Lehman: A Victim of Necessary Unfairness

It was inevitable that we would see this sooner or later:

From the perspective of a few days, the big mistake was letting Lehman go, without saving the creditors.

Which is basically another way of saying:

If the government bailed out Lehman, the ensuing crisis of confidence would never have happened, and this weekend's monster bailout would not have been necessary.

I don't buy it. Hank Paulson has been working on his RTC II plan for months now, quietly; if Lehman hand't precipitated its need, then something else would have, unless the Treasury stepped in to rescue every financial institution which looked like it might fail.

It's even possible that Lehman wasn't the immediate cause of the crisis, and that a Lehman bailout would have been followed in swift succession by an AIG bailout, a Morgan Stanley bailout, and, not long after that, RTC II.

To put it another way, the big-picture macroeconomic reasons why RTC II has become necessary (or as necessary as it is, anyway) would have been in place whether or not Lehman was rescued. And there are extremely good reasons for allowing Lehman to fail: unless bondholders face a non-zero chance of losing money, there will be no end to the risk and leverage that financial institutions will take.

This is also the reason why John McCain is so wrongheaded when he says he wants a more consistent Treasury policy in funding private-sector bailouts. Consistent means predictable, and if you know in advance exactly which institutions will be bailed out, then anybody can and will lend them bottomless amounts of money without taking any credit risk. A classic recipe for a credit bubble.

I'm not saying that letting Lehman fail, followed by bailing out AIG, followed by RTC II is exactly the sequence of events that, in hindsight, would have been optimal -- far from it. If you're going to implement something like RTC II, then best to do so before major institutions fail, rather than after.

But given volatile and unpredictable markets, the federal regulatory response is also liable to have an element of volatility and unpredictability to it. And that's not necessarily a bad thing at all.