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04/09/2010

Book Review: A Failure of Capitalism


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A Failure of Capitalism Most call it simply “the crisis.” Richard Posner calls it a depression. When it comes to analyzing the factors behind it, he objects strongly to the addiction—common among journalists, politicians, economists, and ideologues and populists of every stripe—to finger-pointing, name-calling, and partisan sniping. At the same time, he rejects Wall Street’s claims of helpless innocence, its contention that no one could possibly have known what was coming, its grumblings of hindsight being 20–20. Posner cites economists and journalists whose foresight needed no spectacles, whose warnings covered everything from the housing bubble, to low savings rates, to deregulation, to risky new instruments. Despite some major shortcomings, A Failure of Capitalism (Harvard University Press, 2009) will be of use to anyone who’s still looking for an overview of the meltdown. And those weary of populist, partisan accounts will find Posner’s no-nonsense, jargon-free engagement with tangible issues refreshing.

Posner argues that the economic collapse was not caused by greedy or incompetent financiers, by irresponsible homebuyers, or by government interference in the free market. The real villains? Financial deregulation, dating from the 1970s and consolidated during the Clinton administration; and interest rates kept too low for too long by the Greenspan and Bernanke Feds. Those two policy decisions encouraged increased leverage in financial institutions and lower personal savings rates, weakening the economy’s resilience to shock. Overleverage in the financial system allowed small losses to threaten the solvency of major institutions. Consumers’ lack of savings left them without recourse when faced with job losses or other hardships. Systemic weakness followed these developments as night follows day. The main culprit, according to Posner, was the system’s vulnerability to the bursting of the housing bubble.

But why would managers risk bankrupting their companies by taking on too much debt? Why would consumers take out unaffordable mortgages? For Posner, these aren’t the right questions. Economic decisions are always made in an environment of risk and uncertainty, he points out, and financiers and consumers have little incentive to worry about small probability events.

In economics, the best guide to the future is usually the present. If housing prices go up today it is, as a matter of fact, reasonable to expect that they will continue to rise. There’s no judging whether the price increase represents fundamentals or is the result of a bubble until the moment when the bubble, if it exists, actually bursts. Even if the increases are unsustainable, living in the bubble is the rational response, says Posner. He argues that “bankers and consumers alike seem on the whole to have been acting in conformity with their rational self-interest.” The depression is simply the result “of normal business activity in a laissez-faire economic regime.” The market economy failed us.

Coming from Posner, a Reagan judicial appointee and a leading conservative intellectual, these are startling words. No less startling is his conclusion that “we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.” Posner has determined that it falls to the government to remember that individual investors’ rational indifference to improbable events carries with it the risk of catastrophe.

So far, his approach is surprising and interesting, though many readers will prove resistant to Posner’s reasoning, particularly his definition of rational behavior and his assertion that blame should be assigned only to such market failures as incomplete incentives, conflicts of interest, moral hazard, and search costs. And when it comes to planning the future, rather than raking over the past, the author stumbles. His chapter “The Way Forward” is among the shortest in the book—only the chapter on the future of conservatism is shorter, tellingly. To expect a comprehensive plan of regulatory reform may be asking too much, but Posner’s attempt at forward thinking is seriously disorganized.

To bolster his case, Posner quotes former Citigroup CEO Chuck Prince’s infamous statement that “when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Prince said this in July 2007, however—long after the housing bubble had already burst and the subprime mortgage market had collapsed. Perhaps, as Posner believes, it’s rational to keep dancing as long as the music is playing. But if you’re jitterbugging on once the band has left the stage, people may begin to ask how much you’ve had to drink.


–John Merante, CFA, is a banker and economist who has advised governments in Asia and Latin America on financial crises and debt restructuring.

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