Posner's A Failure of Capitalism -- II
The first chapter of Failure lays out the standard theory of what causes depressions and how governments should normally respond, and then discusses what about our financial industry makes the current depression unusual.
Judge Posner's explanation of depressions seems (to me) to be basically Keynesian: A "shock" to the economy causes the value of individual savings to drop, which causes people to reduce their spending in an effort to rebuild their savings, which causes demand to drop, which causes producers to produce less, which results in layoffs, which makes individuals still more nervous and more inclined to spend less, which causes the pattern of contraction to continue. If banks were overextended when the shock occurred, "cascading" failures will make it harder for the pattern to be broken.
The government's tools for dealing with this situation are increasing the money supply through the banking system and, if that fails, to increase spending by spending more itself or by cutting taxes.
The shock to economy in this instance, as in the 1930s and in the late 1990s, was the bursting of an investment bubble. The bubble started in the housing industry and spread to the financial industry as a result of "low interest rates, aggressive and imaginative marketing of home mortgages, auto loans, and credit cards, diminishing regulation of the banking industry, and perhaps the rise of a speculative culture[.]"
Judge Posner then discusses how banking has changed in a way that helped bring about the depression. "[T]he regulatory barriers separating the different types of financial intermediary have eroded to the point where [for present purposes] all financial intermediaries can be regarded as 'banks.'" Restrictions on risky lending were eroded, and subprime lending increased.
Banks do not have enough incentive to avoid the risk because the rewards outweigh their exposure to a disaster that (they think) is of low probability. "A depression is too remote an event to influence business behavior." Hence government regulation is needed to prevent excessively risky lending.
Moreover, Americans' saving rate was so low in the 2000s that many now have little set aside to enable them to keep spending at the pre-downturn levels. The Fed's easy money policy in the 2000s (as it attempted to correct for the bursting of the dot-com bubble) enabled lending to continue even as people saved less.