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A Failure of Capitalism: The Crisis of '08 and the Descent into Depression

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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

Posner makes several interesting observations, but when he is done with his argument, I'm not quite convinced about his central thesis. His arguments are anecdotal and he uses almost no quantitative analysis. Douglas Hubbard's bookThe Failure of Risk Management: Why It's Broken and How to Fix It makes a better case for the idea that very specific models failed, not capitalism in general. If you want a purely narrative (non-quantitative) explaination of events Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis woul be a good place to start.

Capitalism existed before and after the Great Depression (which by any measure was much worse than this downturn) and capitalism existed before and after the introduction of particular risk analysis methods, the political pressure on Freddie Mac and Fannie Mae to buy unqualified mortgages, and the irrational optimism in indefinitely increasing housing prices.

Saying that recessions (or this depression, as Posner insists it is) prove the failure of capitalism is sort of like saying a hurricane is a failure of the weather or that a antelope being killed by a lion is a failure of nature. Recessions, even depressions, are one of the corrective mechanisms in capatalism just as periodic forest fires are now known to be part of natural cycles required for sustainable habitats.

He doesn't adequately define what he thinks "failure of capitalism" means. Does he think capitalism *should* have prevented this? Does he think that some non-capitalist system *would* have prevented this? Show us the math (like Hubbard does when he compares risk management methods) to prove not only that capitalism itself failed by that some other system would have done better. Does he include in capitalism the failure of, say, private ownership of capital assets, the idea of having a privately owned bank, the idea that lots of people can own little pieces of a company, or that people are free to buy and sell their assets as they see fit? These are all aspects of capitalism, but Posner seems to equate capitalism with very specific markets, models, and regulatory structures. If this is a failure, then he has shown the failure only of a very specific version of capitalism made of only recently developed models and regulations.

Between Hubbard's book and books like Taleb's The Black Swan: The Impact of the Highly Improbable, a more viable explanation is offered. Posner is a judge. Taleb and Hubbard are quantitative analysts. Posner sees the problem from his point of view and Taleb and Hubbard see the problem from their point of view. The important difference, however, is the the view of Hubbard and Taleb lends itself to scientific arguments and Posner's does not. Sarbanes Oxely, remember, was written by lawyers and accountants using the same anecdotal treat-the-symptom-and-not-the-desease logic employed by Posner. Posner's recommendations fixed nothing because he doesn't understand how much some very popular - and flawed - mathematical models had to do with this economy.

Posner does cover a lot of interestig material and events so I can't completely discredit it. However, even though Hubbard wrote a book about a much broader topic, I would recommend Hubbard's book for understanding the real culprits at a level Posner glosses over.

I love reading Posner for the same reason I love reading Nietzsche - he's bold, witty, bitterly funny, and sincere - even when sincerity is a bit irresponsible. When Posner's in prime form, he's willing to think dangerous thoughts in his search for a working version of "the truth." But this book has little of his trademark edgeiness.

More importantly, Posner has aimed this book at the layperson...and missed. Even though he has tried "assiduously to suppress the extraneous," he presumes a post-grad readership with a large and specialized vocabulary. One wonders, with amusement, when Posner last spoke to a "layperson" (and whether that person was a circuit-level judicial clerk).

He does a very good job of explaining the economic mechanisms involved in recent events, and if you're looking for that you'll do no better than this book. But, in my view, the Posner "brand" stands for fearless, airtight polemics - the kind of thing that makes you think "that can't possibly be right" and then spend the next 6 months thinking about it. When he lobs a couple of grenades at his own team (e.g. attributing the crisis to market failure, criticizing executive compensation) there is a glimmer of the classic Dick. But for the most part this is a dry, neutral primer on the economics of depression.

Which is not to say it's bad. It's excellent, in the way that some of the spicier textbooks are excellent. It's reliable and has little of the rushed-to-market sloppiness that characterizes contemporary law-and-econ (Cass Sunstein). As a Fed-junkie, I was bored by it, but I'm giving it to my friends and family members.

At nearly 350 pages long, Posner's new book is definitely not a short book. Notably, the chapter on 'The Government Responds' is nearly book-length long. For a more professional review of this book, do look up Dr. Solow's review on the NYRoB. Here's my more pedestrian take.

I am not an economist by training. Yet, believe it or not, Posner writes engagingly for the informed reader who wants to know more about the probable causes and impacts of the Financial Crisis beyond the piecemeal reports of the press, which are increasingly resembling fragments picked up after a major explosion.

Anyhow, I find the chief merit of this book to be Posner's capacity in writing in a comprehensive, yet systematic fashion on all fronts. He updates the reader on what is most recent (one constantly gets the idea that the book was sent to press in a great rush, as if Posner was waiting till the last minute to do so--the binding glue of my book is still not quite dry); he also speculates with great reasonableness on what is likely to transpire. Importantly, Posner also weighs in the political implications of this Crisis without trying to be too political at the same time--he reserves his criticism for the Monetarist as well as the Keynesian at the helm.

In another word, Posner renders a non-technical and a detailedly fair depiction of the Financial Crisis that is also one of the most non-partisan and up-to-date version one can find in the world today. I have only two complaints.

The first is agreeing with Solow--many parts of the book are extremely repetitive--perhaps Posner is trying to help the lay reader along by making the same point on Economics 101 again and again, a possible conjecture that must have escaped Dr. Solow. That said, I did share with Solow the same sentiments that the book seemed to have been dictated as if in a great rush. I also happened to chance on a few editing mistakes--such as more than a handful of improbably long and chained sentences--that ought not to occur in a supposedly better edited publication (as this!).

The second complaint, which may be a regional one depending on how you see it, is Posner's most interesting but misleading title. This book is titled, "A Failure of Capitalism...", not "A Failure of Capitalism in the American Economy...". Yet Posner's entire book seems to have been written only for the American economy as if the implications of his 'Depression' conjecture are merely insulated within the folds of the American economy, rather than one evidently laced with major impacts on the global economy today. On this complaint, I see an even greater global reception, not to mention usefulness, if Posner had at least provided a short chapter to ponder on the implications of his thesis in the global context. He did mention his practice of keeping a blog as a supplementary tool to this book. Perhaps he has reserved his more global musings on the blog; of this I do not know.

Perhaps the greatest contentions on Posner's book is his polarizing bid on 'Depression', than 'Severe Recession' or 'Protracted Recession'. Posner admits that there is no clear cut, word-in-the stone tablet defining line between Depression or 'protracted recession'. Only time will tell if this is a marketing bid or an acute prophecy. Yet like all 'sound-bites' that end up on the tables of decision-makers (or at least their aides), they do enter into the consciousness of decision-making and thus affect real, practical actions. And so even when Posner rejects the commonplace idea with certain folks that 'all the talk of depression has made this into a real depression', more books written on, as policy actions enacted to treat this as a depression can indeed lead to one.

All said, I have not enjoyed reading a non-fiction piece such as this for a long time. On one hand Posner discusses a most pressing event with great sure-footedness. Obviously he did his homework and clearly he has filled in the gaps with his extraordinary judgment and insights. On the other hand Posner also tries to make this seemingly intractable issue simple for the informed reader without making it trite. This is not a simple feat. And if we further infer that he must have conceived and written this book in the short span of 5-6 months inclusive of time to press, I have only great admiration for his energy, intellectual acumen and social responsibility. These qualities, I presume, are those traditionally associated with great public intellectuals--personalities and characters that are most enviable and needed in a time like this.

Richard Posner: Judge, Academic, Public Intellectual, Author (of both Popular and Scholarly work) and Blogger (of two Blogs now). Is there anyone better suited to explain the economic turbulence to the laypeople that live through them?

"A Failure of Capitalism" won quite a bit of attention (including a review in the NYRB), mostly focusing on his criticism of Capitalism - apparently astonishing critics who know Posner merely as a conservative. But Posner has never been an ideologue; anyone who actually knows Posner's works must realize that he's thoughtful and non-Partisan - as he puts it, he is a classic Liberal in the John Stuart Mill sense (see Overcoming Law). That he would be willing to support government regulation of the economy is hardly surprising.

Posner's book is a good introduction to the economic crisis, and it reminds me of Paul Krugman's The Return of Depression Economics, indeed, it pretty much does to the current depression what Krugman's book did to the economic woes of the 1990s. Posner writes elegantly and clearly, making "Failure of Capitalism" the best written, friendliest exposition of the Depression I've read anywhere. However, I think it is aimed slightly too high. Posner assumes too much knowledge of his readers, and proceeds a little too quickly. A few times, I had to re-read a sentence before understanding it completely (this never happened with Krugman's book - and Krugman actually explained business concepts such as "Hedge Fund" and "short selling").

The most exciting and troubling aspect of Posner's book - and hence the title - is the contention that the crisis is a failure of the Capitalist system. Conservatives argue that the underlying cause of the Depression was government actions - mainly the government subsidizing of mortgages via Fannie Mae and Freddie Mac and tax incentives, under the policy by both the Clinton and the Bush administration of advancing an "ownership society", and the Fed's nurturing the bubble via its low interest rates.

But Posner argues, convincingly in my view, that they are wrong. The root of the crisis is that rational human beings, acting in their interests, can cause disastrous consequences. The main reason is asymmetry in their results. CEOs who took gambles could make huge amounts of money in bonuses if the gambles succeeded, but at worst would be out of job if they failed, and often would enjoy large severance pay ("golden parachutes"). This is also true, albeit to a lesser extent of the owners, because they havelimited liability.

A critic of Capitalism may reasonably argue that this puts to question the basic assumptions of the Capitalistic order. The underlying assumption in Capitalism is that the pursuit of self interest furthers the ends of society as a whole. In Adam Smith's words (In The Wealth of Nations (Bantam Classics)):

"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages."

The current crisis suggests that this is not always the rule. Sometimes, when people pursue their own self interest, even within a framework of laws, havoc ensues. The critics may feel the urge to say "I told you so".

But maybe they should resist it. The failure of foreseeing the crisis was widespread, especially among economics and politicians, both Left and Right. Scores of highly influential people underestimated the problem - and the government's actions actually made the crisis worse. The government's failure topped the market's failure.

Posner focuses more on describing the crisis, and the responses to it, than on offering policy prescriptions. Even his discussion of the solutions offered by the Bush and Obama administrations is lacking in that respect: Posner argues against the right that fiscal stimulus should be in the form of public spending rather than cutting taxes because tax cuts would lead to more saving, which the economy does not currently need. Right wing critics like Greg Mankiw argue that tax cuts have a larger multiplier effect, and Posner doesn't answer them. Nor does he answer the Left wing critics who call for the nationalizing of Banks, which they claim worked in the Norwegian Banking Crisis of the late 1980s.

Most conspicuously absent from Posner's account is the Global perspective. Although Posner acknowledges that this is a Global Depression, he hardly discusses the experience of countries other than the US. Even American readers who are naturally more interested in the US, may be interested in a comparison to other countries, if only to find out who is doing what, and how it is working. Beyond brief references to the Japanese "Lost Decade" of the 1990s, Posner's view is strangely and atypically parochial.

"A Failure of Capitalism" is also very much a typical Posner book, complete with Such Posnerian tropes as appeals to Bayesian reasoning and bitter critiques of academic theorists and excessive praise to active men - In this case, Academic economists are lampooned, but "financial managers[`] IQ exceeds my own" (writes the man whom Justice Alito called "the smartest man in the world" on p. 77), In other cases, it's academic moralists and "Moral Entrepreneurs" (The Problematics of Moral and Legal Theory) Law Professors and Judges (How Judges Think) or Academic versus non Academic Intellectuals (Public Intellectuals: A Study of Decline, With a New Preface and Epilogue).

For all its faults (which probably have more to do with Posner's rushing it to publication than anything else), "A Failure of Capitalism" is an insightful, clear and concise account of the economic crisis. After you finish reading it, you'll know more about the Depression - although not necessarily what to do about it.

Posner brings simplicity to his interpretation. He chronologically outlines the major and significant issues that challenge the historical framework and understanding within capitalism. He posits that self interest lead to misallocation of resources; thus various incentive systems were miscast. He downplays the role of Congress and regulatory failures (which is the books greatest weakness of analysis). In total he gives an insightful review of the crisis that currently confronts America, and the enormous challenges the country will continue to face.

Larry

In A Failure of Capitalism, Judge Richard Posner has written an accessible, clear-headed exploration of the current economic depression, including its causes and potential remedies. The book would be an excellent supplement to an undergraduate course on macroeconomics or money and banking. It is also an equally excellent introduction to these issues for non-economists.

Judge Posner points to several causes of the depression. First and foremost was the collapse of the housing bubble. The bubble was inflated by low interest rates and excessively risky lending and borrowing. The crisis was also abetted by an improvident lack of regulation that allowed financial institutions to become over-leveraged and subject to runs. Another contributing factor was the high level of private debt. When housing and later financial markets began to fall and when banks pulled back their lending, households were vulnerable because they could not draw on savings to smooth consumption. Yet another factor was a sharp energy price spike that led to a collapse in demand for large SUVs and trucks that had been the profit base for the American automotive industry.

Posner is at his best as an economic instructor when he describes how individually rational decisions by financial firms and households contributed to the inflation of the bubble and to its aftermath. These individual actions were the failure of capitalism.

Posner also makes an especially valuable contribution by making the case that the country has experienced a full-blown depression, which Posner defines as a sharp reduction in economic output that is severe enough to risk a deflation. In a deflation, the economic downturn becomes self-sustaining over a long period. Posner, a well-known conservative, could have tried to minimize the crisis; however, he addresses it head on.

Posner goes on to discuss the immediate policy tools that are available to fight the depression. These include bailing out financial institutions, flooding the markets with liquidity, using federal deficits to stimulate output, and regulating the financial industry. Each of these tools has drawbacks. For example, the precarious condition of financial institutions has put us in a "liquidity trap" that severely limits the standard monetarist tools of increasing the money supply and increasing liquidity. Massive deficit spending (the Keynesian approach) may increase output now but at the risk of inflation and lower growth later. Posner explains how each of these tools can help but also how they can hurt. There are no magic bullets, but given the depth of the crisis, Posner argues that none of them should be taken off the table.

The strengths of Posner's book are its "above the clouds" and even-handed treatment of the crisis. Posner seldom gets lost in the weeds, and he keeps blame-giving to a minimum. Readers will gain a greater understanding of how the country fell off an economic cliff and of the controversial options for clawing our way back up. The principal weaknesses are the exploratory and tentative nature of the analysis. In the end, Judge Posner's conservatism leads him to hedge by offering modest policy considerations instead of firm policy advocacy.

THIS IS AN IMPARTIAL, NON-PARTISAN ANALYSIS OF THE CURRENT RECESSION (DEPRESSION) THAT IS UNDERSTANDABLE BY THE NON-ECONOMIST IN ALL OF US. POSNER WARNS THAT WE NEED TO RESTORE BALANCE IN THE ECONOMY BEFORE WE TRY TO RE-ORGANIZE OR RE-REGULATE IT. IF THERE IS ONE BOOK THAT EXPLAINS IT ALL COGENTLY AND UNDERSTANDABLY, THIS IS IT.