When I wrote my diary called Black September a few months ago, I termed it a "first draft of history": an attempt to explain how the shallow, Wall Street and housing-focused recession of early 2008 had suddenly morphed into a systemic economic collapse. I described it as an "autonomous consumer slowdown" that didn't have to happen, but did in large part due to the panicky response by government officials to admittedly serious body-blows to the financial system that occurred seemingly almost daily during last September (and secondly due to the meltdown of 401k assets during the market crash that did not occur until the first 10 days of October).

Now several mainstream economists have independently picked up on the idea, challenging the conventional wisdom that the subsequent economic free-fall is All Because Lehman Brothers was Allowed to Fail. And the conventional wisdom is fighting back.

Macroeconomist William Buiter, writing in the Financial Times, says:

I believe the Lehman collapse was mishandled by the authorities. They committed two egregious errors, ....

While the demise of Lehman and the destruction of most of its unsecured creditors was an unnecessary surprise, it was still the best option available to the authorities, given the absence of an SRR [an in-place government liquidation plan]. Markets and market participants are educated only by painful example.

The cardiac arrest followed the realisation, well after Lehman went kaput, that (1) most of the internationally recognisable US banks were insolvent or would be but for past, present and anticipated future government financial support; that (2) many other non-bank financial institutions (AIG) and shadow-financial institutions (GE) were either insolvent or at death’s doorstep; and that (3) the government was not on top of the issues and the Congress was deeply divided and irresponsible.

Buiter's article is based in part on a paper by John Taylor (pdf) discussing credit spreads during last September.

This has drawn a riposte from James Surowiecki:

In any case, no one is arguing that Lehman’s failure alone was responsible for investors’ flight from risk—Congress’s failure to pass the first version of the Treasury’s bailout plan certainly made things much worse. But it was the first, and crucial, moment in last fall’s market panic, a panic that crushed stock and bond prices and set off a negative cascade that spread to the real economy and which we are still suffering the consequences of. In this case, then, conventional wisdom seems to be right.

Surowiecki is wrong on two points. First, as I pointed out at the time, Lehman's failure was one of a daily cascade of failures and nationalizations that occurred throughout September, including Fannie, Freddie, AIG, Wachovia, First National City Bank, and a number of others. Secondly, the "panic [that] crush[ed] stock and bond prices" didn't occur until the first 10 days of October, driven by hedge fund redemptions most of which probably had to have been lodged with fund managers by August 15 -- and it didn't crush bond prices, which soared!

Prof. Krugman also has a reply:

you’re looking at some building, and you hear the fire alarm go off, and smoke starts trickling out the windows. Then a lot of fire trucks and firemen arrive — and only after that do flames start shooting out the top of the building.

Clearly, the fire department turned a small problem into a crisis.

Except that's not what happened in September. Here's what happened:

you’re looking at some building, and you hear the fire alarm go off, and smoke starts trickling out the windows. Then a lot of fire trucks and firemen arrive — and only after that do flames start shooting out the top of the building.

Then officials from the fire department get on TV, radio, and on bullhorns to announce "OMG THERE'S A DIRE EMERGENCY!!! RUN FOR YOUR LIVES!!!!! THE BUILDING IS ON FIRE AND IF WE DON'T PUT IT OUT IN THE NEXT 15 MINUTES THE ENTIRE CITY IS GOING TO BURN DOWN AND YOU'RE ALL GOING TO DIE!!!!!!!!!!!!!"

Gee, perfesser, ya think that might induce a little panic?

Lehman was bad, no doubt about it. But the academic spin on September's events is almost laughable. What the hell do these people think consumers were reacting to, when they abruptly stopped patronizing auto showrooms and furniture stores in September? "OMG look at the LIBOR and the TED spread?" "OMG look at the signal this Lehman failure sends to the markets?" "OMG investors are really going to flee from risk now?" ???

On the contrary, it was the bungling and panicky response by the Bush, Paulson, and Bernanke -- telling Americans that if $700 Billion wasn't thown at Wall Street NOW! NOW! NOW!!! Your Paychecks Will Bounce -- that made things much worse than they otherwise would have been. There was nothing inherent in the failures of Black September that had to cause consumers to decide, abruptly, to halt spending, and which was the immediate and proximate cause of the economy's free-fall since.