The ‘Lehman Brothers Plan’ for Economic Recovery

The ‘Lehman Brothers Plan’ for Economic Recovery
May 23, 2011

People often ask what I would recommend instead of QE (quantitative easing) inflation to help the economy. My answer is for the government not to fight the depression with more spending and cheap credit. Trying to stop the market from correcting past errors only delays the consequences and makes them much worse.

Government should balance its budget.

There should be no new credit expansion by the Federal Reserve.

Most importantly, government should not meddle in markets to try to soften the correction. Specifically, no bailouts, stimulus packages, or new public works projects.

Do not prop up wages.

Allow competition to lower the prices of land, labor, and capital.

The only positive steps for government to take are to cut taxes, spending, and regulations, and promote free trade.

Failed Firms
I call this the “Lehman Brothers Plan,” named after the large Wall Street financial firm that was allowed to go bankrupt in September 2008. This plan relies on allowing big firms to fail. Had this policy been followed from the beginning, I have little doubt this crisis would be over—and we would not have added the debt problem.
 
Lehman Brothers had been a great American success story. Henry Lehman started in business in 1844 with a dry goods store in Montgomery, Alabama. After his two brothers joined him, they changed the name to Lehman Brothers in 1850. They accepted raw cotton in exchange for their goods, which increased the volume of their business because people had more cotton than money. They made money selling the goods and then made more money selling the cotton.

They later opened an office in New York and helped start the New York Cotton Exchange in 1870. Then they joined the New York Stock Exchange and helped sell the initial public stock offerings of companies including Sears, Macy’s, B.F. Goodrich, Woolworth’s, and Studebaker.

Unfortunately, Lehman Brothers in its last years became heavily involved in the subprime mortgage market. The company went into bankruptcy. Assets were sold to other firms to meet the company’s obligations to creditors, who recovered some money but sustained losses.

Consumers were largely unhurt, except for losses sustained generally in the market. The big losers were Lehman stockholders. The biggest losers were those who were running Lehman Brothers—people who had made tons of money during the boom.

Deflation in a Crisis
At this point a mainstream economist likely would complain that allowing large-scale liquidation would result in contagion, runaway deflation, and an economic “black hole.” So let’s consider the role of deflation during a crisis.

First, the prices of capital goods fall. This happens first with stock prices, but eventually the prices of office buildings, warehouses, retail stores, etc. also fall.

Second, the price of labor will fall as the unemployment rate rises. Wage rates are somewhat “sticky” compared to stock prices and leasing rates for commercial space, but they do tend to fall in real terms if they are not propped up by government intervention and unemployment insurance.

Third, the prices of consumer goods will also fall, though not as much. The demand for “nondiscretionary” consumer goods is not elastic. Things like milk, flour, and electricity have what economists call “income inelastic demand” because we don’t change the amount we buy when our incomes increase or decrease. In the past, the quantity of margarine demanded has actually increased when incomes have gone down.

Profit Opportunities
This means that in the deflationary-corrective process, the prices of land, capital goods, commodities, and labor fall relative to consumer goods. This provides potential profit opportunities for entrepreneurs to purchase these greatly depreciated resources to make products to sell to the consumer. In other words, the deflationary process is more like a shock absorber than the black hole imagined by mainstream economists.

Not only do profit opportunities emerge, but wage-labor opportunities are scarcer and less attractive. Both influences encourage entrepreneurial behavior. This is a key factor in any corrective-recovery process.

Following the Lehman Bros. Plan would result in a contraction in bubble-generated activities and an expansion of consumer-generated activities. Saving would expand relative to consumption. The largest firms would shrink or go out of business, while smaller firms would expand to capture remaining market share.

New Businesses, New Jobs
New firms would be established to take advantage of profit opportunities and because of the decrease in employment at big companies. It is well known that small firms create the bulk of new jobs. Less well known is that new small firms create the most jobs.
 
Remember during the mini-depression of 1980-1982, when Federal Reserve Chairman Paul Volcker raised the Federal Funds rate to 20 percent, ending the stagflation of the 1970s and ushering in one of the most prosperous periods in American history? It also provided an economic environment rich with cheap resources for new companies to use, as Microsoft did in becoming a huge success in the personal computer software market. Similarly, the dot.com meltdown in early 2000 provided low-cost resources that allowed companies such as Google to become kings of the Web search market.
 
The Bernanke/Bush/Obama approach ends in misery and mounting government debt. The Lehman Brothers Plan would rebalance the scales between “too-big-to-fail” corporations and entrepreneurs who would help write our future.

Mark Thornton (mthornton@mises.org) is an economist and senior fellow at the Mises Institute in Auburn, Alabama.