beijing considerable concern — as it should — and may yet drive Xi Jinping to make sufficient concessions to ensure that what today looks increasingly like becoming an all-out Sino-US trade war is avoided.

[Note: This being said I have little confidence in Treasury Secretary Steve Mnuchin being able to strike a deal with China which will placate the trade hawks — Robert Lighthizer, Peter Navarro — around Mr Trump in the near-term.]

Is America still essential?

However, and worse still, more recently it has become just as clear that Mr Trump is equally disdainful of the post-1945 global order, the so called Pax Americana which has been the essential framework for the remarkable economic growth which we have seen globally over the past seven decades. As Philip Stephens writes in the 13 September edition of the FT considering how the collapse of Lehman helped ease the gates open for China’s drive to power:

“…all the while [under the Trump Presidency] America has been surrendering its greatest advantage — the network of alliances, treaties and norms underpinning a US-designed global system. Chinese officials once fretted it would take decades to undercut the world order established after 1945.”

I would have liked at this point to have hyperlinked or even quoted the entirety of an excellent article by the aforementioned Danny Quah which was published in the premium section of the Straits Times on 8 September. But it is subscriber access only and too long to reproduce in full. In essence, Mr Quah, using some compelling economic statistics for support, argues that, should Mr Trump continue to err towards autarky:

“The rules-based system can be one that works for all, both great powers and small states, with or without American leadership”.

I have no doubt that this is correct. But it does leave open the very big question of whether, without the US, other countries, large and small, can sustain the existing system or alternatively build a new one still based on the rule of law. Nevertheless, as Mr Quah concludes:

“The form of this new international system might differ from that of the last seventy years, but we must not think America’s order had monopoly on inclusiveness or mutual economic success. Performance — both in growth and inequality outcomes — across systems very different from America’s has shown that some of those others can be equally successful….

Going forwards, we cannot exclude improbable friends with whom we can together rebuild an international system based on mutual respect and transparent rules. America used to describe the Great Power rivalry between it and all others as choosing between ‘on the one hand, Rule of Law, and the other, arbitrary use of power’. Given how Trump has normalised what was previously unacceptable, the choice between America and others is no longer a daunting one, if ever it should have been.”

I offer as two acid tests the ability of the rest of the world to uphold the Paris Climate Change accord and to defend the World Trade Organisation from Mr Trump’s clear intent to neuter, if not destroy. And, in so saying, let us keep firmly in mind that not only the EU but also China has a huge vested interest in the survival and success of both — not to mention, as Mr Quah, rightly asserts a whole host of smaller nations.

But would America step back quietly?

In considering six previous hegemonies which occurred over the past millennium, Messrs Findlay an O'Rourke, conclude that such periods are very good for economic growth as they remove barriers to trade, thereby enriching societies (but not necessarily — and, as we can see today, importantly — not all individuals within them, at least proportionately). However, the end of hegemony is marked by a u-turn, ie barriers to trade go up, economic growth shrinks — and what we now call nationalism is resurgent. Or, to put it another way, globalisation goes into reverse.

This isn’t, in my view, where we are today in that globalisation has not (yet?) gone into reverse. Consider the data. Globally, trade in goods is still (perhaps surprisingly) expanding. Financial flows remain not only massive but also largely unobstructed. So too the internet. And, migration aside, so does the flow of people around the globe (look at airline passenger statistics). This is globalisation in practice: and, for all the threats to it, it remains in rude health for now at least. However, we are clearly on a track where history suggests there may well be worse to come.

In five of the six hegemonies identified by Messrs Findlay and O’Rourke the next direct consequence of relative decline was violent conflict (the sixth being the First World War, the causes of which are more complicated). This phenomenon is what is now known as Thucydides's trap and history strongly suggests that there is good reason for us to be wary of falling into it in the foreseeable future.

With luck, if we do continue down this track the result will 'just' be a trade war, not a nuclear one.

A race against time?

Amid all of the pessimism about 'the West', however, there lies a very big assumption, ie that Xi Jinping can sustain China on his chosen path through the coming years.

Emboldened by, first, the collapse of Lehman and, second, the electoral success of Mr Trump, Xi Jinping seems to have determined that China's illiberal model will succeed liberal democracy. This is remarkably self-serving as far as the Communist Party of China (CPC) is concerned in that it has (inevitably) completely failed to come up with a satisfactory answer to Deng Xiaoping's 1995(-ish) exam question, ie how do we become more democratic but remain in power.

To his credit, Xi Jinping has recognised that this doesn't compute; but he still hasn't come up with 'the answer'. What he has done instead is set up a de facto race between his stated aim of making China at least the US's equal by 2035 and the inevitable demands of increasing numbers of Chinese for more accountability and transparency — which is not the same as liberal democracy but is the 'slippery slope' in that direction. He has, to be fair, come up with his anti-corruption drive to try to accommodate this. But I doubt that will take him through another 17 years. In short, China will inevitably be subjected to the same domestic pressures from its citizens as the West, albeit in different ways.

Can the West in the meantime repair what an ancient Chinese proverb refers to as its “rotting timbers”? At best, this will certainly take time.

In the US, Mr Trump is, first and foremost, a symptom rather than a cause. So even if he proves to be a one-term president his mere departure from the White House would not be an instant ‘fix’.

In Europe, populism and nationalism, coupled with anti-globalisation, remain a powerful threat — to the point where I am firmly of the view that the 2021-22 election cycle could prove to be even more risky than the 2017-18 one.

As for the international institutions established by the West in the post-war era one only has to think of the minimal reform to date of the IFIs, let alone the UN Security Council, to realise that much needs to be done if they are accurately to reflect today’s balance of economic and wider power; and that there is very little likelihood of this happening quickly.

But China too has its share of “rotting timbers”. It is far from inconceivable that it could “collapse under the weight of its internal contradictions or be bogged down by huge domestic debts”, to quote China expert James Kynge writing in the FT towards the end of last year.

Consider too the words of Robert Kaplan last November opined as follows:

“China can be stopped only by its own internal demons. As Samuel P. Huntington wrote in his classic 1968 study, ‘Political Order in Changing Societies’, the more complex a society gets, the more responsive its institutions must become, otherwise the creation of a large middle class is destabilizing.”

In other words, if Mr Kaplan is correct (and I believe he is), China will, sooner or later, have to evolve socio-politically if it is to avoid a major domestic crisis even though its authoritarian system has, so far, proved remarkably resilient.

Thus, Xi Jinping may have avoided having to answer Deng Xiaoping’s ‘exam question’ for now. But, by extending his term beyond 2022, he may well have condemned himself to having to address it eventually even if he is able to pursue his ambitious agenda with a marked degree of success. And perhaps especially if the West can rise to the challenge in the meantime and reform and regenerate to the point of restoring the credibility of liberal democracy.

Conclusions

There is no doubt that much of the malaise in ‘the West’ is self-inflicted, including the collapse of Lehman Brothers and what I firmly believe to be the gross mishandling of much of the consequences thereof. Insofar as this is the case, fixing the problems also lies largely in our own hands. Even if much still seems to be heading in the ‘wrong’ direction, this is still doable.

However, stepping back from that event per se (which I suspect few commentators will be able to do over the coming weekend or so), it becomes clear that there is a much bigger context, ie the relative shift in economic power from west to east where economics undoubtedly will lead geopolitics. This will be much more difficult successfully to manage. But it may help if we keep in mind that autocrats too face major challenges and that neither the demise of liberal democracy and reversal of globalisation is inevitable. Indeed, far from it.

One way or the other, as was the case when Clare and I were in Botswana in 2008, it may well be some time before we know how the game plays out.

Alastair Newton

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