Janet Yellen: Credit bubbles and Lehman’s failure, mistakes of the government

After a speech in New York Federal Reserve Bank of San Francisco President Janet Yellen said that letting Lehman Brothers Holdings Inc. fail was a mistake on the part of the government as long as the company was “too big to fail” and added the impact of its failure “was devastating”, reports Bloomberg.

She said: “That’s when this crisis took a quantum leap up in terms of seriousness.”

Yellen noted that she disagreed with Fed officials who asserted that rescuing the company would lead to excessive risk-taking among investors.

“Lehman was a systemically important institution,” Yellen said, noting she was “sitting in California” at the time of Fed deliberations and “wasn’t involved in anything having to do with it.” 

Echoing Fed Chairman Ben Breanne she said that the government needs the authority to deal with the non-bank financial institutions. She stressed that Congress should pass corresponding legislation to enable “the orderly wind-down of a non-bank institution”. She said: “I’m sure it would have been used in the case of Lehman”. In the absence of the proper instrument Fed officials had to act impromptu to address the credit crunch.

“Bear Stearns, Lehman, AIG -- these have all been horrendous, miserable situations,” Yellen said. “We’re pushing the envelope of our powers, but we’re choosing to do that because the consequence of failing to do that seem unthinkable.”

Yellen also noted that central banks need to deal with bubbles in asset prices before they get too big, although monetary policy may not be the best tool for the job.

“Now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look,” she said in her speech. “What has become patently obvious is that not dealing with certain kinds of bubbles before they get big can have grave consequences.” 

"Episodes of exuberance, like the ones that led to our bond and house-price bubbles, can be time bombs that cause catastrophic damage to the economy when they explode," she added.