Looking Back at Lehman: An Empirical Analysis of the Financial Shock and the Effectiveness of Countermeasures

Abstract

This paper uses a daily measure of U.S. financial conditions called the Bloomberg Financial Conditions Index to assess the financial shock associated with Lehman’s bankruptcy and the effectiveness to date of the strong countermeasures initiated by policymakers. In contrast to the analysis of Lehman skeptics such as John Taylor (2008, 2009) and John Cochrane and Luigi Zingales (2009), the evidence we present supports the view of many practitioners that the decision not to rescue Lehman represented an immediate and massive shock to the financial system that was larger by an order of magnitude than anything seen over nearly two decades. Since this shock came against the backdrop of already highly stressed financial conditions and an ongoing recession, it lends support to the view of many economists that the Lehman decision was a significant policy error. The paper also illustrates how the Bloomberg index can be used to conduct an event analysis to help gauge the effectiveness of particular countermeasures and focuses on measuring the largest movements in overall financial conditions on a one-day and three-day basis during the critical period of September through October 2008. Finally, the paper uses a standard VAR model and Granger causality tests to demonstrate that the Bloomberg Index can be a useful leading indicator of both bank lending conditions and overall GDP growth, and that such analysis can help calibrate the degree of effectiveness of unconventional policy measures in restoring growth in the aftermath of a significant financial shock.