Sunday, April 26, 2009

Posner's A Failure of Capitalism -- V

Chapter four of Failure focuses on why government did not pay attention to warning signs that the housing market was hugely inflated and that the inevitable bursting of the housing bubble would trigger widespread bank failures. Judge Posner reviews the warnings that were given by Nouriel Roubini, The Economist, and others during the 2000s, along with the collapse of several mortgage hedge funds in 2007. He also discusses possible reasons why the warnings were ignored or underappreciated, and why governing officials in general lack incentives to take precautions against low-probability catastrophic events. "Until the biggest financial ninepins started falling in September 2008, the magnitude of the crisis was largely invisible to government, the business community, and most economists, even specialists in financial economics and macroeconomics."

Among the reasons Judge Posner offers for this lack of comprehension are a reliance on faulty pro-non-interference preconceptions when facing uncertainty, the political costs associated with using Fed policy to preemptively pop the bubble, the uncertainty of whether the social costs of preemptive action will be less than the costs of letting things run their course, and the sheer size of the mass of data from which one would have had to sift out reliable warnings.

Notwithstanding his recognition of those countervailing forces, Judge Posner feels that the Fed and Treasury should have known to take action after the Bear Stearns collapse:

It is the passivity of the Federal Reserve between Bear Stearns' collapse in March 2008 and the calamitous collapses in September, and the failure (for which the Fed was jointly responsible with the Treasury Department) to avert Lehman Brothers' bankruptcy, that merit strong criticism.

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