What was the Fed thinking in the summer of 2008?

How the Fed Let the World Blow Up in 2008
High oil prices blinded the Fed to the growing danger before the crash

Three things stand out beyond the absolute cluelessness of most of the participants.

One: That the Fed and Treasury had allowed the banking system to become opaque to every one, even themselves. No one knew how much risk was in the system nor which institutions were most threatened by it.

The world changed on August 9, 2007. That's when French bank BNP Paribas announced that it wouldn't let investors withdraw money from its subprime funds anymore. It couldn't value them, because nobody wanted to buy them. The effect was immediate. Banks stopped trusting, and lending to, each other. They all had their own subprime problems, but none of them knew whose was the worstor who had insured whom.

And this:

Hawks had convinced themselves that the financial crisis had been going on for so long that it wasn't one anymore. That banks had had more than enough time to cut their exposure to troubled firms. That one bankruptcy, say Lehman's, wouldn't cause a cascade of others. Or, as St. Louis Fed president James Bullard put it, that "the level of systemic risk has dropped dramatically, and possibly to zero."

Two: The blithe acceptance of a severe shock like the bankruptcy of Lehman Brothers.

And the economy really couldn't afford it if they decided, like Richmond Fed president Jeffrey Lacker suggested, that "at some point we're going to choose to let something disruptive happen." That is, let a too-big-to-fail bank fail.

After they did let Lehman fail, there was still an unworldly calm about what just happened:

"We have a lot to talk about," Bernanke said. That they did. Lehman had failed the day before, and markets were trying to figure out what it meant. After some consideration, they decided it was the end of the world.

It was easy to see why. Markets had expected Lehman to be bailed out. Lehman had expected Lehman to be bailed out. So when it wasn't, nobody was prepared. It wasn't clear who had lost what, and who had claims on what. But what was clear was that the insurance giant A.I.G. was going to need a bailout. That money market funds were, as Rosengren had warned, about to break the buck. And that there was a run on every financial asset that wasn't guaranteed by the government.

The Fed, though, was surprisingly upbeat. Lacker had gotten the "disruptive" event he had wanted, and he was pretty pleased about it. "What we did with Lehman I obviously think was good," he said, because it would "enhance the credibility of any commitment that we make in the future to be willing to let an institution fail." Hoenig concurred that it was the "right thing," because it would suck moral hazard out of the market.

Three: There was no real planning or preparation for crisis. They did not have contingency plans for the post-Lehamn fallout just has they did not have a clear understanding of what the failure of a TBTF institution would mean.

It was the day after Lehman failed, and the Federal Reserve was trying to decide what to do.

It had been fighting a credit crunch for over a year, and now the worst-case scenario was playing out. A too-big-to-fail bank had just failed, and the rest of the financial system was ready to get knocked over like dominos.

This echoes something Joseph Lawler noted in his review of Hank Paulson's memoirs:

huge decisions determining the fates of endlessly complex institutions are gamed out in the crudest of terms by two pals in conversations depicted with a level of detail, dramatic tension, and moral awareness that would be better suited for a Sesame Street segment about cooperation.

I find this mind-boggling. For 150 years modern militaries have used war-games, scenario planning, and other strategic tools to prepare for nearly all contingencies. The plans themselves are not the key product of these exercises. It is the development of a collective mental framework and the exploration of messy problems not given to pat answers.

The Prussians were the first to systematize the process withing their General Staff and War College. The goal was to avoid exactly the problems that we see with the Fed and Treasury in 2008:

Continuity of conception is imperative to safeguard leadership in the nervous trials of reality. Knowledge or capacity in individuals is not enough. In war the organically developed capacity of a majority is necessary

President Eisenhower:

In preparing for battle I have always found that plans are useless, but planning is indispensable

Colin Gray notes that for Ike "the principal value of military planning is not to produce ahead of time the perfect plan, but rather to train planners who can adjust and adapt to changing circumstances as they emerge."

Adm. Chester Nimitz on his Naval War College experience (1922)

The enemy was always-- Japan-- and the courses were so thorough that after the start of WWII-- nothing that happened in the Pacific was strange or unexpected.

Perhaps the greatest example of the power of the military model is this: The German Army, with its reconstituted General Staff, developed tank doctrine and the concept of the Blitzkrieg before the army possessed any tanks.