Earlier this week, I debated Portfolio magazine finance blogger Felix Salmon about the merits of letting Lehman Brothers fail. Unlike almost everyone else in the world, I continue to support the decision not to rescue Lehman. Felix is an apostate from the heterodox position. In his view, the turmoil we’ve seen in the financial markets since Lehman declared bankruptcy demonstrates that we should have rescued Lehman.

I won’t rehearse the entire argument here. (You can read the transcript of our debate of Felix’s blog.) Instead, wanted to respond to a clever new argument Felix raised yesterday. The gist of it is that the bankruptcy of Lehman contributed additional moral hazard rather than instilling market discipline. Here’s how Felix explains it:

If Treasury had bailed out Lehman, there would always have been the chance that it wouldn't bail out the next bank to get into difficulties -- just as the bailout of Bear Stearns didn't mean that Lehman was safe. But after Treasury let Lehman fail, no further failures could be allowed, and indeed one of the main functions of the TARP bill was to make government bailouts much easier.



People like Carney, then, who care deeply about moral hazard, should probably wish that Lehman had been bailed out, rather than be happy that it wasn't.

It’s hard not to admire that kind of intellectual jujitsu. Unfortunately, it’s way off base. While the apparent adoption of a no more bank failures policy will indeed have serious costs—banks will make riskier loans and engage in riskier trades, investors and counterparties will be less vigilant, and resources that could be used productively will be diverted into the perceived safety of government sponsored banking—these would all have been worse if the government had bailed out Lehman Brothers.



Lehman was the sick man of Wall Street, with a balance sheet black hole that rivals AIG’s. If Lehman could be rescued, anyone could. The failure of Lehman demonstrated that there was a some vague point of massive insolvency beyond which Hank Paulson would not cross. And, according to his recent comments to the New York Times, he continues to stand by that position. This at least puts some limits on the massive risks created by the various bailouts.



Lots of people changed their view about Lehman’s bankruptcy in the last few weeks. We won’t be at all surprised if lots of people change their mind again, once we learn the true costs and benefits of letting a failed firm actually fail.