Getting Lehman Wrong a Second Time

There are few economists who would defend the decision to allow Lehman Brothers to go bankrupt
last September. Its collapse induced a worldwide panic that sent stock
markets plummeting and caused credit to freeze up. In the subsequent
months, the downturn went into over-drive, with the United States
losing almost three million jobs from October through February.

This
set of events has led almost everyone to conclude that the trio who let
Lehman go under - Treasury secretary Henry Paulson, Federal Reserve
chairman Ben Bernanke and the then-head of the New York Fed, Timothy
Geithner - erred badly in this decision. That seems a reasonable
judgment.

However, the conventional wisdom includes a corollary
that is much less obvious: because the Lehman bankruptcy was a
disaster, US taxpayers must honour in full all the debts of all the
banks. This corollary could put US taxpayers on the hook for trillions
of dollars in commitments that the Wall Street boys apparently made on
our behalf. Before we cough up the dough, we might want to consider
whether Paulson, Bernanke and Geithner were not quite as stupid as the
current conventional wisdom would imply.

The problems that
followed from Lehman did not just stem from the fact that the
government was not honouring Lehman's debts. This was an uncontrolled
bankruptcy of a huge investment bank in a world where the official line
was still that everything was under control. The Washington Post had
even run a column the day before Lehman's collapse ridiculing those who were making negative comments about the state of the economy.

In
this context, an uncontrolled bankruptcy of a major investment bank was
sort of like a sledge hammer in the face: a rather rude and unexpected
blow. The most immediate consequence was that Reserve Primary,
one of the largest money-market mutual funds in the world, suddenly
could not pay its shareholders in full, because it had tens of billions
invested in Lehman. In the wake of Lehman's bankruptcy, Reserve Primary
did not know how much, if any, of this investment it could recover. In
the post-Lehman world banks could suddenly no longer trust each other,
and the interbank lending rate went through the roof.

But now we have had six months to adjust. The Fed and Treasury are now guaranteeing deposits in money-market mutual funds. The Federal Deposit Insurance Corporation
doubled the size of the bank accounts it guarantees, and
non-interest-bearing accounts of any size are guaranteed. In addition,
the Fed is now lending hundreds of billions of dollars directly to
non-financial corporations, establishing a channel of funding that goes
outside the banking system.

These and other measures have
restored some measure of stability to the financial system. Now that we
have these measures in place, is it still true that we can't subject
Citigroup, Bank of America or Goldman Sachs to a managed bankruptcy
(aka "nationalisation") without the world coming to an end?

With
a managed bankruptcy, all the insured deposits would be fully covered.
However, the government would only repay bondholders a portion of their
investment, depending on how severe the banks' losses are. By not
compensating bondholders in full for their losses, the government could
save taxpayers hundreds of billions, perhaps even trillions, of
dollars.

In addition, a managed bankruptcy would also help to
address the problem of moral hazard created by the bailouts thus far.
Investors did not pay adequate attention to the health of banks and
other large financial institutions like AIG
because they assumed that the government would bail them out if things
went badly. If the government makes these investors eat some of their
losses, maybe they will put more thought into their investment
strategies in the future. This could also let some big investors make
some of the "sacrifices" for which fiscal conservatives - including
some big investors - are so eager.

The silence of the fiscal
conservatives on the vast sums going to the banks is hard to
understand. After all, how can someone get so upset about the prospect
of $200m being spent to re-sod the National Mall in Washington, but be unconcerned when $160bn - almost 1,000 times as much money - goes out the door to AIG?

The sums of money going to bail out the financial industry dwarf the waste and pork that get John McCain
and other budget hawks excited. Yet they are strangely calm about the
bailout money. In fact, the amount we spent patching the financial
system could well be large enough to make the Social Security system
fully solvent over its 75-year planning horizon, yet we barely hear a
peep from the Peter Peterson Foundation and its merry band of anti-Social Security crusaders.

The
only answer we ever get in response is that we have no choice. But just
six months ago, Henry Paulson, Ben Bernanke and Timothy Geithner
thought we could make a much more extreme choice. They were wrong then,
but they are not stupid. We should go back to the bankrupt Lehmans and
see if we can do it right this time.