Judge Posner devotes chapter three to a fuller explanation of a point he made briefly in chapter one: that systemic forces led bankers and others to take risks -- notwithstanding some perceived threat of catastrophic failure -- that were excessive. This is a key component of his argument that the current depression resulted from market failure. I.e., if people were for the most part acting rationally in the run-up to the depression, then we cannot expect market forces alone to prevent depressions.
As Judge Posner explains, executives, private investors, and home buyers were acting in their rational self-interests in making the decisions they did over the past nine years. The depression was not the result of irrational exuberance or bad motives "such as 'greed' (whatever that means)." He lays out the various circumstances (including some conflicts of interest in the financial world) that caused the rational course of action to be largely what people did.
The problem -- and the reason why this was a market failure -- was that decisions that were rational on an individual basis were irrational, and harmful, for the economy as a whole. Government action is therefore needed to prevent actions that are harmful in the aggregate:
Rational indifference to the indirect consequences of one's business and consumption behavior is the reason the government has a duty, in regulating financial behavior, to do more than prevent fraud, theft, and other infringements of property and contract rights, which is the only duty that libertarians believe government has. Without stronger financial regulation than that, the rational behavior of law-abiding financiers and consumers can precipitate an economic disaster.
Judge Posner acknowledges that not all market failures should be prevented. If the regulations needed to do so would cost more than the "social cost" of the failure, then trying to prevent it would be a net waste of resources. But depressions, he argues, are not of this type. The Great Depression "inflicted horrendous costs," including "the excesses of the New Deal," and possibly Nazi Germany and World War II. The current depression could likewise result in far-reaching costs, such as over-regulation, dependence of business on government handouts, etc.