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

• Author: Green, Craig
• Position: Book review

A FAILURE OF CAPITALISM: THE CRISIS OF '08 AND THE DESCENT INTO DEPRESSION. By Richard A. Posner. Cambridge, Massachusetts, and London: Harvard University Press. 2009. Pp. xix, 346. $23.95.

"The world's banking system collapsed last fall, was placed on life support at the cost of some trillions of dollars, and remains comatose. We may be too close to the event to grasp its enormity." (p. vii).

"The production of books on financial crises is counter-cyclical." (1)

INTRODUCTION

A Failure of Capitalism by Richard Posner (2) is not a great book, and it does not pretend to be one. (3) Posner summarizes the economic crisis of 2008-09 and considers proposals to reduce current suffering and avoid future recurrence (p. xvi). But when the book's final edits were made in February 2009, it was still too soon for authoritative solutions or full accounts of what had happened. (4) Instead, Posner wrote a conspicuously contemporary--and thus incomplete--description of the crisis as it looked to him at the time (p. xvii).

Now one year later, readers may need a reminder about the value of Posner's quick-baked efforts. His book was one of the first to describe the crisis, and it is a work of fluid prose and potent intellect, written by a scholar with immense personal knowledge and easy access to nationally prominent macroeconomists. (5) In the first wave of academic writing about the crisis, Posner's book is by far the most accessible, and it is also one of the best. (6)

But such works have short shelf lives. For example, some of Posner's arguments are already superseded, having been either accepted or debunked by macroeconomic experts and unforeseen events. (7) A review of Posner's book might perhaps be written to catalog which of his claims remain valid and which fell flat, thereby describing the crisis more fully and measuring the accuracy of Posner's hurried sketch.

This Review takes a different path and addresses two longer-term questions near the core of modern government. (8) First, does the recent economic crisis prove that market actors act irrationally? Second, does it show that small-government, "Chicago-School" deregulation should be abandoned? The answers to those questions will chart the future of economic governance and will frame many decades of debate over what the present crisis means.

Such issues are also vital to Posner's book. Posner is probably the most famous leader of America's law-and-economics movement, and he has raised a longstanding voice against broad governmental regulation. (9) His title "A Failure of Capitalism" thus leads readers to ponder whether we should have less capitalism, whether such failures occur rarely or often, and whether they can be avoided or must be grimly endured.

From the perspective of conventional politics, Posner's book is unorthodox and even surprising. For example, he does not follow conservative monetarists in blaming the crisis solely on errors of the Federal Reserve, nor does he think that unaided markets will set our economic ship aright (pp. xii, 2). Yet we shall see that Posner also has not abandoned his famous enthusiasm for unrestrained supply and demand; far from it. As with other "Free Marketeers," a persistent issue that looms over Posner's analysis is how much market ideology may be salvaged after the world's highly developed markets have collapsed.

This Review proceeds in four steps. Part I summarizes Posner's account of how the economic crisis happened. Although such content will be familiar to some readers, Posner's descriptions fill the largest part of his book, and they form an obvious predicate for his distinctive conclusions.

Part II considers market rationality and avoiding economic crises in the future. Before reading Posner's book, one might have assumed that "housing bubbles" and "financial crashes" necessarily implied some level of irrational optimism or panic. (10) Indeed, scholars in behavioral finance and behavioral law and economics view the 2008 crisis as conclusive evidence that markets can be warped and buckled by human emotions and cognitive failures. (11) Posner rejects this view out of hand. Instead, he claims that private actors behaved rationally throughout the current crisis, and that they cannot be blamed for systemic consequences of their actions. By contrast, I suspect that Posner's claims of market rationality are premature and incomplete. Because I cannot myself specify exactly which market participants were rational in 2008, however, I will examine how Posner's assumptions about market rationality might affect policies to avert future crises.

Part III concerns governmental intervention to remedy our current crisis. Posner divides economic downturns into two categories and says that we are in a "depression," not merely a "recession" (pp. ix-x, 9-11). Based on the strength of those labels, Posner recommends massive government spending, permissive monetary policy, and assorted regulatory interventions. Such conclusions may seem congenial to liberal economists and politicians at present, but uncertainty in identifying depressions may erode common ground all too quickly. Regardless of its politics, I suggest that Posner's approach to depressions and recessions is unworkable. Even for a general readership, more realism about antidepression politics is needed to analyze governmental decisions before, during, and after an economic crisis.

By way of conclusion, Part IV maps the limits of inexpert macroeconomic analysis like Posner's and--even more--this Review itself. (12) Macroeconomic theories that describe how billions of individuals, millions of entities, and hundreds of governments buy, sell, hire, work, and circulate money are almost absurd in the breadth of their ambition. Yet Posner is right that macroeconomics is as vital to global productivity as weather predictions are to agricultural societies. (13) He is also fight to stress the need for "concise, constructive, jargon- and acronym-free, non-technical, unsensational, light-on-anecdote" analysis (p. xiv). A deeper question, however, is why Posner should be the one writing such work, instead of professional economists and financial journalists. Aside from Posner's evident speed and skill, his own reply is that most experts' writings "are by authors with an axe to grind" (p. xiii). This uncharitable characterization will prompt readers to ask whether Posner himself has left all his axes at home. As it happens, he has not, but neither have I.

1. POSNER'S DEPRESSION

   Let us start by reviewing some basic elements of the economic crisis, which are now well known. (14) Housing prices rose, and then they fell. Banks and other financial institutions overinvested in mortgages, and were then crippled when borrowers defaulted and real estate collateral dropped in value. Financial institutions' losses raised credit costs for numerous businesses and individuals, which reduced consumption, production, and employment across the country. The mix of these real and expected consequences reinforced each other and caused massive declines throughout the economy. (15)

   This simple account raises harder questions. Why did housing prices rise and fall? Why did financial institutions overinvest in mortgages? And why were defaults and lower property values such a surprise? Posner offers a multipart explanation, which generally tracks that of most analysts. (16) The Federal Reserve and foreign investors increased the availability of cash, which let financial institutions lend money cheaply. Commercial banks had become decreasingly regulated for several decades, and their competition with unregulated financial institutions increased appetites for high-risk, leveraged investments. Advanced and highly complex securitization techniques raised demand for subprime mortgages because they let lenders create relatively safe investment instruments from a pool of risky assets. (17)

   When these factors combined with our national confidence in real estate investments, and with the biases of realtors, mortgage agents, and security-rating agencies, it is easy to see how the "housing bubble" emerged. (18) An unprecedented number of borrowers sought land with fervor that was matched by ever-increasing property prices. And lenders gave loans even to people who might default because (a) high-risk loans could be securitized to serve broader investment goals and (b) so long as the underlying property increased in value, distressed borrowers could always sell their land in order to retire unsustainable loans. These dynamics further amplified demand for real estate, raised property prices, and fed a continuing upward cycle that made many people, on every side of these transactions, very wealthy indeed.

   Despite this seemingly happy story of profitable homeowners, lenders, agents, and investors, mistakes were made. Lenders lacked reliable models to predict how many subprime borrowers would default, and many of these new borrowers were unpredictably more risky than prior mortgagors (pp. 23, 58-59). Securitized mortgages made things worse. Securitization meant that dispersed security holders could not renegotiate loans to avoid foreclosure if property prices dropped and borrowers could not resell land to cover their mortgage; such foreclosures could consume 20 to 60 percent of a property's value, making lenders' losses that much higher (pp. 59-60). More importantly, risk-segregated securities obscured exactly which investors would bear the uncertain risks of debtor default. Many security holders responded by purchasing investment insurance from American International Group ("AIG"), but this created even more complexity in assessing whose money was at stake if land prices dropped. (19)

   Posner offers a distinctive explanation for why sophisticated investors placed so much money on risky bets. Posner notes that investors must try to make money while the sun shines, even when they know that darkness is coming. (20) He also...