Capitalism’s Fault Lines
“This recession,” President Obama said recently, “was not caused by a normal downturn in the business cycle. It was caused by a perfect storm of irresponsibility and poor decision-making that stretched from Wall Street to Washington to Main Street.” Richard A. Posner is having none of it. A perfect storm, yes: but a storm of responsibility and reasonable decision-making. The Crash of ’08 happened because businesspeople and consumers did what markets and society expect them to do. Don’t blame capitalists or, for the most part, government. Blame capitalism.
It comes as something of a surprise that Posner, a doyen of the market-oriented law-and-economics movement, should deliver a roundhouse punch to the proposition that markets are self-correcting. It might also seem odd that a federal appellate judge (and University of Chicago law lecturer) would be among the first out of the gate with a comprehensive book on the financial crisis — if, that is, the judge were any other judge. But Posner is the late Daniel Patrick Moynihan’s successor as the country’s most omnivorous and independent-minded public intellectual. By now, his dozens of books just about fill their own wing in the Library of Congress.
In “Catastrophe: Risk and Response” (2004), he took up the problem of low-probability, high-impact events. The financial meltdown certainly qualifies. In this compact and bracingly lucid volume, he offers a simple, but not simplistic, primer: “a concise, constructive, jargon- and acronym-free, nontechnical, unsensational, light-on-anecdote, analytical examination of the major facets of the biggest U.S. economic disaster in my lifetime and that of most people living today.”
If you read the newspapers, you will not see much in “A Failure of Capitalism” by way of unfamiliar particulars. Cheap money and an inrush of foreign capital fueled a lending boom, which poured credit into the housing market. As prices went up, up, up, even risky mortgages seemed safe and everyone piled in, including banks. Financiers relied on securitization and complicated financial instruments to dilute the attendant risk, but the result was to spread that risk through the financial system, making it impossible to locate. When the housing bubble popped, everyone was holding bad debt, but no one was sure how bad or even how much. With banks suddenly looking undercapitalized, lenders stopped lending and started selling assets to raise cash. The faster everyone ran for the exits, the faster asset prices fell, dragging banks’ balance sheets down with them. Credit markets seized up, depressing the economy, causing more mortgage defaults and asset-price deflation, further weakening banks, further paralyzing credit, depressing the economy still more. . . . Repeat ad nauseam.
You know that story, and Posner tells it well, with a particular flair for showing how dozens of moving parts interacted. Being Richard Posner, however, he is not content to be an amiable guide through the thicket. His real interest is in finding and detonating grenades in the underbrush.
One is right there on the title page, which flaunts the D-word. The current crisis, Posner maintains, is a depression. True, it is not (we hope) a great depression. But the typical postwar recession is a partly self-correcting disinflationary contraction that soon subsides, often leaving the economy healthier. The present downturn is a self-sustaining deflationary contraction whose costly aftereffects will linger for years. The Great Depression led to World War II. Today’s depression presumably won’t be that bad, but it may cause a huge loss of output, an immense increase in the national debt, a swing to excessive regulation, a nasty bout of inflation, a decline in America’s economic and geopolitical power, and increased political instability abroad.
A typical recession is a market correction, usually of inflation or other economic imbalances; a depression is a market failure. And it is a failure (here is grenade No. 2) that the market is powerless to prevent. “An interrelated system of financial intermediaries” — a banking system, broadly defined — “is inherently unstable,” Posner writes. Think of it as “a kind of epileptic, subject to unpredictable, strange seizures.”
Populists and libertarians will hate this book, though I wouldn’t want to predict which group will hate it more. A perfect storm of irresponsibility? Hardly. The crisis came about precisely because intelligent businesses and consumers followed market signals. “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.”
Were a lot of people reckless and stupid? Of course! But that cannot explain why the whole system crashed, since a lot of people are always reckless and stupid. The problem, fundamentally, is that markets cannot, and rationally should not, anticipate their own collapse. “A depression is too remote an event to influence business behavior.” Any single business can rationally guard against its own bankruptcy, but not the simultaneous bankruptcy of everybody else. “The profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy.”
During the housing bubble, for example, sitting out the mortgage boom meant forgoing large profits. “Even if you know you’re riding a bubble and are scared to be doing so,” Posner writes, “it is difficult to climb off without paying a big price.” So people made decisions that were individually rational but collectively irrational. To see the crisis through populist spectacles, as President Obama does when he attributes it to “irresponsibility,” is to misunderstand the whole problem by blaming capitalists for a failure of capitalism.
And so — here is the part libertarians will hate — markets, entirely of their own accord, will sometimes capsize and be unable to right themselves completely for years at a stretch. (See: Japan, “lost decade” of.) Nor can monetary policy be counted on to counteract markets’ tippy tendencies, as so many economists had come to believe.
Alas, economists and policy makers got cocksure. They thought they had consigned depressions to history. As a result, they missed warning signs and failed to prepare for the worst. “We are learning,” Posner writes, “that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.”
By doing what, exactly? Posner thinks laissez-faire economics has nothing relevant to say. The rest of the economics profession is all over the map. The system of financial regulation will need an overhaul, but Posner argues that the time for that is not now, in the heat of crisis. Anyway, no one is sure what to do. He halfheartedly suggests a few reforms but concedes they are “pretty small beer.” If pressed, I suspect, he might also acknowledge some 20-20 hindsight in his insistence that the government should have prepared for an event that hardly anyone thought possible.
By the last page, not a single lazy generalization has survived Posner’s merciless scrutiny, not one populist cliché remains standing. “A Failure of Capitalism” clears away whole forests of cant but leaves readers at a loss as to where to go from here. In other words, it is only a starting point — but an indispensable one.