RUSS ROBERTS

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Should We Have Let Wall Street Go Bust?

This article originally appeared in Zócalo Public Square on 3/19/13.

Tough question. It’s like asking whether chemotherapy is worth it even if you’re not sure you’ve got cancer. Neither choice is attractive. Much better to avoid a suspicion of cancer in the first place.

Policymakers faced very unpleasant choices in 2008. It would have been better to have avoided the mistakes that let banks get so large in the first place. The coddling of creditors beginning with Continental Illinois in 1984 encouraged lenders to be reckless even as banks became increasingly leveraged. The potential for creditor rescue encouraged banks to become larger and more interconnected.

banks

The key question is whether we should have let the first big bank die in March 2008—Bear Stearns. Letting Bear Stears go bankrupt might have had unpleasant consequences. But by making sure that all of Bear’s creditors received 100 cents on the dollar when its obligations were assumed by JP Morgan Chase, the government sent a powerful signal to the market that lenders would be made whole once again, despite having made lousy loans.

When Lehman Brothers was allowed to go bankrupt, Reserve Primary, a money market fund, “broke the buck” and helped create the panic, such as it was, when Lehman died. But why did a money market fund lend to Lehman Brothers when it was well-known that Lehman’s balance sheet looked a lot like Bear’s? Surely Reserve Primary reasoned that Lehman’s creditors would be rescued—so why not take the extra return that Lehman offered? Had Bear been allowed to die, the subsequent damage would have been smaller.

The coddling of creditors is the single most damaging policy mistake of the past three decades. If we can stop the cycle of creditor rescue, banks will shrink naturally and too-big-to-fail will no longer be relevant.

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