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Lehman bankruptcy: In capitalism, failure is not a dirty word

My reaction to Lehman Brothers' declaring of Chapter 11 bankruptcy and the refusal of Treasury Secretary Hank Paulson and others to take extraordinary Bear Stearns-like measures for the government to prop the firm up can be summed up in three words: It's about time!

Business failure is not only a permissible outcome of capitalism, it's a necessary one. As the great economist Joseph Schumpeter has written, the process of "creative destruction" is essential for the market to function. For innovation to flourish and the standard of living of the populace to improve, the market must be free to reward success and punish failure.

As Schumpeter wrote in his 1942 book Capitalism, Socialism and Democracy, there is an ongoing "process of industrial mutation — if I may use that biological term — that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in, and what every capitalist concern has got to live in."

There is no doubt Lehman's failure will be difficult for the firm's employees, investors and others affected by the firms' dealings. But Wall Street and the U.S. economy has survived similar failures before and come back to prosper. The investment banking firm Michael Milken's Drexel Burnham Lambert, a powerhouse of the '80s, went bankrupt in the early '90s. The '90s decade still roared, and many of the innovative companies financed by Drexel, such as Turner Broadcasting, still continue to prosper to this day.

At press time, the stock market was recouping some of its losses, and the trouble with the financials seems not to be affecting consumer and technology stocks, some of which are even posting price gains. Those investors and companies seem to be treating Lehman's failure as business as usual, which in a capitalist economy, is exactly what business failure - though not usually of Lehman's size -- is.

Hopefully, Paulson and other government officials have realized that bailouts pose their own systemic risk. The Bear Stearns precedent still carries the dangers that financial players won't merge with troubled firms without trying to get a government guarantee. Also, firms that don't even want bailouts may be wary to acquire companies without an official government blessing, fearing that the government could come back and undercut the deal. That why the Bear bailout, even though it was smaller, still poses more danger to a functioning market than that of Fannie Mae and Freddie Mac, which as Open Market has pointed out were always quasigovernment enterprises. As Manhattan Institute scholar Nicole Gelinas recently wrote in Investor's Business Daily, the Bear bailout threatens to almost transform private investment banks into Fannie-like "government-sponsored enterprises."

In fact, though most of Lehman's failure must be left at its own door, the Bear and Fannie bailouts that Paulson engineered may have hurt Lehman's prospects to find a buyer. His decision that creditors for these companies get 100 percent while shareholders get nothing turned out to be too clever by half. It made it nearly impossible, as CNBC's Jim Cramer has said, for Lehman to issue new stock, because investors feared this stock too would be wiped out in another government-engineered creditor bailout deal at the expense of shareholders.

If not bailouts, what should public policy do? Economists Larry Kudlow and David Malpass and American Enterprise Institute scholar Peter Wallison have noted that accounting regs may be adding significantly to the turmoil. The mark-to-market accounting rules from the quasiprivate Financial Accounting Standards Board and other regulatory agencies are complicating potential mergers by forcing valuation of assets at today's market prices. This is the case even when that information is unavailable if markets for things like mortgage-backed securities have collapsed.

With mark-to-market, many mortgages and other loans now have to be "written down" simply because they can't be sold -- even if they are still being paid and financial institutions plan on holding them to maturity. This forces an acquiring bank to record what is probably a paper loss, but one that could get it a credit rating downgrade and risk violating requirement for "regulatory capital."

Also, private equity companies should be allowed to buy small stakes in banks without regulations treating them as "controlling" the bank, as they currently often do.

One think we shouldn't do is get rid of bipartisan financial deregulation of the past 20 years. These policies, such as the lifting of New Deal restrictions separating commercial from investment banking, predate the Bush administration and were pushed through by President Clinton and a GOP Congress. And they are largely responsible for the '90s economic boom that everyone is so nostalgic for.

We should get rid of bailout policies and government support of institutions such as Fannie and Freddie that encourage excess. But we must also recognize that excess is a part of long-term economic growth and prosperity.