This book review was originally written for the Harvard Law & Policy Review Online.
Richard Posner, A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression, Harvard University Press, 346 pp., $23.95
Richard Posner’s A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression is about a macro-economic crisis. It is also a surprisingly inward-looking book. Richard Posner, a judge on the Seventh Circuit Court of Appeals and a law professor at the University of Chicago, has been a prominent figure in the law and economics movement, an effort to bring insights from economics into legal and policy discussions. The sudden economic crisis in the fall of 2008 clearly took Posner, like most Americans, by surprise. Any reader familiar with his reputation in law and economics will see that the 2008 crisis has forced Posner to challenge some deeply held ideological beliefs.
Posner’s disappointment with the economics profession in light of the 2008 economic crisis is understandable. The profession’s unanimous failing in missing the housing bubble strikes at many of the principles that Posner had built his career around. In A Failure of Capitalism, Posner begins looking in new directions and strives to wrap his head around the crisis: how did the market, the government, the professionals, and the experts all get this so wrong? For a laissez-faire Chicago economist and the leading intellectual force behind the law and economics movement, Posner’s questioning of his own convictions represents an enormous turning point in the country’s intellectual climate. His book is a testament to his versatility as a thinker and to his willingness to confront the 2008 crisis with the appropriate amount of seriousness and self-criticism.
A Failure of Capitalism is readable, thorough, and unforgiving toward all of the parties involved in producing the crisis. No actors are left out—the banks, the sub-prime lenders and borrowers, the Fed, the lame-duck Bush administration, the executives with the wrong incentive-structures, the palpably absent regulators, the American consumers who borrow endlessly and never save a penny, the risky new financial instruments, decades of laissez-faire faith in markets, and most of all, former Federal Reserve Chairman Alan Greenspan and low interest rates—no one gets a free pass.
This interconnected array of actors and complicated financial instruments does not lend itself to a linear narrative. At times, Posner errs toward over-inclusiveness instead of orderliness, and he frequently veers off track with asides and peripheral economics lessons. Yet through the frequent attempts at self-summary and the regular repetition of themes, a coherent non-technical account of the crisis begins to emerge.
The timing of A Failure of Capitalism is perhaps the clearest insight into its shortcomings. Posner attempted to assay the destruction of the financial crisis before the dust had even settled, making the book feel as though it were written hurriedly in order to pull off a May 2009 release. This rushed quality shows, both organizationally and in some of Posner’s bolder claims that have failed to pan out. In particular, it is hard to reconcile Posner’s eagerness to label the crisis a “depression” and “a failure of government” with his admonitions that 2009 was too soon to initiate regulatory reform. There is much the book does well, however, and its contents deserve public airing. Unfortunately, it is too unkempt and alarmist to serve as more than a starting point for a more deliberate discussion of this crisis. Indeed, less than a year later, Posner has already published a second book on the topic, The Crisis of Capitalist Democracy.
A Failure of the Market and an Absentee Government
Posner’s vision of what went wrong centers on low federal interest rates and leverage—the heavy use of debt to supplement investments. A decade of cheap credit encouraged borrowing of all kinds, fueled spending, and pushed investors toward higher-return, riskier financial products. It was not uncommon for institutional investors to be leveraged as much as 30-to-1 on investments, meaning that for every dollar they invested, they were investing another 30 dollars of borrowed money. When this risk was aggregated into a small number of elite financial institutions, the first signs of instability were enough to send shockwaves through the economy. While Posner paints a somewhat more disjointed picture, I have attempted to trace a line through what he calls the proximate causes of the crisis.
Above all, Posner blames (in a chapter unflinchingly titled Apportioning Blame) the Federal Reserve and its former chairman, Alan Greenspan, for setting interest rates dangerously low for an unprecedented span of years. By setting interest rates low, saving became less valuable for consumers and investors, thus encouraging excessive spending and borrowing throughout the economy. The traditionally steady housing market absorbed much of the excess credit as people sought out investment properties and an increasing number of people became first-time homeowners. The growth in the housing market pushed mortgage brokers, urged on by financial institutions, to extend mortgages to riskier (sub-prime) borrowers and to offer complicated products like adjustable rate mortgages that became more expensive over the life of the loan. This brought even more people into the housing market, thus fueling further price increases, and produced what is now well understood to be the “housing bubble.” As it became evident that many of these borrowers were in houses they could not pay for, demand leveled off and home prices started to fall. With no market demand, people were stuck with homes they either needed to flip or simply could not afford, and they started defaulting on their mortgages.
The bursting consumer housing bubble quickly spilled over into the financial markets, where banks and other financial institutions had invested heavily in new financial products tied closely to the consumer housing market. Relying on credit agency ratings and using historic models of mortgages as safe investments, financial institutions staked billions of leveraged dollars on mortgage-backed securities. These securities were comprised of groups of mortgages, whereby investors would receive returns as payments were received on the underlying mortgages. Posner emphasizes that it was not mortgage-backed securities themselves that produced the fundamental instability of the financial institutions. Leverage and the extent to which institutions had become interdependent were far more precarious. If the price falls far enough, the ability to repay that borrowed capital is called into question, which in turn makes lenders less likely to recover on their loans. The risk inherent in such an arrangement can spread quickly throughout the entire financial sector. Like a sinking ship, one failing firm can quickly pull down everything in its proximity.
When consumers started defaulting on their mortgages, mortgage backed securities quickly declined in value and investors rushed to unload them. With no market to buy the securities, these investments quickly became unpriceable and soon earned the name ‘toxic assets’. Investment banks like Lehman Brothers held vast sums of these securities, previously worth billions, that were suddenly hard to price. This rendered the entire value of the company uncertain and set off a cascade of investors trying to liquidate their investments for cash, producing essentially a bank run on Lehman Brothers. Lehman was forced into a fire sale and could not scrounge up enough cash to cover its debts quickly enough. This quickly turned into a chain reaction. Other institutions dealing with Lehman were unable to call in their investments and suddenly confronted a similar threat. If they didn’t get rid of their mortgage-backed securities and get their money from Lehman, they wouldn’t be able to cover their own debts. The whole financial system lurched.
This story is, as Posner insists in numerous passages, a series of market failures enabled by an absent government. Although the government might have contained the damage by preventing the Bear Sterns or Lehman Brothers collapses, Posner sees untrammeled markets as the root cause of the disaster. Even in evaluating the government’s culpability, the central failing is the dearth of political will and an ideological faith in markets. Washington left Wall Street relatively free to set its own rules, and many preexisting rules were stripped away during the 1990s and early 2000s. Posner also finds fault with the government’s unprepared, improvised response to the collapse of both Bear Stearns and Lehman Bros. But according to Posner’s version of the story, the government’s primary failing was its glaring absence—an absence which enabled a race to the bottom as market actors invented new, riskier ways to gamble.
In retrospect, according to Posner, the 2008 crisis could have been averted, or at least mitigated, in any number of ways: higher federal interest rates, enhanced capital requirements for institutional investors, limitations on leveraged investments, derivatives regulations, more stringent mortgage requirements, compensation packages that do not incentivize excess risk-taking, etc. Unfortunately, prior to 2008, hardly anyone seriously contemplated any of these options. The government failed to provide a sufficient regulatory regime, but investors and academics were similarly blindsided by the crash. Faith in the infallibility of markets provided the backdrop to the entire calamity.
Posner writes, “[T]he depression has shown that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.” It is hard, however, to know exactly what Posner has in mind. Any call for a more active government role is undermined by Posner’s own concerns about the costs of regulatory reform and the book’s refrain that “a depression is not the right time for regulatory innovations beyond the bare minimum essential for recovering from the depression.” My view is that we should be done by now with the idea that a market without a government is possible. Such a thing has never existed. The more appropriate question is how we should balance the two. We need to learn how we can use government to encourage healthy market growth while preserving stability and innovation.
An Ideological Failure
While never excusing the oversight, Posner acknowledges that there are plenty of plausible reasons why nobody, not even the economic profession, saw the crisis coming. Our frame of reference in a market system tends to be on the winners and losers only in the very recent past. Even the most sophisticated computerized models lacked historic data about many of the forms of risk being traded. Many models accounted for the possibility of individual defaults, but few considered the possibility of mass foreclosures or other forms of system-wide risk. But academics and financial analysts were not the only ones looking in the wrong directions. The Republican Party had invested politically in a free-market ideology, and fiscal conservatism was becoming increasingly common even among political moderates and socially liberal Americans. Ideologically, the entire nation was blinded by its preconceptions about the ability of free markets to self-correct.
The dearth of political will in Washington, while blameworthy in hindsight, can be explained at least partially by our democratic process. Americans were doing well financially, and there had not been a serious financial collapse in nearly 80 years. Wall Street was coming up with innovative investment products faster than Congress or a dedicated agency would have been able to follow. The SEC, though understaffed, failed on its duties to police corruption, nowhere more evident than in its failure to prosecute the Madoff ponzi scheme that had been brought to its attention on several occasions. Neither the financial professionals with billions at stake nor the relatively more insulated economics experts anticipated any system-wide threat. Economic regulation had almost no political salience, and any connotations it did have were mostly negative.
Even to the extent warning signs were present, our political and financial incentives are currently structured in such a way that there is little to be gained by spotting a bubble early. As Posner writes, “virtually all warnings are premature.” Until a bubble is at its crest, it is still possible for rational economic actors to make money in the short term. Particularly when everyone else in the economy is profiting off of a growing bubble, the pressures to ride the wave are overwhelming. This, I believe, provides one of Posner’s most devastating critiques of our market arrangements and one of his strongest cases for governmental regulation. Information cascades and the absence of regular feedback have given us an economic system that regularly generates bubbles that can only be identified in retrospect. If investing in a bubble is rational from an individual investor’s standpoint, we need a mechanism for pricking them before they grow large enough to create systemic risk.
Posner notes that there is a related problem in the political and academic arenas that make them similarly unlikely to identify bubbles in advance. There are inadequate incentives for spotting or preventing a crisis before it happens—if an intervention prevents the crisis from happening, nobody knows how bad things would have been had the intervention not taken place. Posner writes, “The point I want to emphasize is that it is very difficult to receive praise, and indeed avoid criticism, for preventing a bad thing from happening unless the probability of its happening is known.” If someone had proposed policies that would have averted the “housing bubble,” it is very likely that they would become politically unpopular, perceived as anti-competitive or as offering only theoretical benefits.
In one of the most provocative portions of the book, Posner argues that what went wrong was not caused by investors or consumers behaving irrationally. He maintains that the financial crisis was a result of ‘rational’ market actions within a poorly regulated economic structure. The distinction is important for a few reasons. When investors behaving rationally in pursuit of profits still produce catastrophic bubbles, the problem is structural and not attributable to any particularly greedy or wayward actors. The inability of markets to stop this process is a typical common resource problem, when individually rational decisions become collectively irrational. This is a clear instance of a predictable market failure and a standard case for government intervention. If bubbles are an inevitable byproduct of rational actors within our market economy, then absent appropriate regulation, it is only a matter of time before the next crisis hits.
Posner is less forgiving of the economics profession, though he does offer several reasons that most economists missed the warning signs. It has been a long time since the country last confronted the possibility of depression. Moreover, the trend toward mathematical and statistical analysis in economics has not produced much fruitful research about depressions, since very little historical data is available. In addition, fragmentation within the profession has encouraged tunnel vision, as financial economists rarely communicate with macroeconomists in their work and often do not even write with the same vocabulary. Political and intellectual factionalism within the profession has also disrupted consensuses and made it more difficult for policymakers to obtain neutral information about the economy. But above all, according to Posner, economists fell victim to the same ideological preconceptions that blinded those in government and the private sector—their faith in the functioning of free-markets meant that many economists simply could not imagine the possibility of an economic crisis.
Posner praises the lone economists, such as Nouriel Roubini, Raghuram Rajan, Dean Baker, and Paul Krugman, who spotted the housing bubble and predicted the financial crisis before it hit. But without consensus among economists, these warnings were too scattered to have the necessary effects on prominent actors in government or the banking industry. The social costs of economic crisis or a protracted recession are unacceptably high, and the fact that something of this magnitude could go largely undetected delegitimizes the entire economics profession. Posner suggests a more centralized way for information about the economy and the financial sector to be collected and analyzed so that economists and regulators can begin to contemplate the way risks interact and accumulate to affect system-wide stability.
Posner’s eagerness to diagnose the economic and financial crisis of 2008 as a full-fledged depression provides one of the book’s most curious features. While in 2008, the financial crisis may have looked like a bottomless pit, a year later the worst of the crisis does appear to be over. At a time when policy-makers were terrified that the very mention of the word “depression” might turn into a devastating self-fulfilling prophecy, why was Judge Posner so impatient to label the 2008 economic crisis a depression?
Posner’s fear of depression stems from the fact that, like the Great Depression of the 1930s, the 2008 economic crisis originated out of a crisis in the financial sector. A financial crisis creates a lending freeze that makes it difficult if not impossible for the Federal Reserve to stimulate the economy by expanding the money supply. At the time Posner was writing, it was still unclear that the bailout was enough to ensure that banks would start extending credit to one another or to anyone but the most qualified borrowers. Without banks lending, consumer spending would decline, demand would fall, and the market would quickly enter a deflationary spiral. This situation, fortunately, has been averted, but at the time Posner was writing it did not seem like the most unlikely of outcomes. There is something ironic about this stance, however, considering that Posner spends an entire chapter arguing that it is too early to regulate or inject the government into the market. Consider this passage:
It is a temptation, but I think it would be a mistake, for the new [Obama] administration to try to emulate Franklin Roosevelt’s astonishing first 100 days. The United States fortunately is in less desperate straights today and American government and the American economy, and specifically the American banking system, are all immensely more complex than they were in 1933. [...] Let the comprehensive structural solution await calmer days.
There may be something to the view that the most sensible thing to do right now is to see how things unfold, but the view is undercut by Posner’s own doom-saying elsewhere in the book. One could understand the urge to be on the right side of history by being the first to spot a depression. But if that’s the stance Posner wants to take, it’s a little disingenuous to hedge with a mild endorsement of the bank bailout and nothing but wait-and-see policy suggestions. To his credit, Posner acknowledges in his introduction that the spring of 2009 was too early to fully assess the economic fallout precipitated by the financial and economic crisis. It is unfortunate that he so quickly dispenses with this humility. But then again, Posner’s lack of humility is probably what made this book possible on such short notice.
Far more harmful, however, is Posner’s insistence that it is not appropriate to press for enhanced regulations mid-recession or mid-depression. Not only is he demonstrably wrong to characterize all possible regulations as market-destabilizing, his call for regulatory postponement ignores a basic political reality: the further we get from the economic crisis, the less likely any government regulation will ever get passed.