Book Excerpt: A Failure of Capitalism

     The world’s banking system collapsed last fall, was placed on life support at a cost of some trillions of dollars, and remains comatose. How could it have happened after all we’ve learned from the Great Depression? In these excerpts from his latest book, noted author and jurist Richard A. Posner presents a concise and non-technical examination of this financial disaster and the stumbling efforts to cope with it.

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Excerpted from A Failure of Capitalism: THE CRISIS OF ‘08 AND THE DESCENT INTO DEPRESSION, by Richard A. Posner, published by Harvard University Press Copyright © 2009 by the President and Fellows of Harvard College

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The Underlying Causes

Conservatives do not agree that the economic emergency is a failure of the market to internalize the costs of an economy-wide catastrophe. They argue that the cause was government. They point to legislative pressures on banks to facilitate homeownership by easing mortgage requirements and conditions, to which could be added the deductibility of mortgage interest payments and interest on home equity loans, along with real estate taxes, from taxable income and the repeal in 1997 of capital gains tax on most resales of residential property.

I examine some of the legislative pressures later. For now it is enough to note that small-government conservatives, at least those who were in power, were happy with these policies—President Bush pushed homeownership as a cornerstone of the “ownership society” that he advocated as part of his political philosophy of “compassionate conservatism”— until a governmental scapegoat was needed to explain the depression. The housing bubble and the risky lending practices could have been prevented by more aggressive regulation and the elimination of tax benefits for homeowners. But the absence of these or other preventive measures was the result not of too much government but of too little: not of intrusive, heavyhanded regulation of housing and finance but of deregulation, hostility to taxation and to government in general, and a general laissez-faire attitude, “conservative” in a currently prevailing sense of the word. Conservatives wanted taxes to be lower rather than higher and regulation to be lighter. They considered markets to be self-regulating, from which it followed that bubbles, risky lending, defaults, and other market perturbations would be self-correcting unless the government interfered. (In an older sense of “conservative,” risky lending, risky borrowing, heavy indebtedness, bubbles, andspeculation would have been thought antithetical to a conservatively managed economy.) There is an illuminating analogy to industrial pollution in capitalist society. Suppose government provides no remedies at all (whether judicial or administrative) against harms from pollution. Then rational profit-maximizing producers, in deciding how much to pollute, will not consider the effects of their pollution on people with whom they have no actual or potential contractual relationship (as they do with their workers). Yet when those effects are taken into consideration the social costs of the pollution may exceed the cost savings from not doing anything about it.

If government refused to do anything about pollution, one could call its refusal a “cause” of the pollution if one wanted, but a more illuminating formulation would be that the government had failed to do anything about pollution caused by industry. Similarly, the social costs of a recession or depression are external to the rational self-interested decision-making of financial institutions because nothing an individual firm can do will avert such an event. The aggregate self-interested decisions of these institutions produce the economic crisis by a kind of domino effect that only government can prevent—which it failed to do. That was a grave government failure, which allowed a failure of the financial market to produce disastrous consequences for society as a whole. The roots of the failure lay in widespread dissatisfaction, beginning in the 1970s, with public-utility and common-carrier regulation, and other forms of economic regulation as well, including the regulation of banking and investment. The economists who inspired the deregulation movement were not macroeconomists and did not differentiate between banking and other regulated industries, such as railroads and airlines. They were not alert to the macroeconomic implications of competition in banking; and macroeconomists, as we shall see, thought that the problem of depressions had been solved.

We must not ignore the costs of regulation. Some market failures cannot be corrected at a cost less than the social cost of the market failure, and it is best to ignore them. But are depressions such a market failure? They are not, even if we could be confident that a depression would occur only once every eighty years (this year is the eightieth anniversary of the stock market crash of October 1929), and of course we cannot be. The Great Depression of the 1930s inflicted horrendous costs, quite apart from the suffering inflicted on tens of millions of Americans, not to mention—since it was a global depression—more tens of millions abroad. Among the costs, as conservatives should take note, were the excesses of the New Deal. And without the depression there might have been no Nazi Germany and no World War II. The costs of the present depression may include a swing to excessive regulation, a politically as well as economically unhealthy dependence of business on government largesse (I give an example later, involving Citigroup), a huge loss of economic output, an immense increase in the national debt, a high inflation rate, a decline in U.S. world economic power, a weakening of the nation’s geopolitical power as the country turns inward to address its economic problems, and increased political instability in many parts of the world. It may turn out that if the asset-price bubbles of the last decade are subtracted from measures of economic growth, the U.S. economy will be adjudged to have been stagnant—that rather than being productive during this period, Americans were living on borrowed money.

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Why a Depression Was Not Anticipated

As in the lead-up to the attack on Pearl Harbor, so in the lead-up to the financial crisis that struck in September 2008, most competent analysts disagreed that the economic prospects were as dire as Roubini and the other “Cassandras,” “alarmists,” “Eeyores,” and “prophets of doom” (notice the absence of a neutral term for someone who warns of disaster—there is no noun “warner”) were contending. For all the reasons I have mentioned, most people, even most experts, were unlikely to be persuaded by the doomsters. But it is unforgivable that the government, though alerted by them beginning in 2005 to the signs warning of a possible economic catastrophe, did not deploy its formidable resources to study the issue in depth. The explanation may be the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on largescale economic risk. It is a machinery the Federal Reserve and the Treasury Department could have created, and presumably would have had they not been overconfident that another depression could be prevented more or less effortlessly even after a financial crisis hit, just by a lowering of interest rates.

Little bits of knowledge about the shakiness of the U.S. and global financial systems were widely dispersed among the staffs of banks, other financial institutions, and the regulatory bodies, and among academic economists, financial consultants, accountants, actuaries, rating agencies, mortgage brokers, real estate agents, and business journalists. There was no financial counterpart to the CIA to aggregate and analyze the information—to assemble an intelligible mosaic from the scattered pieces. More precisely, no agency assumed that role, though the Federal Reserve, the Treasury Department, or even the President’s Council of Economic Advisers might have done so. Much of the relevant information was proprietary and therefore shielded from journalists and academics. Investment banks, hedge funds, mortgage originators, and other financial firms conceal information about business strategies that might help competitors, and avoid, as far as the law permits (and sometimes farther than it permits), disclosing adverse information about the firm’s prospects. Even the regulatory agencies lacked access to much crucial information about the financial system, because of limitations on their authority that were thought appropriate in an era of triumphal deregulation.

Lacking authority to regulate the new derivatives, financial regulators could not force disclosure of information that might have revealed how risky the financial system had become. At its peak, the market in credit-default swaps was larger than the entire U.S. stock market (though that is misleading, because swaps are largely offsetting—if an insured event comes to pass, the liability of the issuer and the claim of the purchaser should cancel, as in my A-B example in Chapter 2). And because the issuers of the swaps, unlike conventional insurance companies, were not required by law to maintain adequate (or for that matter any) reserves, there was no protection against the kind of run that brought down AIG, leaving the buyers of the swaps uninsured. Home financing was regulated, but by different agencies from those that regulated banks; hedge funds were barely regulated at all.

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What We Are Learning about Capitalism and Government

Capitalism will survive the current depression as it did the Great Depression of the 1930s. It will survive because there is no alternative that hasn’t been thoroughly discredited, which wasn’t as clear in the 1930s. It is clear now. The Soviet, Maoist, “corporatist” (fascist Italy), Cuban, Venezuelan, etc. alternatives to capitalism are unappealing, to say the least. Yet capitalism may survive only in a compromised form—think of the spur that the Great Depression gave to collectivism. Spawned in the depression, the New Deal ushered in a long era of heavy-handed government regulation of the economy; and likewise today there is both advocacy and the actuality of renewed regulation and an impending increase in the size of government. Hence the importance of the question whether government may have been responsible for the current crisis. For if so this would be a powerful argument against reregulation—against the new New Deal that liberal economists like Paul Krugman and Joseph Stiglitz are dreaming of—though not an argument that would have much political traction during the present emergency.

I have already indicated my doubts that the government bears the basic responsibility for causing the depression. As far as one can judge on the basis of what is known today (obviously an important qualification), the depression is the result of normal business activity in a laissez-faire economic regime—more precisely, it is an event consistent with the normal operation of economic markets. Bankers and consumers alike seem on the whole to have been acting in conformity with their rational self-interest throughout the period that saw the increase in risky banking practices, the swelling and bursting of the housing bubble, and a reduction in the rate of personal savings combined with an increase in the riskiness of those savings. The market participants made plenty of mistakes, but that is par for the course. Whenever has it been different? Economic life is permeated with uncertainty. The media are having a field day exposing instances of financiers’ malfeasance, misfeasance, folly, and seemingly egregious extravagance. Sometimes they misunderstand what they denounce. An example is the thunder of criticism of John Thain’s $1.2 million redecoration of his office suite when he became CEO of Merrill Lynch, months before Merrill Lynch’s swoon into the arms of Bank America. Companies that raise billions of dollars, some of it from immensely wealthy investors, have a legitimate business interest in decorating their quarters in a manner apt to impress such investors. The financial crisis was indeed the consequence of decisions, some mistaken, by financiers. But the mistakes were systemic—the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools.

Laissez-faire capitalism failed us, but government allowed the preconditions of depression to develop and wreak havoc with the economy. And its responses to the crisis were late, slow, indecisive, and poorly articulated. The responses also created “moral hazard” (the tendency to engage in risky behavior if one is insured against the consequences of the risks’ materializing). They did this by eliminating the limits on federal deposit insurance of bank deposits and by extending that insurance to checkable accounts in money market funds, but more important by bailing out failing firms deemed “too big to fail”—an incentive for corporate giantism and financial irresponsibility (which go hand in hand because the difficulty of controlling subordinates grows with the size of an organization). The government gratuitously disrupted the operations of hedge funds by limiting short selling—at the height of the banking crisis the Securities and Exchange Commission forbade short selling of financial stocks. And by substantially increasing the federal deficit, the government’s responses to the crisis are sowing the seeds of a future inflation. But of these criticisms, the main ones— the creation of moral hazard and the planting of the seeds of a future inflation—concern the unavoidable side effects of any effective measures to limit a depression.

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Conclusion

What is inexcusable is the failure of the Federal Reserve and other economic agencies within the federal government to have prepared contingency plans for the possibility, remote as it seemed, that a crumbling of the banking industry would set the stage for a depression. When the financial crisis hit in mid-September 2008, the government was unprepared and responded with a series of improvisations that did avert the most catastrophic imaginable consequences of the crisis but could not avert a depression. The improvisations were bumbling, incoherent, poorly explained; the President seemed absent, so far as attending to the economy was concerned, during the critical period. Even now, four and a half months after the crisis hit, the government has no coherent plan of recovery. In the absence of such a plan, it is, or soon will be, trying everything at once—flooding the economy with money, which may not work, as I argued in Chapter 5; trying to restore output and employment by massive deficit spending, which may not work either; bailing out the banking industry—or perhaps confiscating much of it (“nationalization”) (odd how saving the industry and swallowing it are discussed in the same breath); reforming the regulatory framework and as part of the reform perhaps consolidating the myriad agencies that have a piece of the financial regulatory pie; and relieving mortgagors of some of the burden of their mortgages. All are measures with strengths and weaknesses that cannot be gauged in advance; all suffer from having to be adopted without having been thought out in advance; some, such as regulatory reform, are overly ambitious. And doubtless there is more to come. The atmosphere is electric with proposals for economic recovery—so many that the government may lack the intellectual resources to evaluate them.

I am not a forecaster. I do not know when the recovery from this depression will begin. But if it begins tomorrow, the trillions of dollars that the government has spent to speed recovery, and the restructuring of banking and its reform that will bring in their train untold problems and uncertainties, will overhang the economy for years to come, as when an expensive treatment cures a deadly illness but leaves the patient debilitated.

WEBINAR
Tune in while Judge Posner discusses A Failure of Capitalism in a roundtable discussion broadcast on FinReg21.com's Pundit Pit. Posner is joined by two noted financial services experts, economist Robert E. Litan and Brian P. Brooks, a nationally recognized attorney who specializes in subprime mortgages.

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Richard Allen Posner is currently a judge on the United States Court of Appeals for the Seventh Circuit in Chicago. He helped start the law and economics movement while a professor at the University of Chicago Law School; he currently serves as a senior lecturer at the Law School. Posner is the author of nearly 40 books on jurisprudence, legal philosophy, and several other topics. He is considered to be one of the most respected judges in the United States and one of the most cited legal scholars of all time. 

A Failure of Capitalism can be purchased from Harvard University Press.