A retrospective on the subprime crisis and its aftermath ten years after Lehman’s collapse

This paper reviews the interactions between policymaking, the financial system and the U.S. economy before, during and after the subprime crisis, with particular attention to current controversies about the policy decisions that led to Lehman’s downfall and their lessons for the future. The first part of the paper documents and analyzes the interactions between policy, financial markets and the economy during the acute and subsequent moderate phases of the crisis as well as during the later gradual exit from the zero lower bound and the extremely slow reduction in high powered money and bank reserves. The remaining parts develop alternative aspects of the thesis that mutual uncertainties inflicted by financial institutions on policymakers and by the latter on financial markets were at the root of the non-negligible surprises that the crisis inflicted on everybody. In particular, it discusses the political economy of bailout operations, reviews and evaluates recent controversies about the reasons for not rescuing Lehman Brothers, and informally presents the structure and policy lessons from a general equilibrium model of the financial sector highlighting the consequences of policy actions that have raised (Knightian) bailout uncertainty. The last section takes a brief look ahead and discusses some longer term consequences of the crisis.