April 29, 2009


How to Understand the Disaster: A Failure of Capitalism: The Crisis of '08 and the Descent into Depression
by Richard A. Posner (Robert M. Solow, NY Review of Books)

There is no doubt that Posner has been an independent thinker, never a passive follower of a party line. Neither is there any doubt that his independent thoughts have usually led him to a position well to the right of the political economy spectrum. The Seventh Circuit is based in Chicago, and Posner has taught at the University of Chicago. Much of his thought exhibits an affinity to Chicago school economics: libertarian, monetarist, sensitive to even small matters of economic efficiency, dismissive of large matters of equity, and therefore protective of property rights even at the expense of larger and softer "human" rights.

But not this time, at least not at one central point, the main point of this book. Here is one of several statements he makes:

Some conservatives believe that the depression is the result of unwise government policies. I believe it is a market failure. The government's myopia, passivity, and blunders played a critical role in allowing the recession to balloon into a depression, and so have several fortuitous factors. But without any government regulation of the financial industry, the economy would still, in all likelihood, be in a depression; what we have learned from the 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. The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.

If I had written that, it would not be news. From Richard Posner, it is. The underlying argument—it is not novel but it is sound—goes something like this. A modern capitalist economy with a modern financial system can probably adapt to minor shocks—positive or negative—with just a little help from monetary policy and mostly automatic fiscal stabilizers: for example, the lower tax revenues and higher spending on unemployment insurance and social assistance that occur in a weakening economy without any need for deliberate action. It is easy to be lulled into the comfortable belief that the system can take care of itself if only do-gooders will leave it alone. But that same financial system has intrinsic characteristics that can make it self-destructively unstable when it meets a large shock. One such characteristic is asymmetric information: some market participants know things that others don't, and can turn that knowledge into profit. Another is the capacity of financial engineering to produce securities so complicated and opaque—for example, collateralized debt obligations and other exotic derivatives—that almost no one in the market can understand their implications. (Insiders still have an exploitable advantage.)

Yet another characteristic is the inevitability of market imperfections, so that what is essentially the same object can sell for two or more different prices; or so that some market prices can be manipulated by large, informed operators; or so that some markets take a long time to match supply and demand. And yet another is the possibility that large financial institutions can raise large sums of credit, in amounts and ways that can affect the whole system, without anyone taking account of, or feeling responsible for, the systemwide effects.

Posted by Orrin Judd at April 29, 2009 6:35 AM
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