Back in September, after Lehman Brothers was allowed to fail, top U.S. financial officials acted as if they had seen a ghost. They ran from the specter of bankruptcy as fast as they could. They made the classic slasher-film mistake: They did not look to see what was lurking in the other direction, the wraith of public wrath.

The public is outraged that American International Group (AIG) employees who helped deliver more than $150 billion of failure could receive at least $150 million in bonuses. This uproar threatens to undercut public support for salvaging the failing financial sector and is driving Congress to pass retributive measures of dubious constitutionality.

The crux of the problem is that we are not allowing major companies to fail.

The crux of the problem is that we are not allowing major companies to fail. We peeked into that crypt once in September and recoiled in horror. The episode led Federal Reserve Chairman Ben Bernanke to conclude: “Lehman proved that you cannot let a large internationally active firm fail in the middle of a financial crisis.” The Lehman bankruptcy was the high-finance equivalent of chaining the doors of a bank on Main Street. It has long been known that such an approach can cause panic among customers—it is why we have the Federal Deposit Insurance Corporation (FDIC). We relearned that lesson last fall as money market funds scrambled to secure their investments and credit markets dried up. Only belatedly did the government offer the equivalent of FDIC insurance to those funds, by which point the panic was well under way.

Now the government seems to have concluded that no one can fail. Not AIG, not Citigroup, not GM, not Chrysler. The feds seem intent on pumping in tens of billions of dollars from public coffers until things get better. This avoids the panics of disorderly bankruptcies, but it has some terrifying implications of its own.

AIG was a poorly run company that made bad decisions. One of those was to sign generous “retention bonus” contracts with select employees. These agreements made the recipient employees creditors of the company, just like the banks who purchased credit default swaps.

There is an accepted legal way to rework such contracts when a company fails: bankruptcy, under which a court could determine how to divvy up the company’s resources among all claimants. A court’s treatment of the AIG bonus contracts would probably not be as vengeful as the public might like, but it would be a well-established means to set aside the contracts.

Without bankruptcy, it is hard to avoid rewarding failure.

Instead, Congress is discussing legislation that would apply very high tax rates to select individuals as a way to claw back those bonus payments. This comes dangerously close to an ex post facto law or “bill of attainder” of the sort forbidden in the Constitution. James Madison wrote in Federalist No. 44 that such laws “impairing the obligations of contracts, are contrary to the first principles of the social compact, and to every principle of sound legislation.”

It is a principle of sound economic practice that those who make bad decisions should pay a price. In the corporate world, the responsible parties are the shareholders, the owners of companies, to whom management reports. In bankruptcy, the shareholders would receive nothing; the remains would be divided among creditors.

Without bankruptcy, it is hard to avoid rewarding failure. This has been the fundamental problem with plans to rid banks of their toxic assets. Any plan that pays market prices will not help the companies. Any plan that pays higher prices will reward banks and shareholders in proportion to the bad decisions they made. This unpalatable choice has left us with zombie banks, focused on restoring their capital ratios rather than on funding new endeavors. A reorganization under bankruptcy would allow the toxic assets to be separated off into a “bad bank” without worrying about shareholder gains. If this were handled skillfully, the administration could forestall panic in the markets while being able to assuage public anger.

There are real and apparent economic threats associated with bankruptcy. There are equally serious but hidden dangers associated with public indignation.

These problems are not unique to the financial sector. The large auto companies are saddled with legal obligations to workers, retirees, creditors, and state laws governing dealerships. It should be no surprise that reworking all these obligations without the protection of a bankruptcy court has proven difficult.

There are real and apparent economic threats associated with bankruptcy. There are equally serious but hidden dangers associated with public indignation. Without bankruptcy, measures to save the economic system are equated with bailouts of those who gambled and lost. The public is right to be indignant about that. Unless measures like recapitalizing the financial sector are delinked from rewards for existing shareholders and management, public rage may well block necessary emergency acts. This poses a systemic risk in its own right.

If our leaders do not realize how grave this threat is, their actions are likely to come back to haunt them.

Philip I. Levy is a resident scholar at the American Enterprise Institute.

Image by Darren Wamboldt/The Bergman Group.