05/15/2010 05:12 am ET Updated May 25, 2011

Inadvertently, CNBC's Larry Kudlow Makes Strong Case for Breaking Up the Big Banks

Analyzing the report on the collapse of Lehman Brothers -- the event that sent Wall Street into a tizzy, begging for government (!) help -- CNBC's Larry Kudlow made a compelling case for breaking up the big banks.

Kudlow rightly observed that Lehman's accounting chicanery was not identified by its outside auditor, Ernst & Young, despite the Sarbanes-Oxley law that was passed in the aftermath of the Enron scandal. It was missed by the Federal Reserve auditors. It was missed by the Company's "Audit Committee" that, by Sarbanes-Oxley rules, must be composed of non-corporate officers and meet separately from the management with the outside auditor.

Kudlow's conclusion is that strengthening regulations will not prevent another financial meltdown.

I agree.

We disagree on the remedy. Kudlow's remedy, however, is so tangential to the problem of systemic risk that it is laughable.

Kudlow observed that short-sellers vaguely sniffed out some problems, and shorted the stock. This, according to Kudlow, was the answer -- the "free market" will somehow save us from the next financial collapse the "free market" just brought upon us.

Kudlow is a very smart fellow. But, he is also a right wing ideologue whose primary purpose is to support right wing economic ideology regardless of the facts and analysis. He is also a Wall Street sycophant.

Kudlow's solution is mind-bogglingly ridiculous. The "free market" was in full operation when Lehman collapsed. It was only the following week that a temporary ban on short-selling of financial stocks was instituted (by Bush's SEC, whose chairman Kudlow applauded when he was appointed).

Lehman's failure caused the entire financial system to "freeze up". That, in turn, led to the financial meltdown and the extraordinary -- although misdirected -- bailout of the big banks to save the economy from further contraction (whereas all it really did was save the big banks, credit remains frozen to this day).

Short-selling did not, and will not, save a single institution from collapse. All it will do -- in addition for making a ton of cash for the short-sellers themselves -- is signal doom a bit before rigor mortis sets in.

And, if that institution is as large as Lehman was, its failure -- due either to chicanery or mistake -- will cause the rest of us to lose our shirts.

Since, as Kudlow said, more regulations will not work, and since short-sellers cannot, and did not, prevent an institution from failing, it follows that the only way to save the rest of us from the collateral damage of a large institution failing is to ensure no bank is so large that its failure matters to anyone but its management, employees, shareholders and creditors.

Kudlow made the case, and could not have made it stronger. The inexorable conclusion -- that Kudlow avoided because of ideology -- is that because there is no way to ensure a bank does not fail, no bank should be so large so that its failure brings down the economy.

You and I should not fail because a bank fails. The only way to achieve that goal is to break up the big banks.

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