Freeman

BOOK REVIEW

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

JANUARY 05, 2010 by CHIDEM KURDAS

Filed Under : Federal Reserve, Capitalism, Interventionism

Richard Posner’s latest book belongs to the fast-expanding cottage industry of financial crisis books. A federal judge with a grounding in economics, Posner would seem to be an ideal person to tackle this complicated subject. Alas, he provides neither fresh material nor an interesting perspective.

Posner describes well-known events—the failure of investment banks Bear Stearns and Lehman Brothers, the series of bailouts by the Treasury and the Federal Reserve, the stimulus package passed by Congress—then tries to explicate the causes of the crisis. His account, unfortunately, merely hews to current conventional wisdom.

Here’s a capsule version: Deregulation of banks combined with cheap and easy credit to cause interlinked debt and real estate bubbles. “Free market ideology” left banks and other financial firms free to take huge risky bets on mortgages, which they did. In 2007–08 the twin bubbles collapsed, resulting in a steep downturn in economic activity. The government had to shore up the system with extraordinary measures. The long-term solution is more government action to restrain and supervise financial institutions, although Posner would wait until the dust settles before reregulating.

It’s true that some household borrowing was channeled to risky instruments like adjustable-rate mortgages and much of the lending by banks was turned into complex securities backed by debt. When property prices declined and foreclosures spread, the values of these securities also declined, decimating bank balance sheets. But all that is a consequence not a cause of the trouble.

At the heart of the story is the ready availability of credit that fueled excessive borrowing and lending. Posner describes how the Fed flooded the economy with money in the early 2000s in response to the collapse of the previous bubble in stocks. However, he claims that even without the Fed’s loose monetary policy, an alleged global capital surplus brought in enough money from abroad to keep interest rates low.

That claim is dubious. Yes, Asians saved a lot, but other people, notably Americans, saved relatively little. In the world as a whole there was no surge in saving to drive down interest rates. It was the Fed’s easy money that pushed markets into a credit binge.

Posner’s line is that “Laissez-faire capitalism failed us, but government allowed the preconditions of depression to develop and wreak havoc with the economy.” He discusses the Federal Reserve’s culpability for the crisis, granting that it “would be a powerful argument against re-regulation,” but places more blame on that hobgoblin, “free market ideology.” The “free market” canard requires one to ignore that the United States hasn’t had anything close to a free financial market in a century.

Major mistakes by experts pose a challenge for Posner’s way of looking at behavior. For example, he describes Fed Chairman Ben Bernanke’s neglect of the warning signs of an impending crash as “extremely puzzling.” As a proponent of neoclassical economics, Posner assumes that people act rationally in the sense of making the best choices in view of all available information. And the Fed must be even more rational than the rest of us.

Another academic tribe, behavioral economists, attributes the crisis to human quirks like herding or imitation. Posner rejects those explanations on the ground that such behavior is not really irrational. On regulatory issues, however, he does not differ from behavioral economists who assume that government experts are trustworthy because they’re better informed than the general population.

Long before the currently fashionable behavioral school emerged, F. A. Hayek criticized the neoclassical rationality premise but came to a different conclusion from today’s proregulation behavioral economists. He found that government agents possess less wisdom than the market, which pools the knowledge of many individuals. The “fatal conceit” (as Hayek put it) that government knows better has resulted in economic disasters ranging from the Soviet Union to the Federal Reserve’s destabilizing policies.

Now the Fed is to become an even more powerful regulator of vaguely defined “systemic risk.” Posner grasps that “The successive Federal Reserve chairmanships of Greenspan and Bernanke must be reckoned prime causes of the financial crisis,” but even so agrees with President Obama that more government intervention is needed.

As a reform, Posner advocates the consolidation of agencies like the Securities and Exchange Commission into one top regulator along the lines of Britain’s Financial Services Authority. He appears oblivious to the fact that this authority with its overarching powers did not save Britain from financial crisis.

This highlights the book’s great flaw: Posner clings to the myth of benign government rationalism.

ASSOCIATED ISSUE

January/February 2010

comments powered by Disqus

EMAIL UPDATES

* indicates required

CURRENT ISSUE

December 2014

Unfortunately, educating people about phenomena that are counterintuitive, not-so-easy to remember, and suggest our individual lack of human control (for starters) can seem like an uphill battle in the war of ideas. So we sally forth into a kind of wilderness, an economic fairyland. We are myth busters in a world where people crave myths more than reality. Why do they so readily embrace untruth? Primarily because the immediate costs of doing so are so low and the psychic benefits are so high.
Download Free PDF

PAST ISSUES

SUBSCRIBE

RENEW YOUR SUBSCRIPTION

Essential Works from FEE

Economics in One Lesson (full text)

By HENRY HAZLITT

The full text of Hazlitt's famed primer on economic principles: read this first!


By FREDERIC BASTIAT

Frederic Bastiat's timeless defense of liberty for all. Once read and understood, nothing ever looks the same.


By F. A. HAYEK

There can be little doubt that man owes some of his greatest suc­cesses in the past to the fact that he has not been able to control so­cial life.


By JEFFREY A. TUCKER

Leonard Read took the lessons of entrepreneurship with him when he started his ideological venture.


By LEONARD E. READ

No one knows how to make a pencil: Leonard Read's classic (Audio, HTML, and PDF)