A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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The Rational Crisis
Richard Posner takes on the financial meltdown.
15 May 2009
A Failure of Capitalism: The Crisis of 08 and the Descent into Depression, by Richard Posner (Harvard University Press, 368 pp., $23.95)
Coming from a leading free-marketer, Richard Posners new book may look at first glance like a confession of intellectual defeat. Actually, it is closer to healthy self-criticism. Capitalism, writes Posner, should be not rejected but repaired. Posner has joined the still-modest number of scholars who try to understand their mistakes without jettisoning their entire system of beliefs. Former Federal Reserve chairman Alan Greenspan became a member of this group after publicly admitting some months back that he had overrated the financial markets capacity to self-regulate. Posner, however, goes much deeper: his book offers a sophisticated explanation of what he sees as an approaching, if unacknowledged, depressionone that will last for some years and deeply threaten our society.
To grasp the depth of Posners arguments, I suggest reading the book twiceand that wont be a hardship, since it is relatively short, fluently written, and devoid of jargon and mathematical formulae. A first read brings no major surprises: Posner provides a thorough account of how the United States, in preferring speculation to savings, inflated the real-estate bubble, and of how the bubbles burst imperiled the entire financial systemleading Posner to call it a depression instead of a recession. He regards recessions as normal features of a capitalist economy, the occasional responses to external shocks (oil price hikes, for example) or internal ones (as when innovation displaces industries and workers). In a depression, by contrast, the whole economy spirals downward, and investments and innovation stop.
Though Posner is a jurist rather than an economist by training, he sees the big picture better than many economists do. Yet writing in the aftermath of financial meltdown, he yields to the temptation to build causal arguments ex post facto. Was it really that evident when Lehman Brothers went bankrupt last fall that a global stock-exchange crash would occur? Eventually, like a newborn Keynesian, Posner blames the crisis on an absence of regulation and sees more regulation as the cure, overlooking how heavily regulated the markets already were. Certainly the existing regulations werent adequate, but to this day, no one knows for sure what the right regulatory approach would be.
On a second reading, one begins to realize that Posners book is an explosive manifesto in the ongoing philosophical feud among economists between rational-action theorists and behaviorists. This may sound arcane and tangentialbut its central. Today, free-market economists and the politicians who more or less follow their lead split into two leading schools of thought. On one side, the rational-action theorists, led by Chicago economist Gary Becker, think of individuals as behaving rationally, with their own best interests in mind; each of us acts to maximize his profit, based on the available information. A stock trader, for example, will deliberately take huge risks if he believes that he can earn a sizable profit. To act greedy is rational when the bonus system common to financial firms rewards such greed.
Behaviorists, on the other hand, based on some still-limited psychological experiments and brain scans, conclude that individuals are moved more by passionsKeynes called them animal spiritsthan by reason. (Nobel Prizewinning psychologist Daniel Kahneman is the founding father of this school, and Robert Frank, author of the just-published The Economic Naturalist, is its best public advocate.) We thus are prone to make financially unsound choices that eventually work against our best interests. Rational-action theorists are inclined to let individuals choose whats best for them in slightly regulated markets where information flows abundantly. Behaviorists suggest strong government regulations to protect people against their own instincts.
Not surprisingly, Posner sides with the rational-action theorists (he and Becker author a weekly blog, applying the theory to all manner of things). He shows how unbridled rationality could lead us into a depression, without making any psychological or moralistic judgment about it. Weve already seen how rational-action theorists view stock traders behavior as rational within the context of the bonus incentive. Bankers, for their part, may have provoked the crisis by excessive fund leveraging and hazardous credit: these were rational choices, from their perspective. If bankers hadnt joined the bubble, their customers would have fled, attracted by competitors offering higher returns. Bankers knew that they ran the risk of bankruptcy someday in the future: they werent stupid, Posner reminds us. They understood that the bubble would eventually burst, but the risk of bankruptcy is part of a bankers entrepreneurial existence. It was rational to accept that risk when the returns were high: at the end of the day, or at the end of the year, the banker might lose his company, but if his personal savings were massive enough, he had no rational reason to care.
What about subprime lenders, mortgage buyers, and credit-card consumers? When credit was so cheap and real-estate values endlessly climbing, they would have been irrational not to join the fray. According to Posner, then, each economic actor acted rationally within a dangerous framework. Who was responsible for the outcome, then? Those who designed the rules, he argues, not those who played by them.
Posner proposes two explanations for the regulators failure. First, he indicts economists as a profession: they neglect to study depressions because theyre such rare events. Its quite true that most economists, the free-marketers at any rate, acted as if depressions could never occur againa fatal conceit, as Hayek might have put it.
Second, Posner argues, free-market economists have been too ideological in their commitment to a deregulation-first approach. They mistakenly argued that deregulation of the financial markets would have the same beneficial effects as deregulation within the real economy, such as in the airlines or telecommunications industries. Posner is right about this: financial markets and the real economy do not follow the same logic, as Yales Benoit Mandelbrot and Columbias Rama Cont (not cited by Posner, unfortunately) have demonstrated. The real market, Mandelbrot shows, follows rather predictable rules, while the financial markets obey a law of wild randomness or the Black Swan Effect, a term coined by Nassem Taleb, a Mandelbrot disciple. Financial markets therefore require prudent regulation in order to limit, to the extent possible, the most extreme consequences of wild randomness.
If an imaginary trial took place to adjudicate responsibility for the financial crisis, Judge Posner (he sits on the U.S. Court of Appeals) would most certainly exonerate the business community, which acted rationally, in his view. The economists would go free on bail and under probationary warning to modify their theories. The politicians would be blamed for failing to prepare any contingency plansand they still dont have a clear one, Posner complains. His own suggestion is that the United States should build the equivalent of a financial CIA to protect the market against major threats. He cites a historical precedent: when the Japanese attacked Pearl Harbor, no institution was in charge of putting together the myriad of scattered data that were available and that might have, once gathered, served as a warning.
Beyond Posners remarkable book, one is tempted to add a general commentary on all that has been published on the current crisis. Most commentators, motivated by science, ideology, angst, or revenge, try to explain the crisis as if it had to happen. They selectively find in the recent past the logical causes that inevitably led to the crisis. This approach recalls what the French historian Fernand Braudel criticized in studies of the eighteenth century that viewed the French Revolution as inevitable. The revolution, Braudel argued, could very well not have happened at all; history follows no necessity. The same applies to economics. Crises arent doomed to happen. Depressions remain unpredictable by definition; they obey only wild randomness. The I-told-you-so pundits fall into a logical trap, confusing failures in capitalism, which happen and will continue to happen, with the notion that they had to happen. Yet only Karl Marx believed that capitalism was fated to disappear in a final crisis, and he was more a messiah than a scientist. We should explore the way out of the current crisis with humility and caution.
Guy Sorman, a City Journal contributing editor, is the author of numerous books, including the forthcoming Economics Does Not Lie.