Early in the first world war, British generals decided to attack German trenches with light artillery bombardments followed by the infantry walking in close order across no man’s land. The result was tens of thousands killed, but the generals reacted with only small adjustments to their approach and persisted in repeating the same mistakes for years. “The English soldiers fight like lions,” one German general remarked. “True. But don’t we know that they are lions led by donkeys?” someone replied.

Today, a year after the world came to the brink of financial meltdown and great pain was inflicted on millions of investors and workers, our leaders are lining us up to suffer the same horrible experiences again.

The collapse of Lehman Brothers in September last year demonstrated just how far our economic system in general and bank management in particular have gone awry.

Lehman borrowed at low interest rates in global credit markets and invested more than $500 billion of other people’s money in assets which, today, are worth next to nothing: failed ski resorts in Montana, abandoned suburban housing in California, and crazy bets on derivatives (options to buy or sell securities, in various complex combinations).

Worries about these investments sparked a run on the bank. And, after a mad weekend of trying to save Lehman, the American “authorities” — meaning Henry Paulson,Treasury secretary at the time, Ben Bernanke, Federal Reserve Board chairman, and Timothy Geithner, then president of the New York Fed — decided to let it go bankrupt. Creditors, realising no big bank was safe if our leaders might let them fail, pulled cash from financial institutions and sank it into comparatively safe US treasuries and UK gilts.

Today Lehman’s senior debt trades at a mere 10 cents on the dollar, suggesting its $600 billion in assets was a mirage. This outcome is even more startling when compared with senior debt at Kazakhstan’s defaulting large banks, where management is accused of serious malfeasance, yet that debt trades at 20 cents on the dollar — twice the price of Lehman’s.

At the recent G20 meeting, finance ministers united behind two key steps that they claim would “prevent another Lehman”: tighter controls on the pay of executives and more capital for banks. France and Germany blame the crisis on lax regulation in Anglo-Saxon markets and excessive pay packets that encourage too much risk taking.

The British and Americans counter that European banks have too much debt (in the jargon, they are “overly leveraged”) and need to raise more capital. The final communiqué proposes to address both issues, and we will hear more of the same at the forthcoming G20 summit of heads of government in Pittsburgh. But, in reality, both sides want only minor adjustments that cannot solve the real problems.

Geithner, now US Treasury secretary, is pushing for higher capital requirements for banks — that is, they need to have more shareholder funds to protect against future losses. But he surely knows that two weeks before the bank’s demise, Lehman’s management reported that it was well-capitalised, with a tier one capital ratio of 11% — roughly twice what the United States now considers is needed for a well-capitalised bank, and much higher than the American side is proposing in private conversations.

Christine Lagarde, France’s finance minister, and Angela Merkel, the German chancellor, helped to convince the G20 that bank pay policies need to be amended to encourage long-term incentives. They need look no further than Lehman Brothers for a good model. The top management and many employees were largely compensated in shares of the company which vested over many years, so when Lehman collapsed, it brought crashing down the lives and finances of its 20,000 employees.

Dick Fuld, the highly paid head of Lehman, lost many millions of dollars — presumably a large part of his total wealth. Apart from criminal penalties (of the kind not seen for banking in a century), can we think of a better way of aligning incentives with the outcomes for a bank?

The real problem with our financial system is that our economic and political systems work together to encourage excessive risk, and this risk in turn leads to cycles of prosperity and collapse.

In 1998, a much smaller Lehman was placed in financial peril in the aftermath of the Asian financial crisis and failure of Long-Term Capital Management, a big hedge fund. The Federal Reserve responded by lowering interest rates, and other central banks followed suit.

This cut the cost of obtaining funds, in effect bailing out Lehman and other institutions that were in trouble. The markets learnt that the Federal Reserve was quick to bail out institutions (and executives) in trouble, so they saw no need to be more cautious.

This policy of responding to bursting bubbles, rather than using regulation to deflate them before they start growing, has become the standard procedure of most central banks. It is usually combined with a fiscal policy stimulus and other measures to support the economy.

Each time banks fail, by bailing the system out once again we teach our finance sector a lesson — you can safely take too much risk because, when you lose, the taxpayer will pick up the bill.

We also send a simple message to creditors: it is safe to lend to the likes of Goldman Sachs or Barclays because taxpayers and our nations’ savers are standing by to cover your losses. Rational bank executives and creditors respond as anyone would: creditors lend to banks at low interest rates, and our banks gamble heavily hoping to make large profits. Such a system is destined to fail, but the party can run for a long time.

Decline and fall

Dick Fuld, former chairman of Lehman Brothers, used to live in the office, writes Dominic Rushe in New York. Now the banker — nicknamed “the gorilla” — divides his time between a Connecticut estate and a country home in Idaho.

Fuld, below, is not enjoying a quiet life, though. “I’ve been pummelled, I’ve been dumped on, and it’s all going to happen again. I can handle it,” he said in the run-up to the anniversary of the bank’s collapse.

He and a dozen other Lehman alumni are being grilled by three grand jury inquiries. He has been named in more than 40 lawsuits. On a more personal note, Fuld, below, has had pie thrown at him.

He is not short of cash, having banked $480m (£287m) in the eight years before Lehman’s demise, but still commutes into Manhattan a few times a week to work at a hedge fund.

He and his wife, Kathy, once stars of the social scene, now keep a lower profile. They sold their Park Avenue apartment for $25.87m and a $13.5m slice of their art collection.

Peter Boone, chairman of Effective Intervention, a charity, and Simon Johnson, a professor at MIT’s Sloan School of Management, write for The Baseline Scenario, an economics blog

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