[OPE] Solow, "How to Understand the Disaster" (review of Posner's book on failure of capitalism)

How to Understand the Disaster
By Robert M. Solow
A Failure of Capitalism: The Crisis of '08 and the Descent into Depression
by Richard A. Posner
Harvard University Press, 346 pp., $23.95

No one can possibly know how long the current recession will last or how
deep it will go. That is because the dangerous combination of the "real"
recession-the unemployment and idle productive capacity that come from lack
of demand-and the financial breakdown, each being both cause and effect of
the other, makes the situation more complex, more unstable, more vulnerable
to psychological imponderables, and more distant from previous experience.
Whenever the US economy returns to some sort of normality, or preferably
before then, it will be necessary to improve and extend the oversight and
regulation of the financial system. The main goal should be to make another
such episode much less likely, and to limit the damage if one occurs.

To make progress in that direction requires some understanding of the
origins of the current mess. I once saw a hospital discharge diagnosis that
read "sepsis of unknown etiology"; that sort of thing will not help in this
case. The need is not only for a clear picture of what happened but for an
assessment of the motives and actions of the main players, the causes and
consequences of what they did, and the ideas and institutions that
encouraged, inhibited, and shaped the outcomes. Richard Posner's book is
intended to fill that need, in clear and understandable language. I think it
is at best a partial success; it gets some things right and some things
wrong, and the items on both sides of the ledger are important.

More striking than what the book says is who says it. Posner is a judge of
the US Court of Appeals for the Seventh Circuit, and so preeminently a
lawyer. In addition, he is an apparently inexhaustible writer on...nearly
everything. To call him a polymath would be a gross understatement. A
partial list of his publications in the past ten years alone includes How
Judges Think; Law, Pragmatism and Democracy; Frontiers of Legal Theory; the
seventh edition of his Economic Analysis of Law (first published in 1973);
the third edition of Law and Literature; three volumes of essays on The
Economic Structure of Law; and books on plagiarism, constitutional aspects
of national emergencies, the election of 2000, the US domestic intelligence
system, countering terrorism, public responses to the risk of catastrophe,
the Clinton impeachment, dealing with the AIDS epidemic, and, significantly,
Public Intellectuals: A Study of Decline. There is a prehistory of still
more books, and many articles in legal and other periodicals.

Judge Posner evidently writes the way other men breathe. I have to say that
the prose in this book often reads as if it were written, or maybe dictated,
in a great hurry. There is some unnecessary repetition, and many paragraphs
spend more time than they should on digressions that seem to have occurred
to the author in mid-thought. If not exactly chiseled, the prose is
nevertheless lively, readable, and plainspoken. The haste may have been
justified by the pace of the events he aims to describe and explain. Posner
has an extraordinarily sharp mind, and what I take to be a lawyerly skill in
argument. But I also have to say that, in some respects, his grasp of
economic ideas is precarious. In his book on public intellectuals, Posner
blames the decline of the species on the universities and their
encouragement of specialization. I may be acting out that conflict. Remember
that even hairsplitting is not so bad if what is inside the hair turns out
to be important.

The plainspokenness I mentioned is what makes this book an event. 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.

In that kind of world, imagine a period of low interest rates. Once a set of
profit opportunities is found, big operators will be tempted to borrow so
that they can play with much more than their own capital, and thus make very
large profits. This has come to be called "leverage." Suppose I have
$100,000 of my own, and I see an opportunity to earn a 10 percent return. If
it pans out, I make $10,000; if it earns nothing, I have my original stake.
If it loses money, that comes out of my initial capital. But I have a shot
at something bigger. I can borrow $900,000 at, say, 5 percent interest, and
invest the whole million. If it earns the expected 10 percent, I have
$1,100,000; I can pay off my debt, plus interest of $45,000, and have
$155,000 left. I have earned 55 percent on my money. Only in America! Of
course, if the investment earns zero, I must still pay back my borrowing,
with interest, which leaves me with $55,000. I have lost almost half of my
capital; and it could be worse. Risk cuts both ways. What I have just
described is 10-to-1 leverage; the size of the total bet is ten times my
equity.

In the past, 10-to-1 leverage would have been about par for a bank. More
recently, during the housing bubble that preceded the current crisis, many
large financial institutions, including now-defunct investment banks such as
Bear Stearns and Lehman Brothers, reached for 30-to-1 leverage, sometimes
even more. So suppose I borrow $2.9 million to go with my very own
$100,000-leverage of 29 to 1. I can buy $3 million of whatever asset I
fancy. If it earns 10 percent, I repay the $2.9 million plus $145,000 in
interest and go home with $255,000, having earned a mere 155 percent on my
own capital. But now, if the investment earns zero, I have an asset worth $3
million and liabilities of $3.045 million. I am, to coin a phrase, bankrupt.
And this is when I have invested in an asset that is worth, at the end of
the year, exactly what I paid for it at the beginning. If I had bought a
piece of a complicated package of subprime mortgages, as many investors did,
it might be worth less than I paid for it a year ago. In fact, there might
be no takers at all. There is no way of knowing what the package of
mortgages might be worth in a couple of years; when it comes to raising more
cash to cover my debt, it is worth essentially nothing, i.e., it can neither
be sold nor used as collateral. Whoever lent me the $3.045 million,
including interest, has lost the whole thing.

Why did I do such a risky and, as it turned out, stupid thing? Well, it had
worked in the past, and made a lot of money for many people. If I had backed
off, others would probably have continued to make money for a while. I would
have looked like a fool, and very likely an unemployed fool.

This sob story is just the beginning. Many highly leveraged financial
institutions-banks, hedge funds, and insurance companies among them-have dug
themselves into similar, interconnected holes. They have borrowed from other
financial institutions to make complicated bets on risky assets, and they
have lent to other leveraged financial institutions so that those
institutions could make complicated, risky asset bets. These are the "toxic
assets" that weigh down the balance sheets of banks. No one knows for sure
what anyone else is worth: they own assets of uncertain value, including the
debts of other institutions that own assets of uncertain value.

All those banks and others are now unwilling to lend to one another because
they fear that the potential borrower is already broke and will be unable to
repay. And so the credit markets freeze up and ordinary businesses that need
credit for ordinary business purposes find that they cannot get it on any
reasonable terms. This is what happened in September 2008 when the
commercial paper market-the market for daily business borrowing-ceased to
work. The breakdown of the financial system exacerbates the recession; many
who want to buy or build cannot get credit with which to do so. The
recession then endangers the solvency of more financial and nonfinancial
borrowers and worsens the state of the financial system.

I have deliberately kept this story stylized, omitting the juicy details
about complicated derivative securities that seem to bear only the most
tenuous connection to the everyday economic realities of production,
employment, consumption, and so on. I have also ignored the even juicier
details of greed, stupidity, and corruption. Posner does not ignore those
things. They provide an irresistible target for amusement and contempt. I
wanted instead to focus on the central role of leverage, because it is
leverage that turns large banks and financial institutions into ninepins
that cannot fall without knocking down others that cannot fall without
knocking down still others. That seems to be the key to the potential
instability of an unregulated financial system. It happens without any of
the private actors violating the canons of self-interested rationality.
Those canons would have been different if the SEC, the Fed, and other
institutions charged with regulation had insisted both that all transactions
be made public and that there be some limits on leverage.

It is a noteworthy intellectual event that Posner has come to this
understanding and expressed it forcefully and fearlessly. This same
understanding must then also be the key to designing regulations that can
reduce the frequency of financial crises like the current one, and limit the
collateral damage to the real economy that they entail. Regulation should
require that the uses and amounts of leverage, still largely hidden, be made
public and that limits be set on the amounts of leverage that financial
institutions can bring into play.

Now let me turn to the recession itself. Posner prefers to label it a
"depression"-see his subtitle-as if there is some unambiguous dividing line
that has been crossed. He defines a depression as a "steep reduction in
output that causes or threatens to cause deflation and creates widespread
public anxiety and, among the political and economic elites, a sense of
crisis that evokes extremely costly efforts at remediation." All sorts of
obvious questions arise. How steep? How many prices must fall for how long
to qualify as deflation? "Core" consumer prices-meaning prices for all
consumer goods and services exclusive of energy and food-had not fallen at
all at the end of 2008. Even more recently, decreases in the price indexes
have been few and sporadic. Wage rates have not fallen either, still less so
when benefits are added in. Anyhow, one should mean by "deflation" a
cumulative, sustained fall in prices, not a scattered episode. Deflation is
certainly a "threat." In a time of roughly stable price level, any recession
entails a threat. My guess is that Posner overstates it. Finally, a "sense
of crisis" seems merely to replace one vague word by another.

I am going to stick with "recession." Posner thinks this is a euphemism in
aid of denial. No: we are in a long and serious recession. When it is over
we will be able to estimate roughly how much production was lost in the
course of it. But I want to avoid the suggestion that something qualitative
happened at the end of 2007 or sometime in 2008, over and above the
combination of recession and the financial breakdown, or that we are on our
way to the 1930s, which is grossly unlikely. What is important is the
interaction of the "real" recession and the financial crisis. I mentioned at
the beginning that they are reciprocally cause and effect, and that is what
I want to clarify, at least broadly.

Posner starts the story, reasonably enough, with the period of easy money
and low interest rates that began in 2001 as the Fed's normal response to
the recession of that year, and lasted until the middle of 2004. There was
plenty of liquidity-money, or assets that can be readily turned into
money-and one result was a housing boom. In fact, construction had already
increased pretty sharply during the prosperous 1990s, in spite of generally
unfavorable demographics, such as the aging of the population and the
corresponding slowdown in family formation, both of which diminish the need
for living space.

But there was certainly a further spurt. About 1.2 million private housing
units were started in 1990, 1.6 million in 2000, and 2.1 million in 2005.
Posner emphasizes the corresponding run-up in house prices, and he is right
to do so. But the housing boom was not just a financial fact. By 2005 the
country had clearly built many more houses, maybe two or three million more,
than it could afford to occupy and finance. There would have been a housing
slump in any case. We have had housing booms and slumps before, with
consequences no worse than an interval of slow growth or a brief downturn,
met with normal monetary policy and automatic fiscal stabilizers such as
changes in tax rates or in public spending.

What made this housing boom different, of course, was the mix of low
interest rates and the ability of the original lenders to package many
thousands of mortgages into mortgage-backed securities that could be sold
off to the broad capital markets, where the buyers could have no real grasp
of how risky the underlying mortgages were. (The rating agencies that were
supposed to figure it out for them were waist-deep in conflicts of interest.
Moody's and Standard and Poor's were paid by the same institutions whose
securities they were supposed to be judging.) As a result, trillions of
dollars of mortgages were sold, unscrupulously and deceptively, to buyers
whose only chance of meeting their obligations was a continued rise in
prices. (I remember a ubiquitous TV commercial for a mortgage finance
company whose punch line was: "When others say No, Champion says Yes." I
haven't seen it lately.)

So this housing boom was enhanced by riskier and more opaque financial
products that entangled a wider variety of highly leveraged financial
institutions. The word "bubble" is often misused; but there was a housing
bubble. Rising house prices induced many people to buy houses simply because
they expected prices to rise; those purchases drove prices still higher, and
confirmed the expectation. Prices rose because they had been rising.

To make matters worse, the fever spread to other assets: stock prices
doubled in the five years 2003-2007. When the implosion came in 2007,
enormous amounts of what had been perceived as wealth-true, eventually
spendable wealth-simply disappeared. According to data compiled by the
Federal Reserve, household wealth in the US peaked at $64.4 trillion in
mid-2007, and had plummeted to $51.5 trillion at the end of 2008. Something
like $13 trillion of perceived wealth vanished in not much more than a year.

Nothing concrete had changed. Buildings still stood; factories were still
just as capable of functioning; people had not lost their ability to work or
their skills or their knowledge of technology. But a population that thought
in 2007 that they had $64.4 trillion with which to plan their lives
discovered in 2008 that they had lost 20 percent of that. A standard,
empirically tested rule of thumb is that an additional dollar of wealth
induces the average consumer to increase annual spending by an amount
between four and six cents. So we are looking at a potential drop in
consumer spending of something like $650 billion a year (5 percent of $13
trillion).

To see how big this is, remember that President Obama's stimulus package
amounted to less than $800 billion, spread over two or more years. If every
dollar of stimulus were translated into a dollar of spending, this
particular consumer-spending gap would still not be filled. And not every
dollar of stimulus will be spent; nor is the consumer-spending gap the only
demand failure we have to worry about. But this is one very important route
by which the financial collapse damages the real economy. Another, of
course, is the paralysis of credit markets, limiting the ability of
legitimate businesses and families to borrow and spend. Much the same thing
seems to be happening in Europe and in Asia, with national differences in
detail.

Judge Posner does not quite get the role of the consumer right. He says that
among the "immediate causes of the depression were the confluence of risky
lending with inadequate personal savings...so that people couldn't
reallocate savings to consumption." He is referring to the fact that
American families, who were saving 7 or 8 percent of their after-tax income
not so long ago, had brought their saving rate down to less than 2 percent
on average in the years between 2001 and 2008. If they had saved more they
would find it easier to maintain their consumption spending in hard times.

But from the rational individual's point of view, the goal of saving is to
add to one's wealth, to be used eventually in whatever way seems best. If
your wealth is increasing anyway-as it was-there is less need to save from
current income. The problem was that bubble-generated wealth is very
unreliable, to put it mildly. Judge Posner is much too smart to expect the
average household to see exactly how much of its apparent wealth was at risk
in an unregulated, highly leveraged, deeply opaque, generally shortsighted
financial system. Besides, there is plenty of evidence that many people
rarely, if ever, alter their 401(k) allocations and, when they do, are very
likely to alter them unwisely.

Most commentary, at large, in Posner's book, and in this review, has been
about how the financial collapse damages the real economy. It might be
thought that somehow fixing the financial mess would automatically fix the
real economy. That is not so, for at least two reasons worth mentioning. In
the first place, all that vanished wealth cannot be restored; much of it was
fluff, as we now know. American families are not worth $64.4 trillion. There
is no way to know now whether they are worth more than $51.5 trillion or
less. When all that shakes itself out, both the real economy and the
financial system will be different.

Secondly, the restoration of credit flows is not just a matter of clarifying
and strengthening the balance sheets of banks and other lenders. It takes
two to make a loan: a solvent and willing lender and a credible borrower. In
a deep recession, there are not enough credible borrowers, meaning
businesses and individuals with excellent prospects of being able to repay a
loan on time, with interest. That is why direct stimulus has to accompany
the necessary work of cleaning up the debris cluttering the financial
system, by removing those toxic assets from the balance sheets of banks and
replacing them with clean capital.

There are other weaknesses in Posner's remarks on the real economy. For
example, more than once he says that the various antirecessionary
measures-like fiscal stimulus, bailouts-are very "costly" and "may do
long-term damage to the economy." He does not explain what these costs and
damages are. Sometimes he seems to have budgetary costs in mind. But
bailouts are mostly transfers from one group in society to another, for
example from taxpayers to financial institutions and their owners. They are
certainly not ethically satisfying transfers, but it is not clear how they
do long-term damage to the economy. The components of a fiscal stimulus
package are costs to the federal budget; but to the extent that they put
otherwise unemployed labor and idle industrial capacity to work, they do not
impoverish the economy; in fact, they enrich it. (Of course, one would
prefer useful projects to wasteful ones.) If fiscal stimulus works, even
imperfectly, there is no doubt which way the benefit-cost ratio goes.

Posner is on much firmer ground in worrying about the very large increases
in the money supply and in the interest-bearing public debt that are left
behind by antirecessionary policy. Even there, we do not know how skillful
and lucky the Federal Reserve will be at mopping up excess liquidity when
the economy recovers, whether by arranging repayment of loans it has made to
the private sector, or by selling off the assets it has acquired along with
Treasury debt. And if the economy can be restored to normal growth and
sensible fiscal policy, the ratio of debt to GDP, which is what matters, can
eventually be brought down. Without some analysis, this sort of talk does
not spread light.

There is an even odder chapter called "A Silver Lining?" In it Posner flirts
with the idea that a recession, even a depression, has a good side. It weeds
out inefficient firms and practices. This is a little like saying that a
plague is not all bad: it cleans up the gene pool. No doubt there is some
truth to this idea of a purifying effect. But the notion that it could
possibly compensate for years of lost output and lost jobs seems wholly
implausible. There is certainly no calculation of economic costs and
benefits behind the thought of a "silver lining." I think it is another
example of overemphasis on minor gains in efficiency and neglect of
first-order facts.

Posner's chapter on "The Way Forward" is all of sixteen pages long, and
fairly disorganized pages at that. This means he does not seriously try to
imagine what an effective regulatory regime for financial markets would look
like or, above all, how it could be designed to protect the real economy as
much as possible from damage inflicted by financial breakdown. Nevertheless
he says some useful things; and it is especially significant that they come
from a leading conservative (even if never a tamely doctrinaire one). Here
is a representative statement:

  Other regulatory changes might be desirable, such as limiting leverage;
raising credit-rating standards and changing how credit-rating agencies are
compensated; forbidding proprietary trading by banks (that is, trading of
their equity capital, which puts that capital at risk); adjusting reserve
requirements to take more realistic account of the riskiness of bank's
capital structures; requiring greater disclosure by hedge funds and private
equity funds; requiring that credit-default swaps be traded on exchanges and
fully collateralized; and even resurrecting usury laws.
In addition, he is clear that the enormous collection of federal and state
agencies with various regulatory responsibilities over financial
institutions has to be somehow consolidated and unified. Also, though he is
unnecessarily ambiguous, a new streamlined regulatory apparatus has to apply
to most of the financial sector, including hedge funds, not just the proper
banks. If this is not done, new but just as dangerously risky and opaque
practices will find their way between the cracks; and no agency will have
the capacity or the responsibility to detect oncoming trouble.

Obviously that laundry list is not a blueprint for reform. It seems to me
that effective limits on leverage, even if they have to be different for
different classes of institutions, are basic to controlling the potential
instability of the financial system. Even with more transparency, extreme
leverage is what generates extreme uncertainty and systemic risk. And it
also encourages the dangerous compensation practices that Posner pillories.
Leverage allows a clever player to manage enormous sums; it is then
irresistible to focus on the short run and skim off mind-boggling paychecks
and bonuses before the opportunity goes away.

The Obama administration has been trying to inject enough clarity and
capital into the balance sheets of banks so that they can resume providing
credit for businesses and consumers. The job of regulatory reform has had to
wait. The hints we have had suggest that the administration understands the
need to include the unregulated institutions, and to set up at least an
early warning system to detect major risks before they arrive. But there is
no way yet to know what form the new system will take. One would like to
establish some principles before we forget how bad it can get.

The financial system does have a useful social function to perform, and that
is to make the real economy operate more efficiently. Some human institution
has to collect a nation's savings and put them at the disposal of those who
have productive ways to use them. Risks arise in the everyday business of
economic life, and some human institution has to transfer them to those who
are most willing to bear them. When it goes much beyond that, the financial
system is likely to cause more trouble than it averts. I find it hard to
believe, and I suspect that Judge Posner shares my disbelief, that our
overgrown, largely unregulated financial sector was actually fully engaged
in improving the allocation of real economic resources. It was using modern
financial technology to create fresh risks, to borrow more money, and to
gamble it away.

Posner writes:

  As far as I know, no one has a clear sense of the social value of our
deregulated financial industry, with its free-wheeling banks and hedge funds
and private equity funds and all the rest.
That is already a hint that he thinks its social value is limited. As Posner
sees it, talk about greed and foolhardiness is comforting but not useful.
Greed and foolhardiness were not invented just recently. The problem is
rather that Panglossian ideas about "free markets" encouraged, on one hand,
lax regulation, or no regulation, of a potentially unstable financial
apparatus and, on the other, the elaboration of compensation mechanisms that
positively encouraged risk-taking and short-term opportunism. When the
environment was right, as it eventually would be, the disaster hit.

- April 16, 2009

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Received on Thu Apr 30 08:54:06 2009