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.