A "Spasmodic, Improvisational Response": Richard Posner Tackles the New Depression

Please welcome to our corps of in-house bloggers Dwyer Gunn, a young writer who has studied economics at Wellesley, worked in finance, and been a research assistant at the Becker Center on Chicago Price Theory.

“The biggest economic crisis since the Great Depression,” as described by Richard Posner, began in December of 2007 amidst plunging housing prices and reached its climax in September of 2008 as Lehman Brothers filed for bankruptcy, Fannie Mae and Freddie Mac were placed into conservatorship, and American International Group (A.I.G.) received a government bailout. Throughout the crisis, people all over the country have struggled to understand the causes of the meltdown and the complicated policies the government is pursuing to restore the economy to health.

In his new book A Failure of Capitalism: The Crisis of 2008 and the Descent into Depression, Richard Posner provides a definitive primer on the subject suitable for experts and amateurs alike. He analyzes the underlying causes of the crisis, the government’s policy responses so far, and offers some thoughts on the future of our financial system. Along the way, Posner also explains why he believes the crisis is indeed a depression, disputes the popular idea that investors and banks who bet on rising housing prices were behaving irrationally, and points out the (small) silver lining to the crisis.

Posner is a judge of the United States Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School. He has written a number of books, blogs regularly with Gary Becker, and will soon blog weekly on the financial crisis at a blog called A Failure of Capitalism at TheAtlantic.com.

We mentioned Posner’s new book earlier, and now he has agreed to answer some of our questions about it and the financial crisis.


What caused the financial crisis? Was it the government’s fault?


The government was the facilitator of the crisis, in the following sense. Banking (broadly defined to include all financial intermediation) is inherently risky because it involves borrowing most of one’s capital and then lending it, and the only way to create a spread that will pay the bank’s expenses and provide a return to its owners is to take more risk lending than borrowing — for example, borrowing short (short-term interest rates are low, because the lender has little risk and great liquidity) and lending long (so the lender has greater risk and less liquidity). The riskiness of banking can be reduced by regulation. But as a result of a deregulation movement that began in the 1970’s, the industry was largely deregulated by 2000. Then the Federal Reserve mistakenly pushed down and kept down interest rates, which led to a housing bubble (because houses are bought with debt) and in turn to risky mortgage lending (because mortgages are long term and there is a nontrivial risk of default); and when the bubble burst, it carried the banking industry down with it. The effect on the nonfinancial economy was magnified by the fact that Americans had little in the way of precautionary savings built up. Their savings were concentrated in risky assets like houses and common stock. When the value of those savings fell steeply, people’s savings were inadequate, so they curtailed their personal consumption expenditures, precipitating a fall in production and sales, a rise in unemployment (which made the still-employed want to save even more of their income, lest they lose their jobs too), and, in short, the downward spiral we’re still in.

The banking collapse occurred last September. The government’s unpreparedness (for which Greenspan and Bernanke, successive chairmen of the Federal Reserve, and academic economists bear a large part of the responsibility because of their failure to spot the housing and credit bubbles and their mistaken belief that a depression, as distinct from a mild recession, could never again happen in the United States) and its resulting spasmodic, improvisational responses allowed the crisis to deepen, precipitating the depression we’re now in. Contributing factors, besides the dearth of “safe” savings, were our huge budget deficits, which have greatly added to the costs and the inflation risk of the immense federal expenditures on recovery. Indeed, it is those costs and that risk that justify calling the present downturn a depression rather than just a recession; for the costs of a depression/recession include not only the loss in output and employment during the depression period, but also include the costs of recovery.


In your book, you dispute the notion that irrational behavior by market participants is to blame for this crisis. Can you explain how rational behavior could result in such a painful outcome?


Business firms attempt to maximize profits within the constraints set by regulation (including the Federal Reserve’s monetary policies, which strongly influence interest rates). We want them to do that, as it is the key to an efficient allocation of resources. Part of maximizing profits, however, is taking a certain risk of bankruptcy; it does not pay for a firm to reduce that cost to zero. Banking occupies a strategic role in the economy because of the importance of credit to economic activity; borrowing to spend increases consumption — it is how we shift consumption from future to present.

Moreover, banking is the main instrument by which the Federal Reserve creates money, and by doing so reduces interest rates (provided inflation is not anticipated; for if it is, long-term interest rates will rise), which in turn spurs economic activity. By buying government bonds, it pours cash into banks, both directly, when it buys the bonds from banks, and indirectly, when it buys the bonds from private owners but the owners deposit the cash they receive from the purchase into their bank accounts.

When banks start to hoard cash because their solvency is impaired, the money they receive from the Federal Reserve’s purchasing activity does not spread into the rest of the economy. That is why a cascade of bank bankruptcies is far more serious than a cascade of, say, airline bankruptcies. But a rational businessman does not, indeed cannot afford to, consider the cost of bankruptcy to the economy as a whole as distinct from the cost to his firm. So the rational banker will take more risk than is optimal from an economy-wide standpoint. That is the logic of profit maximization, as explained long ago by Adam Smith: the businessman cares about his costs and his revenues, but not about the costs and revenues incurred or received elsewhere in the economy. He is not an altruist. The responsibility for preventing the collapse of the banking system is the government’s, and it has been shirked, with extremely serious consequences.


There is some debate among economists about the role securitization played in the recession. Do you think securitization is to blame?


It was a factor, perhaps mainly because it brought a lot of foreign capital into the U.S. housing market. Foreign investors would not want to deal directly with American homebuyers, but they were happy to buy the triple-A-rated tranches (slices) of securitized debt, for that was the equivalent of buying bonds. The flood of foreign capital not only reinforced the Federal Reserve’s unsound policy of depressing interest rates, but also spread the housing bubble and the eventual consequences for bank solvency to the rest of the world. The result was to make the depression worldwide, which, incidentally, reduced American exports, which has contributed to the fall of U.S. output and the rise in unemployment.


What is the Federal Reserve trying to accomplish with its quantitative easing program?


The term refers to buying bonds and other debt instruments other than short-term Treasury bonds.

Generally the Fed influences interest rates by buying and selling short-term Treasury bonds; if it buys, it puts cash into the banks, as I explained earlier, and if it sells, it pulls cash out. In the first case, the supply of money expands, and in the second it contracts. Although the interest rates directly affected are short term, there is an indirect effect, in the same direction, on long-term rates. The reason is that the lower the interest rate at which banks can borrow money, the lower the competitive interest rate at which they lend the money; and this will stimulate borrowing and hence economic activity. But if banks don’t want to lend — because their solvency is impaired and because the risk of lending rises in a depression and the demand to borrow falls — they will sit on any new cash they receive rather than lend it. This is true even if the short-term interest rate falls to zero. The Fed’s hope is that by buying other forms of debt it will encourage lending, not only because it will be pumping more money into the economy, but also because, to the extent that its purchases are of debt that pays higher interest rates than short-term Treasury securities, their incentive to lend will increase because they will want to replace that interest. For example, if the Fed buys credit-card debt that pays 10 percent interest, the lender from whom it has bought that debt may decide to issue additional credit-card credit with the cash it receives in order to preserve its stream of income.


Do you believe the government’s new public-private partnership to purchase toxic assets will be successful in healing the major banks?


It is too early to tell. It depends on how much of that overvalued bank capital is bought, and at what prices. The program is very complex and many of its details have not been worked out. Some buyers will be deterred by fear that receiving federal subsidy (it is essentially a program of subsidizing, albeit indirectly, the purchase of these assets) invites intrusive regulation by the Treasury and denunciation by demagogic legislators. There is also some doubt as to how many banks will want to sell these assets at the prices offered, because the sales prices may reveal how little the assets are worth and therefore how undercapitalized the banks are, which would invite further regulation. Probably, the government can coerce the banks to play ball. But the effect on lending is indirect — having a healthier-looking balance sheet does not compel a bank to lend — and will be small if few private investors can be induced to buy, and the banks to sell, the overvalued bank assets.


Is there any “silver lining” to this crisis?


Yes, the silver lining is primarily the fact that the longer the housing and credit bubbles had been allowed to expand, the worse the consequences of the eventual crash would have been. Had the Federal Reserve raised interest rates sharply in 2004, the housing bubble would have burst before house prices had reached the heights they did — heights from which they fell such a long distance that they caused a catastrophic fall in the value of mortgages, which was the fall that precipitated the banking collapse. In addition, the personal savings rate, and the preference for safe savings over risky assets like stock and housing, will now rise; and while that will retard recovery from the depression, once we do recover, if the greater propensity for saving persists, it will make it easier for the nation to finance the support of the elderly out of private savings without need to keep increasing the amount of the national income that goes to public support of the elderly mainly through the Social Security and Medicare programs.


You’ve titled your book A Failure of Capitalism, and the U.S. and other governments are considering new regulations on banks, hedge funds, and certain financial instruments. What do you think the future looks like for our capitalist financial system?


There will be more regulation of financial institutions, and that is probably a good thing, though most of the goals of tighter regulation could probably be achieved just by more assiduous enforcement of existing regulations; regulatory laxity was a particularly marked characteristic of the Bush administration’s economic philosophy. The United States was capitalistic when banks were tightly regulated, and it will still be capitalistic if they are again tightly regulated. My fear is that the rush to re-regulate will produce more than the usual quota of dumb regulations. Since there is not going to be another housing and credit bubble in the next year, I would urge that the proposal of new regulations be deferred for a year, to provide time for a calm and thorough appraisal of the regulatory options.

Particularly in need of sober second thought is the popular idea of a “systemic” regulator — a regulatory body charged with preventing the financial industry from taking risks that could precipitate another financial crisis similar to the current one. Such a body would be excessively powerful and would be prone to overregulate because its only responsibility would be to prevent a crisis. In contrast, the Federal Reserve has the dual missions of maintaining price stability and employment; having to balance the two goals encourages sensible tradeoffs, although the Federal Reserve’s recent history in making these tradeoffs is not encouraging. But at least it has to worry that if it pushes interest rates too low it will create excessive inflation (in fact its interest-rate policies in the early 2000’s created asset-price inflation rather than the more common CPI or WPI inflation, but that was just as bad or worse), while if it pushes them too high it will create excessive unemployment by curtailing current economic activity too much.


Not having had the time to read the book yet, my comments are:

1. Secrecy played a large role. Secrecy differs from lack of regulation in many ways but here is an example: because London doesn't materially report capital flows, a lot of capital flows through there. The US regulators were largely unaware of the extent to which the European banking system had become dependent on short-term dollar financing. When Lehman collapsed, the US money markets called in their dollars - because Lehman was a big debtor (source of funds) - and that created a dollar shortage in Europe which literally froze the markets in place. The Fed swapped $600B to the European Central Bank in an emergency move - which was then lent out to the various banks. In other words, not knowing caused the wrong policy decision and that "oops" precipitated the credit freeze. We need information to regulate. (This information was developed by economists after the fact.)

2. The fault is not all in the US. There was a global credit bubble - exemplar being Dubai. This bubble kept expanding for a significant period after the US housing market had turned downward and after the US housing bubble markets were in steep, steep decline.



sorry, but some of this sounds like more propaganda for the finance industry- his concepts that "we" want banks to maximize profits, and that "rational" bankers will take more risk is simply justifying the deregulation of the industry that started under the Reagan administration- the fact is that wise citizens want stable banks- who cares if the financiers don't make hundreds of millions by skimming off inflated asset reports?- his concept of the fusion of banking proper with investment banking/finance as rational is a mere apology for the corruption involved.
and Posner wants "new regulation to be deferred for a year"???!!!- gee, i wonder how much more money could be looted in a year- again, this is mere propaganda for the finance industry, which Paulson (CEO of GoldmanSachs as 'regulator') attempted to legislate in the initial bailout of $750 billion, which was to have NO legal oversight by Congress!- ironically, that's the way the initial TARP money was taken anyway, but at least pay lipservice to the fact that without regulating the bailout, the money will 'rationally' disappear



How about the rating agencies? They were responsible for the incorrect ratings on the "AAA" pieces that led to a lot of this disaster.

Pat Dwyer

and all these years and I had not known that Dwyer is a first name. I like the sound of that, "Dwyer Dwyer"


"if the greater propensity for saving persists, it will make it easier for the nation to finance the support of the elderly out of private savings without need to keep increasing the amount of the national income that goes to public support of the elderly mainly through the Social Security and Medicare programs."

This is the silver lining Judge Posner, hero of the Chicago school, sees in this crisis. An opportunity to yet again lower the safety net for one of the more vulnerable groups in our society.

If anyone wonders why we are bailing out firms deemed "too big to fail" they could do no better than reviewing Pasner and Bork's antitrust writings which have, unfortunately, provided the guiding light of US antitrust policy for the past 30 years.


When in doubt, blame government? "Government was the facilitator of the crisis" because it didn't regulate. Yet, we now face the "usual quota of dumb regulations". Which way will you have it, Mr. Posner? I know, we must trust the bankers.

And if bankers act "rationally" by following their own narrow interests, then home owners and indeed everyone else has acted no less rationally. So why was this a failure of Capitalism? It seems the system behaved exactly as designed. And when you own the banks and have plenty of greater fools, aka tax payers, who must by decree bail out the system, you haven't failed at all.


The banks ran mismatched books of asset to liability maturities. Their attempts to rein in the risk through opaque over the counter derivative contracts blew up. Regulation that installs meaningful transparecny promotes trade. Regulation that constrains competitive behavior will lead to attempts to evade the rules, piling on systemic risk that again couild blow up..


Posner is always fascinating, but what a knee-jerk conservative he can be. It is pure sophistry to say "the businessman cares about his costs and his revenues, but not about the costs and revenues incurred or received elsewhere in the economy. He is not an altruist." Syllogisms such as that statement do not reflect a world in which people recognize negative externalities and do nothing about them. We can and should imbue discussions of capitalism with ethics. It it an intellectual shortcut not to do so.


Still trotting out Posner when an "intellectual" defense of self-interested economic predation is called for, eh?

Mike Bettts

The notion that this crisis is due to "the failure of capitalism" is ludicrous for the simple reason that the U.S. stopped being a truly capitalist nation a long time ago. Capitalism is based on the premise of personal risk and reward: if you risk your own money and succeed you are rewarded. Today we have executives across all industries paying themselves obscene amounts without taking one iota of personal risk --THAT IS NOT CAPITALISM.

What we have become is a corporate state (i.e., Corporatist), where playing the corporate game, rather than risk-taking, leads to great wealth. How did this happen? As government has expanded its role, the cost of government has concentrated economic power in bigger and bigger corporate entities for a very simple reason--smaller companies are less able to handle the bureaucratic, administrative and tax burdens of more and more government. As this has occurred, the calls for more government regulation have inevitably grown louder--big business becomes too powerful and even bigger government is deemed necessary. Big government begets big business and vice versa.

At this point, calling our country capitalist is like calling a pig a duck. Worrying why it oinks instead of quacks overlooks the true problem. More regulation won't make the pig a duck and neither will it cure the ills of capitalism because capitalism is not the issue. Big business and big government are the problems and increased regulations will just make them more so.



Peter, is it too hard to fathom that there is a middle ground between complete laissez-faire and complete government control of the finance industry? Posner is essentially saying that the crisis was caused by the excesses of free financial markets -- but that we can't swing too far in the other direction.

Alexandra Hamilton

So not it's the governments fault and the banks were just doing their job, ey?
This is to simplistic a view as it conveniently forgets to take the liar-loans into account and the subsequent efforts of the rating agencies and the investment banks to hide this risk inside opaque stuff like CDOs bundled multiple times without having access to the loan tapes when stamping an AAA credit rating on them. It is then simply not true that "Business firms attempt to maximize profits within the constraints set by regulation", because some regulations - as for CDSes - did simply not exist, while others were not enforced by the SEC and OTS or worked around by the banks.
Mr. Posner also forgets the little thing called "moral hazard" that exists when profits are privatized and losses socialized. He also conveniently shoves aside a major problem that led to the crisis, namely that the interests of the banks was not aligned with the interests of the managers.
Finally Mr. Posner claims that it was "too early to tell if the public-private partnership will heal the banks". If indeed Mr. Posners assertions were true, he would be able to predict the result, namely that the banks will not be saved, but the managers will rake in hefty bonuses and the - at least some - investors a nice dividend.

Mr. Posner is acting as a spin-doctor who tries to deflect the attention from the real problem to side issues.



I am dreaming of a day when America too will have honest "professors."


Posner seems to miss several aspects of the crisis: (1) the large amounts of everything from wilful ignorance to outright fraud, including liar loans and fantasy appraisals; (2) the huge financial incentives for executives to roll the dice as one good year made them wealthy for life; and (3) the corruption that allows ex-Goldman employees to distribute billions of dollars which ends up going to Goldman without any acknowledgement of the huge conflicts of interest involved. A fuller explanation of the crisis would include these, and would point out flaws in the market worship inherent in this article. His heart appears to flutter at the thought of the incompetent bankrupt companies who are currently bilking the government (taxpayers) of billions of dollars being subjected to "intrusive regulation" and "denuciation." Generally speaking, I think John Q. Public is more interested in jail time and reparations. Empty words by some congressman, not so much.

Posner has frequently argued against regulation and gonverment interention on the grounds that market forces will produce optimal outcomes. Minnesota bridge collapses? Privatize, because the market will provide the optimal solution. Now that Alan Greenspan has admitted that his belief that companies would work to optimize shareholder value was a mistake, isn't it about time that Posner produces a giant mea culpa and retires quietly from the scene? When do we reach the point that people who were generally wrong about things have the grace and dignity to stop talking?



Hard to believe they didn't see it coming:
"The banking collapse occurred last September. The government's unpreparedness (for which Greenspan and Bernanke, successive chairmen of the Federal Reserve, and academic economists bear a large part of the responsibility because of their failure to spot the housing and credit bubbles..."

Yet a few people of lesser qualifications could pretty much see it...

Posner makes no mention in these passages about the part the rating agencies played. It's funny how these agencies are heard from now...still being quoted but as though nothing had ever happened...


I will have to pick that book up.

I'd not thought/heard of that the asset inflation/monitary inflation subsitution. That's an interesting thought, I'd like to learn more about that idea.


Posner's invocation of Adam Smith in defending the actions of the bankers as rational strikes me as rather strange - Smith never dealt with investment capitalism in any of his works, and his limited theorizing on borrowing/ lending/investing was outmoded within 50 years of his death.

Perhaps when Smith was writing his notion of it not being "the benevolence of the butcher, the brewer, or the baker, ...but from their regard to their own self-interest." that makes the markets function was reasonable. To try to extrapolate this to capitalism in the post industrial-revolution is a myopic stretch at best.


Good Q&A.

Given the number of people who want to shoot the messenger, I'd have to say that Posner is on to something.

Arthur Smith

To listen to Judge Posner is to hear Milton Freidman and Alan Greenspan as well. In their make believe world people are portrayed as acting "rationally" which translates into simplistic strategies of maximizing short term gains re-gardless of long term considerations. Thus they can claim
that the only concern of business is profit maximization for the enterprise regardless of how its actions impact on the
rest of the economy. This approach may reflect a text book definition of 'economic man' but the Bible tells us that "man doth not live by bread alone." And the CEO who ignores long term considerations in order to achieve short term profit maximization will witness the demise of his/her
enterprise. Apparently, Greenspan has recognized the error of his ways and was left in "a state of shocked disbelief" because greed overwhelmed his definition of rationality. Milton Friedman is beyond redemption. While Judge Posner acknowledges the need for regulation, his appeal for delays reflects a lack of trust with regulators.
Regarding Posner's analysis of the source of the economic collapse, it falls short of an honest appraisal.
In his testimony before the Government Oversight and Reform Committee, on Oct. 23,2008, Mr. Greenspan stated that "The breakdown has been most apparent in the securitization of home morgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations would have been far smaller and defaults accordingly fewer. But subprime mortgages pooled and sold as securities became subject ot explosive demand....The surge i;n demand ....supported by unrealistically positive ratings designations...was in my judgement the core of the problem." That Judge Posner's analysis does not recognize the role played by Wall Street and the investment banks in bringing about the collapse of the economy is not too dfficult to fathom, Unlike Mr. Greenspan, he is unwilling to admit that his belief in the dominance of the 'rational' man is subject to question.



Is it really that complicated?

1. Our whole economy is based on credit. How you can finance a farm tractor, business, car, boat, home, 2nd and 3rd homes or more, stocks, clothes, groceries, and whatever electronic gizmo you want buying it on time. Based on a model of paramaters, assumptions and appraisals that are largely subjective. And self serving for the banker, retailer or homebuilder who wants guess what - a sale or deal. And the government agencies who depend on taxes from these transactions and domestic production to operate.

2. 65-70% of our economy is from consumer spending. Consumers are tapped out and headed for the bunkers.

3. We owe more than any country in the history of the world. Factor in the $50-60 trillion entitlements deficits of SS, Medicare/Medicaid, combined with existing federal, state, municipal, consumer and business debt we are closing in on $100 Trillion of debt.

4. There is no chance for all this debt to be repaid. And most creditors get this loud and clear now. Including the banks carrying assets, or debts, that are worth a fraction of what they want the markets to believe. That the Fed has known about for years but was in total denial on. Given the consequences of the one way elevator going the other way with declining values and fewer buyers.

End the zombie economy now and start with a clean slate. New banks with new capital. New manufacturers with retooled plants and new products. New people with new ideas for new businesses and business models. No more bailouts for the old days and the old guard.

The primary risk is inflation. And shock from foreign creditors on our default. They'll get over it sooner or later. They know once we're back on the road we'll be buying 20-25% of the worlds goods and services again.

Turn the page. The old book is done and worn out.