Posner's A Failure of Capitalism -- XI

In chapter nine of Failure (entitled "Apportioning Blame"), Judge Posner explains that his thesis -- viewing the current depression as a market failure -- "doesn't let the government off the hook." This chapter thus overlaps to a considerable extent with chapter seven, "What We Are Learning about Capitalism and Government."

The argument here focuses on the government's failure to keep a recession from devolving into a depression. Recessions are frequent, and it's "unrealistic" to expect the government to prevent them. But the government should be able to prevent depressions, especially given our experience with the Great Depression "and the tools forged then and later to prevent a repetition."

The "seeds" were sown and nurtured in the gradual deregulation of banking and credit, which began in the 1970s. This process included repeal of the Glass-Steagall Act and the decision not to regulate credit-default swaps and other innovative financial products. The experts in charge in the '90s -- Greenspan, Rubin, and Summers -- "allowed the head of steam to build up."

But a depression might still have been avoided were it not for "the Bush Administration's mismanagement of the economy." Judge Posner notes that Paulson's predecessors as Secretary of the Treasury weren't "financial experts." President Bush also erred in "firing" Lawrence Lindsey as chair of the National Economic Council in December 2002. None of Lindsey's successors as chair (until President Obama's appointment of Larry Summers) was an economist.

Other mistakes under President Bush were the budget deficits and increase in the national debt, and a philosophy of lax enforcement of financial regulations. Judge Posner also spends several pages helpfully explaining why, in his view, the decision to let Lehman Brothers fail in September 2008 is "the single biggest blunder to date in the response to the gathering storm." Aside from the financial fallout, the episode and its aftermath shattered confidence by making it "increasingly obvious that the government had no game plan." This was exacerbated by President Bush's apparent lack of engagement with the crisis and abdication of leadership to Bernanke and Paulson, "neither of whom has the communication skills that the emergency required."

Congress is likewise to blame, for its "squabbling and grandstanding and demagoguery" in an effort to use the crisis to advance political agendas, such as its "eagerness to promote unionization in a depression."

Greenspan and, to a lesser extent, Bernanke are also culpable for their actions as chairmen of the Fed. Greenspan did not use the opportunity afforded by his "tremendous prestige" to arrest the housing bubble's growth. Bernanke shared Greenspan's misapprehension that any recession caused by the eventual bursting of the housing bubble could be "neutralized by lowering interest rates."

Finally, Judge Posner explains why he is not being harder on private actors: Although private actors are "responsible" for the depression in the sense that their rational market behavior primarily caused it, they (unlike the government) are not morally culpable "any more than one can blame a lion for eating a zebra." Judge Posner therefore criticizes journalists and politicians "and some who should know better, like . . . Paul Krugman," for directing their ire at Wall Street. "They have the wrong target."

Posner's A Failure of Capitalism -- X

Chapter eight of Failure tries to answer the question why economists did not anticipate trouble. Aside from a few outliers (Judge Posner mentions Nouriel Roubini, Raghuram Rajan, Paul Krugman, Martin Feldstein, and Robert Shiller), economists "whether in academia, the government, or business" gave warnings too late or not at all.

In Judge Posner's opinion, this failure to see what was approaching arose not from "obtuseness" (he acknowledges that "the leading macroeconomists and finance theorists are brilliant people"), but from "disbelief" that we were facing anything more than another manageable recession. Likewise, the failure to warn did not result from over-reliance on "abstract mathematical models." Many of the economists under consideration had real-world experience with financial markets.

One cause that Judge Posner offers is something he has mentioned before: "an overinvestment . . . in a free-market ideology that opposes aggressive governmental interventions in the operation of the economy." Yet he is quick to add that free-market leanings are not confined to conservatives -- "economists can be liberal in the sense of being egalitarian and favoring redistributive policies without wanting to regulate corporate practices."

He also notes that depressions are not well understood; they're hard to model and occur rarely, in disparate settings that are not readily comparable. Consequently, a preference for one theory over another will be more than usually influenced by "preconceptions." The public and politicians have no basis for crediting one position or another -- they "wander in an untracked wilderness."

Nonetheless, current experiences add to our stock of data. Judge Posner offers Ben Bernanke as an example of a "conservative economist" who has "come to doubt that a depression can be averted or cured by monetary policy alone." Unspoken is that Judge Posner himself, while not by profession an economist, could be added to the list of those who have altered their views based on events.

Posner's A Failure of Capitalism -- IX

Chapter seven addresses "What We Are Learning about Capitalism and Government" from the current depression. Here, Judge Posner revisits his claim that the depression was not caused by government action. Rather,

As far as one can judge on the basis of what is known today (obviously an important qualification), the depression is the result of normal business activity in a laissez-faire economic regime -- more precisely, it is an event consistent with the normal operation of economic markets.

He obliquely supports this claim by examining the government's conduct in the years leading up to the depression. The government's role in the rise of risky mortgage lending, he finds, "was one of permission rather than of encouragement." In other words, government allowed the rational self-interest of private actors to pursue, in the aggregate, a course that was harmful.

The government's permissivenes, or inaction, is exemplified in the SEC's failure to investigate the Madoff scheme, notwithstanding Harry Markopolos's repeated efforts over several years to alert the SEC to what was going on. Judge Posner rejects "conservatives'" interpretation of this episode as an example of government incompetence. Instead, he proposes, "the emphatically pro-business philosophy of the Bush Administration made the SEC too trusting of the securities industry."

He concludes that "there undoubtedly was a grave government failure as well as a market failure" in the run-up to the depression. He predicts that the government's response will be, as usual, "regulation and reorganization." Reorganization is the easier move and the less effective. Regulation or reregulation is more likely to do good, but it should not be attempted until the depression is at an end.

Posner's A Failure of Capitalism -- VIII

Chapter six of A Failure of Capitalism -- entitled "A Silver Lining?" -- somewhat quickly reviews possible beneficial effects of the current depression.

These include: The bursting of the housing bubble, which had to happen eventually, and having it happen when it did is preferable to having it happen, say, a year later, when it would be that much bigger. The exposure of fraudsters such as Bernard Madoff, who, again, would have done still more damage the longer the bubble lasted. Increasing the efficiency of business enterprises' use of labor and capital, since the drop in revenues requires that "slack" be taken up. Inducing federal, state, and local governments to increase their efficiency, since tax revenues drop. (But, on the other hand, the depression will also likely cause government to grow in size.)

More beneficial effects: "The depression may give the Administration and Congress pause concerning measures to strengthen unions, such as the proposed Employee Free Choice Act[,]" since unions can cause "an increase in wages, and a reduction in the efficiency with which labor is utilized." An increase in taxes (once the depression is over) will not "necessarily" be a bad thing. Increased unemployment will lead to an increase in the general level of education, since the opportunity costs associated with spending more time in school have been temporarily lowered. The depression has taught the banking industry "a great deal . . . about the risks of leverage and the downside of complex financial instruments intended to reduce the risk of default more cheaply than by traditional means." The public has learned "about the dangers of speculating on housing prices and investing the rest of one's savings in the stock market."

Still more: "The depression has shown that privatizing social security -- that is, allowing recipients to invest in the stock market some or all of the money in their social security retirement accounts -- would have been calamitous." The depression has caused commodity prices to drop, especially with oil. The level of carbon emissions has fallen as business activity has slowed. Lower oil prices have reduced the wealth of many nations that are "either hostile to the United States . . . or politically unstable." The depression will free up to pursue other work a lot of "brilliant people" who were formely employed in the financial industry. "The depression is a wake-up call to the economics profession." And the depression may lead to "a durable increase in the personal savings rate."

Posner's A Failure of Capitalism -- VII

This is the second of two posts on chapter five of Failure.

As I noted in the preceding post, Judge Posner asks, after reviewing the stimulus program, whether it is "an $800 billion mistake?" He answers this question in a roundabout way.

He acknowledges that much of the "stimulus" will not be aimed primarily at stimulating economic activity but will instead be an enactment of President Obama's legislative agenda. Judge Posner then proceeds through a lengthy discussion of the "monetarist" and "Keynesian" views of the Great Depression and of solutions to depressions generally. The monetarist solution (in which the Fed increases the money supply through the banking system in order to stimulate economic activity) is problematic because, as previously mentioned, the current situation is so bad that banks are mainly "hoarding" the additional money in order to build their reserves, not lending it. To get beyond this hoarding, the Fed would have to pump so much new money into the banks that, when the depression finally ends and the Fed starts to contract the money supply (as will be necessary to prevent wild inflation), "a severe recession will be unavoidable." Thus, Judge Posner concludes, the monetarist solution alone will not remedy the depression "at a tolerable cost."

The fear in the background, as he explains in this chapter, is that the economy will enter a deflationary spiral. Deflation is a situation in which the general level of prices persistently decreases. This frightens economists because deflation makes it economically rational not to spend money. Since prices are dropping generally, money gains in value simply by being stuffed in a mattress for a few months. People don't need to put their money to work in order to earn a return. Accordingly, the economy contracts and contracts.

After painting this bleak picture, Judge Posner observes that "[e]ventually deflation will bottom out. As income shrinks, consumers will cease to be able to hoard cash; they will have to start spending everything they have." This will start a "virtuous cycle" of increased spending, increased production, and increased employment. "But the progress of recovery will be protracted because it will begin from a very low level."

Judge Posner now comes back to his question whether the stimulus is a mistake. He has concluded that the monetarist solution is not likely to prevent a deflationary spiral "at a tolerable cost." As a result, Keynesian deficit spending (i.e., the stimulus program) is also needed to prompt economic activity. Although he doesn't use these words, he in effect says that we have no choice.

He further points out that, even if the stimulus "will do nothing to speed recovery from the depression, there would still be a compelling argument for it. . . . "

Suppose that President Obama were to tell the American public: "We're trying to avert or ameliorate a depression by pumping up the money supply, but it may not work, in which event we'll find ourselves in a deflationary spiral that may resemble what happened to the United States in the 1930s and Japan in the 1990s. And then we'll just have to tough it out because our toolbox will be empty." (This is what, in effect, some conservative economists would like him to say.) His statement would guarantee a severe depression, because people would react by curtailing their consumption further, accelerating a deflationary spiral that would carry the economy to a lower level and keep it there for years.

The government must instead, for psychological reasons, express optimism and be seen to be doing something.

I don't have the time to review other interesting passages in this chapter, other than to mention them. Judge Posner argues that the monetarist solution "is potentially more socialistic" than the Keynesian one, because under the former, the Fed has found itself needing to buy stakes in businesses. He also looks at Congress's attempt to reduce the number of residential foreclosures by amending the bankruptcy code. In his view, that is not a good plan. Instead, while his preference would be no mortgage relief at all, he suggests a moratorium on foreclosures or a Columbia-devised plan in which certain lien-holders would be compensated with government funds for consenting to modification of mortgage terms.

Posner's A Failure of Capitalism -- VI

In chapter five -- by far the longest chapter in the book -- Judge Posner examines the efforts the federal government has made so far to combat the current depression.

I will blog this chapter in two parts, this being part one.

By this point, his arguments will already have alienated libertarian and conservative readers. This chapter will now alienate readers on the left. Judge Posner has no illusions about the political nature of what the Obama administration is undertaking. At one point he suggests that the stimulus program perhaps "should be called the 'half stimulus-half New Deal' program," and notes that "[t]here is a legitimate concern that Keynesian depression-fighting theory is being used as a fig leaf to disguise a program of massive government expenditures based on a liberal ideology that a majority of Americans may not subscribe to -- at least not yet." (That closing "at least not yet" is apparently a reference to an argument earlier in the chapter that wealth-transferring programs are very hard to remove once they have been put in place, because they create their own constituencies of supporters/dependents.)

He identifies five phases that the government's response has so far moved through or into, not necessarily in sequence. The first three phases together form the "bailout": (1) the attempt to use TARP funds to buy "sick" mortgage-related assets from banks, (2) direct government investment in large banks in exchange for preferred stock, and (3) loans to GM and Chrysler in December '08 "to head off the bankruptcy of these companies or at least defer it." The fourth phase Judge Posner calls "easy money" -- the Fed's purchase of $800 billion of private debt (as opposed to buying back debt issued by the federal government). The fifth phase is the stimulus program, which had not become law at the time Judge Posner completed the book, in February '09, though he correctly assumed that it would be enacted.

Judge Posner explains the economic rationale behind each of the above phases, the political complications associated with them, and their likelihood of being effective on balance. The first phase, as he discussed in a previous chapter, failed because it was based on the faulty premise that the illiquidity of the "sick" assets resulted from uncertainty as to their value. (It turns out that they're just not worth much.) The second phase did help stabilize banks, but it did not have much immediate effect on the depression because banks needed funds so badly that they added much of the invested money to their reserves rather than loaning it out and thereby boosting economic activity.

The third phase (the second shoe of which is dropping now) was, in Judge Posner's view, more successful than is generally allowed. There was never any chance that the government could remake those companies or the auto industry as a whole. But, he argues, the main benefit of the loans to GM and Chrysler was simply to help them survive until the depression is over. In "normal" times, their bankruptcies would not be a problem. But the failure of such large firms "just as the nation was sliding into a depression" would have dangerously accelerated the cycle of lowered spending / lowered production / increased unemployment / lowered spending / etc.

After discussing the above, Judge Posner turns his attention to the stimulus program. The stimulus was planned (at the time he was writing) to consist of three elements: tax cuts, transfer payments and "other social-welfare expenditures," and public works. Conservatives prefer the tax-cut solution because, of the three, it's the only one that promises to make government smaller instead of larger. Tax cuts alone, however, are unlikely to increase economic activity much, because most people view tax cuts as temporary and therefore tend to save, not spend, the additional money they get to withhold from Uncle Sam. (And people who are so poor that they must spend all the money they have are also so poor that they pay little, if any, income tax in the first place.)

As for transfer payments and social programs, that "component of the proposed stimulus is also questionable, though politically irresistible." On the plus side, this component puts money directly into the hands of the poor, who are the ones most likely to spend it soon -- what we want a stimulus program to accomplish. On the negative side, this component is most likely to create permanent new "drains" on the federal government.

In that regard, the public-works component of the stimulus is superior, because public-works projects are, by their nature, more likely to be temporary. They are also more likely to result in real benefits to society aside from the benefit of helping to end the depression. To an extent, they also accomplish the same thing as the second component, since some of the money spent on public works finds its way to individuals who also spend it. (Relatedly, Judge Posner mentions the Keynesian "multiplier" that is supposed to capture the extent to which government spending results in additional spending down the road. He acknowledges that some estimates put the multiplier at 1.4, but "this is one of the roughest of rough estimates and some economists think the multiplier is less than [1.0].")

The problem with public-works spending is that public-works projects need a long lead time. Judge Posner's solution is to focus the spending on infrastructure repairs, and on projects (whether state or federal) that have already been started but have stalled for lack of funds.

At this point, Judge Posner ask if the stimulus program is "an $800 billion mistake, as the economist Martin Feldstein has called it?"

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.