A Failure of Capitalism: The Crisis of '08 and the Descent into Depression [ハードカバー]

This is the fifth book by Richard Posner (law professor at the University of Chicago and a long-time judge on the 7th Circuit Court of Appeals) that I've read, in addition to many legal opinions. There is no question that he's brilliant and an excellent, clear, and precise writer. There is also no question about his credentials as a libertarian-leaning conservative.

Until now, that is. "A Failure of Capitalism" departs consciously from the prevailing libertarian take on the current recession (or, as Judge Posner argues it should be called, "depression"). In short, he believes that the depression was not mainly caused by government meddling. Rather, it is a "market failure" -- i.e., a crisis that market forces alone could not have prevented. And, given the size of this market failure, government should instead have used regulations to prevent it.

Before I got the book, I had read some indications that Judge Posner was taking this line. But in the book itself, he is crystal clear about his view that deregulation in the financial industry was a major culprit, and his recognition that he is going against the conventional wisdom of both libertarians and conservatives.

The book is well argued and much more thorough than I can convey here. One of the great things about Judge Posner's style is that he anticipates all of the reader's objections and tries to address them in good faith. Whether you agree or disagree, he is always worth reading.

The book also includes a narrative of how the depression developed, descriptions of the systemic problems in the financial industry that made the depression possible, and recommendations for government action.

Although the material may be a little difficult for those with no knowledge of finance, it has been intentionally written with non-specialists in mind. As always, Judge Posner repays the attentive reader.

Judge Posner was appointed to a Federal Appeals Court position by President Reagan, and has sometimes also been mentioned as a Supreme Court candidate. During his legal career he has pioneered the inclusion of economic perspectives in interpreting law and now regularly writes a blog on economics. In "A Failure of Capitalism" he focuses his combined talents on our current economic downturn, and reaches a surprising (for a conservative, "Chicago-school" proponent) verdict. Those most guilty of contributing to the downturn are Alan Greenspan and George W. Bush - Greenspan for keeping interest rates low, fueling the surge in home prices, and Bush for accelerating deregulation of financial markets and then doing little while the economy began crumbling. (Posner also includes the monies China invested in T-bills as a factor holding American interest rates low.)

At the same time, home buyers and their willing enabler mortgage brokers knew they were getting in over their heads. Wall Street, seeing a great opportunity, then leveraged these new mortgages to extreme levels. Thus, both mortgage-takers and Wall Street were in over their heads. (Posner believes home-buyers' failure to save was part of the problem - reality, however, is that they thought they were saving big time through home appreciation.)

Posner's Prescription: More EFFECTIVE government regulation, not just expanding the hodge-podge of overlapping partial management spread over myriad state and federal agencies. This should include limits on leverage, changing how credit-rating agencies operate and are compensated, requiring CDS be fully collateralized, limiting payday loans, etc. Posner also worries about the impact of enormous bailout monies on the value of our currency.

Why the title "A Failure of Capitalism?" Posner recognizes that competition carries the seeds of capitalism's destruction - bankers, etc. realize that if they don't participate in whatever current fad is popular, they risk becoming unemployed and their firm bought out by others who ride the fad to higher P/E multiples. That's why government regulation is essential.

Posner also believes that the free market is incapable of appropriately setting executive salaries and mutual (and hedge) fund fees due to the inherent biases and conflicts of interest involved. Finally, Posner also points out that current conservative thinking on this subject is vacuous.

Richard Posner comes as close to a true American Intellectual, of the old Walter Lippmann type, as anyone alive. His fame and popularity are deserved, and this hard-hitting yet extremely accessible book is probably his most important contribution to American political debate. Financial economics is not all that difficult, there aren't widely divergent schools of thought on the subject, and it is pretty easy to explain, as long as international trade, balance of payments, and exchange rate factors are not at issue. Posner could not be more lucid, and I could discern no mistakes or biases. The title of the book is pretty wrong-headed, though: Posner shows that the failure is one of proper regulation of financial institutions, not of "capitalism," and I very much doubt that we are descending "into depression," as Posner and many other scare-mongers suggest (take a tip from me, dear reader: take any spare money you have and put it into the market, right now; you'll thank me later).

Says Posner at the outset: "Some conservatives believe that the depression is the result of unwise government policies. I believe it is a market failure...The movement to deregulate the financial industry went too far by exaggerating the resilience---the self-healing powers---of laissez-faire capitalism. "(p. xii) The conservative argument, which Posner does not even consider worth addressing in more than a passing manner, is that liberal politicians pushed the banking industry into taking on unwanted risk, using the bullying legislative power of Congress and the irresponsible semi-public mortgage institutions Fannie Mae and Freddie Mac. Posner gives short schrift to the equally dumb liberal argument that the financial crisis was caused by "corporate greed."

Probably the most popular argument for the financial crisis is that put forth by George Akerlof and Robert Shiller, in their book Animal Spirits. This book is quite worth reading, but their argument that it is the "irrationality" of economic actors that causes such crises is probably wrong. Certainly Posner thinks so, as he directs his biggest guns toward showing that it is the normal operation of markets, populated by rational decision-makers, that leads to instability. Posner agrees with Akerlof and Shiller that downward wage rigidity is a precondition for the sort of Keynesian economies we are used to seeing, and that this phenomenon is linked to the softer "social relations" side of the workplace that is usually left out of the economics textbooks. But, beyond this, he asserts, the standard rational calculations of economic actors can account for the housing and credit bubbles we have witnessed.

The first target of Posner's attack is the assertion, often suggested by professional economists and financial analysis, that extensive financial innovation in mortgage packaging (credit-debt swaps and the like) fooled bankers into thinking they had safe assess when in fact they did not. This situation may have held during the early years of the housing build-up, but as early as September 2002, The Economist, widely read by the economically literate, spotted the housing bubble, and the Financial Times followed suit by 2004. The fact that credit rating agencies rated these new instruments as AAA could not fool the bankers, who knew that the credit-rating agencies were chosen by and paid by the firms that they advised, and generally told them what they wanted to hear; what they wanted to hear was that the new mortgage instruments were sound. Of course, if housing prices were to fall precipitously, bank defaults would be inevitable. But the authorities in Washington, including the Chairman of the Fed, were saying that housing prices were bound to level off, but that "new fundamentals" would be established at much higher price levels than in the past. By 2006, houses were seriously overvalued in hindsight, as witnessed by the fact that speculation in houses by the well-to-do accounted for a majority of home purchases even at the height of the bubble.

Posner rightly tresses that in business, investment behavior and general business practice develop by individuals imitating the successful behavior of others, and by assuming that the future will be more or less like the past, unless events indicate otherwise. Thus, asset bubbles sound irrational, but when rational agents are in the middle of one, they do not simply get off the gravy train because of a curious asymmetry of competition. If a large bank said in 2004 that it would no longer participate in the mortgage market, its shareholders would hold it accountable for the foregone profits in case housing prices continued to rise and stabilized at a high level, and would probably force a change in leadership over the course of a year or less. By contrast, if the bank went along with the general state of opinion, even in the case of collapse, they would be unlikely to be blamed because they merely followed the received wisdom of the marketplace. Posner here quotes Keynes approvingly: "The market can stay irrational longer than you can stay solvent."

Moreover, Posner notes that the structure of executive compensation encouraged excessive risk-taking. "The tendency of corporate management to cling to a bubble and hope for the best...is strengthened if...executive compensation is both very generous and truncated on the downside. For then every day that you stay in you make a lot of money, and you know that when the bubble bursts you'll be okay because you have negotiated a generous severance package with your board of directors." (p. 93) Posner is both accurate and eloquent in analyzing how virtually all participants, politicians, lawyers, accounting firms, boards of directors, find it in their interest to prolong the roller coaster ride as long as possible. The result is a disaster for the economy as a whole, and for the many lower-level workers and pensioners who are devastated by the resulting meltdown, but there is nothing irrational in the behavior of the major participants.

It is precisely for this reason that Posner calls the crisis a "failure of capitalism." According to his logic, there will always be expansionary periods that get out of hand, in which the prudent are cast aside in favor of the risk-tolerant, and a tide of justifiable optimistic expectations ensues, even though in hindsight a coordinated retreat could have left all parties better off.

My own agent-based model of large-scale multi-market economies ("The Dynamics of General Equilibrium," The Economic Journal 117 October 2007) quite supports Posner's analysis. The same high level of incomplete information that renders market economies so potent a force in aggregating the plans of millions of consumers, workers, and employers bears as a byproduct the tendency to tolerate and even promote large excursions of prices and quantities away from their equilibrium levels. No doubt there will be new sets of regulations preventing the recurrence of the conditions that led to the current crisis, but new conditions will lead to new bubbles. I'm not sure if this is a failure of capitalism, but it is a stable characteristic of capitalism that cannot be legislated out of existence, save at the cost of severely crimping innovation and growth