Riding the Waves of Culture Understanding Diversity in Global Business 3E_1 pdf

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THE FINANCIAL AND ECONOMIC CRISIS ¬ that began in 2008 is the most alarming of " our lifetime How could it have happened, mm | oN

after all we’ve learned from the Great | Si

Depression? Why wasn’t it anticipated? ree oy What can be done to reverse a slide into " a full-blown depression? Why have the ệ : responses to date of the government > - 7Ý tm aw ns ¬ `

and the economics profession been so

indecisive? Richard Posner presents a vw

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concise and non-technical examination

of this financial disaster and the stumbling Be te tte efforts to cope with it .- _—— | poe Tw em tN ee

Among the facts and causes Posner

identifies are heavy capital flows from ị 1 abroad and the reckless lowering of

interest rates by the Federal Reserve | |

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Board; the deregulation of the financial | | ‘ |

sector; the relation between executive ¬ a compensation, short-term profit goals, | “hos

and risky lending; the housing bubble quên : fueled by low interest rates and aggressive 7 h 4 mortgage marketing; the low savings rate ; | " of the American people; and the highly a | : _ | leveraged balance sheets of large financial

institutions L

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A Failure of Capitalism

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A Failure of

Capitalism

THE CRISIS OF 'O8 AND THE DESCENT INTO DEPRESSION

Richard A Posner

HARVARD UNIVERSITY PRESS

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Copyright © 2009 by the President and Fellows of Harvard College

ALL RIGHTS RESERVED

PRINTED IN THE UNITED STATES OF AMERICA

Library of Congress Cataloging-in-Publication Data Posner, Richard A

A failure of capitalism : the crisis of 08 and the descent into depression / Richard A Posner

com

Includes bibliographical references and index ISBN 978-0-674-03514-0 (alk paper)

1 Financial crises— United States 2 Depressions 3 Capitalism 4 United States— Economic conditions —2001- 5 United States— Economic policy—20o1- I Title

HB3722.P67 2009

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Contents

Preface vii

The Depression and Its Proximate Causes 1

The Crisis in Banking 41 The Underlying Causes = 75

Why a Depression Was Not Anticipated 117

The Government Responds 146 A Silver Lining? 22o

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CONTENTS 8 The Economics Profession Asleep at the Switch 252 9 Apportioning Blame —_ 269 10 The Way Forward 288

1 The Future of Conservatism 304

Conclusion 315

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Preface

The world’s banking system collapsed last fall, was placed on life support at a cost of some trillions of dollars, and remains comatose We may be too

close to the event to grasp its enormity A vocabu-

lary rich only in euphemisms calls what has hap- pened to the economy a “recession.” We are well beyond that We are in the midst of the biggest economic crisis since the Great Depression of the

1930s It began as a recession — that is true—in De- cember 2007, though it was not so gentle a down-

turn that it should have taken almost a year for economists to agree that a recession had begun then (Economists have become a lagging indica-

tor of our economic troubles.) The recession had

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PREFACE

to unsustainable heights in the early 2000s When the market decided that houses were no longer such a super investment, many people who were overmortgaged relative to the value of their houses

defaulted, and either abandoned their house or

were forced out by foreclosure The result was a glut of unsold houses and a drastic reduction in the amount of home building, as well as a great many nonperforming mortgages Two mortgage hedge funds owned by the investment bank Bear Stearns went broke in the summer of 2007, along with American Home Mortgage Corporation and three investment funds owned by the French bank BNP Paribas Countrywide Financial Corporation, the nation’s largest mortgage lender, narrowly averted bankruptcy

The recession was overtaken by a financial crisis in March 2008, when Bear Stearns itself collapsed The crisis became acute in mid-September, when the bankruptcy of Lehman Brothers, the distress sale of Merrill Lynch, the near collapse and ensu- ing government takeover of Fannie Mae and Freddie Mac (giant buyers and insurers of residen- tial mortgages), and the bailout of American Inter-

national Group, the nation’s largest insurance

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PREFACE

ket and a worldwide credit freeze Frantic efforts by

the Federal Reserve, the Treasury Department, and

Congress to save the financial system ensued These efforts culminated in early October when Congress enacted a $700 billion bailout of the banking industry (TARP—the Troubled Asset Re- lief Program) But the bailout could not prevent the further deepening of the recession By the end of 2008 — with the Detroit automakers on the verge of bankruptcy and economic activity everywhere declining sharply, with the Dow Jones Industrial Average having declined to 8,800 (at this writing — February 2, 2009—it is down to 7,900) from 14,000 in October 2007 and from 11,100 as recently as Sep- tember 26, and with the Federal Reserve making desperate efforts to prevent a deflation —the reces- sion was beginning to be seen as the first U.S de-

pression since the Great Depression of the 1930s

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PREFACE

radical measures of the kind that were or perhaps should have been taken during the Great Depres-

sion, we could find ourselves in almost as dire a

predicament It is the gravity of the economic downturn, the radicalism of the government's re- sponses, and the pervading sense of crisis that mark what the economy is going through as a depres-

sion

There is no widely agreed definition of the word, but I would define it as a steep reduction in output that causes or threatens to cause deflation and cre- ates widespread public anxiety and, among the po-

litical and economic elites, a sense of crisis that

evokes extremely costly efforts at remediation It is

too early to tell how protracted the downturn will

be, and I recognize that protraction, so notable a feature of the Great Depression (especially in the United States), is a common marker for depres- sions But it is expected to exceed in length every recession of the last half-century

Not that we are likely to see a 34 percent drop in

output or an unemployment rate of 24 percent, as

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PREFACE

avoid a repetition of the Great Depression will im-

pose enormous long-term costs on the economy The cost of a depression is not just the loss of out- put and employment before recovery begins; it is also the cost of the recovery, including such after- shock costs as inflation; there may be political costs as well

At this writing, the federal government, in a des- perate effort to speed the recovery, has spent or committed to spend (I include the stimulus pack- age now wending its way through Congress, as it

seems certain to be enacted) $7.2 trillion ($5.2 tril-

lion by the Federal Reserve, $2 trillion by the Trea- sury Department), and has guaranteed another $2 trillion in loans and deposits We are facing the cer- tainty of a huge increase in the national debt and the possibility of a future inflation rate so high that, as in the early 1980s, the Federal Reserve will have to engineer a severe recession (by effecting a sud- den sharp increase in interest rates) in order to re- store price stability Such a recession would be an aftershock, and hence a cost, of the present crisis The aftershock would be all the greater if at the

same time that interest rates were rising the govern-

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PREFACE

the pain of a post-depression recession the Federal Reserve restarted the boom-and-bust cycle by forc- ing down interest rates In short, even if the current

downturn is arrested within months, the extraordi-

nary measures that the government is taking to ar- rest it will cause profound economic problems for years

Some conservatives believe that the depression is the result of unwise government policies I believe it is a market failure The government’s myopia, passivity, and blunders played a critical role in al- lowing the recession to balloon into a depression, and so have several fortuitous factors But without any government regulation of the financial indus-

try, the economy would still, in all likelihood, be in

a depression We are learning from it that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails The movement to deregulate the financial industry went too far by exaggerating the

resilience—the self-healing powers—of_laissez-

faire capitalism

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PREFACE

quidity crisis? a solvency crisis? something else? — and what precipitated it? What are the underlying causes? Why was it not anticipated? How well is the government responding to it? Is the depression unalloyed grief, or may it have some redemptive political or economic consequences—the silver lining that every self-respecting cloud should have? What can we learn from it about capitalism, gov- ernment, and the economics profession? What can be done to head off future depressions? What indi- viduals or institutions are most culpable for having failed to foresee and avert the depression? What is its principal political lesson? I organize my discus- sion around these questions

The media’s coverage of the crisis has been ex-

tensive, lively, often insightful, and even riveting,

though now it’s turning silly, with ignorant denun-

ciations of “Wall Street” for greed and extrava-

gance (What did reporters think businessmen were like?) The sheer volume of that coverage is

daunting, however, and much of it is anecdotal,

ephemeral, or both There are books and articles

galore, both journalistic and academic, about de-

pressions in general and even about this depres- sion But many of the writings are by authors with an axe to grind, or are too technical for nonspecial-

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PREFACE

ists to understand, or are months behind the curve,

or assume too much prior knowledge of the finan-

cial system (are too “insiderish”), or, at the other

extreme, are superficial There is a need for a con-

cise, constructive, jargon- and acronym-free, non- technical, unsensational, light-on-anecdote, analyt-

ical examination of the major facets of the biggest

U.S economic disaster in my lifetime and that of

most people living today That is the need this book tries to fill

My focus is on the course, causes, and offered cures of the depression But I also emphasize some points that have received relatively little coverage in other accounts: the depression’s political dimen- sions, the disappointing performance of the eco-

nomics profession in regard to anticipating and

providing guidance to responding to the depres-

sion, how ideology can distort economic policy, the

inherent limitations of depression economics, how the self-interested decisions of rational business- men and consumers can give rise to a depression (so there is no need to look for psychological expla-

nations), and how the failure of officials and econo-

mists to anticipate the financial crisis and prevent

its ripening into a depression echoes the failures of

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PREFACE

and prevent other catastrophic events, like the Pearl Harbor or g/11 attacks or the devastation of New Orleans by Hurricane Katrina (In discussing these analogies I shall be drawing on my previous work on catastrophe and on intelligence failures See my books Catastrophe: Risk and Response [2004] and Preventing Surprise Attacks: Intelligence

Reform in the Wake of g/11 [2005].)

I have tried to be simple without being simplis- tic—to write for generalists but also to suggest points that may interest specialists | have es- chewed the usual scholarly apparatus of footnotes and citations, though I list some further readings at the end of the book for those who want to read more widely in a fascinating and timely subject | have been assiduous in suppressing extraneous de- tail; the book is a high-altitude survey and, since I

am not a macroeconomist, reflects an outsider’s

perspective — but there can be value in such a per-

spective

By way of simplification, I do not distinguish be- tween the overlapping governing bodies of the Fed- eral Reserve System—the Board of Governors of the Federal Reserve System and the Federal Open

Market Committee — but treat them as a single en-

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PREFACE

Committee rather than the board that controls the supply of money, but the same person is chairman of both and dominates both, so for my purposes there is no need to distinguish between the two bodies I also use the words “bank” and “banking” broadly, to encompass all financial intermediaries

(firms whose business is to lend borrowed capital),

because the lines that used to separate commercial banks from investment banks and other nonbank financial intermediaries have so blurred When I want to speak about banks in a narrow sense, but

the context does not indicate that, I use the term

“commercial bank.”

The first five chapters describe how and why the

economy has gotten itself into such a fix and what the government is trying to do to get the economy out of it and how likely it is to succeed The last six chapters focus primarily on the lessons that can be learned from the debacle and from the efforts to avoid or mitigate it—lessons that may help us avoid the next depression

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PREFACE

within weeks, virtually all the imaginable weapons

that can be used against a depression will have

been deployed (though innumerable changes of

course and emphasis can be expected), and it may take years to determine their efficacy and to experi- ence any aftershocks of the depression, such as run- away inflation This is a good juncture at which to

take stock, albeit tentatively, preliminarily, of a mo-

mentous economic event that is likely to affect

America and the world in profound ways Irving

Fisher’s pathbreaking essay on the Great Depres- sion appeared in 1933, long before that depression ended, and John Maynard Keynes’s immensely in- fluential General Theory of Employment, Interest and Money appeared in 1936, before the depression ended in the United States

But because I am writing in medias res, I have decided to create a blog (I will call it “The Posner Economic Crisis Blog”) in which I will blog weekly on the crisis, beginning a week after the publication of this book, in effect continuously up-

dating the book Comments from readers will be

welcomed and posted, and I will respond to as many of the most insightful or informative com-

ments as my time permits

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PREFACE

The economist Gary Becker and I blog weekly on issues of economic policy (See “The Becker- Posner Blog,” http://becker-posner-blog.com/.) We began blogging about the nascent crisis back in June of 2007; and while I did not then foresee a depression, I expressed concerns that events have shown were realistic Anyone interested in my thinking before I realized we were headed for a de- pression should look up my blog entries of June 24, August 19, and December 23, 2007 I have incorpo- rated here and there in the book some materials from my blog entries beginning in September

2008, when the financial crisis hit with full force

I thank my co-blogger, Gary Becker, for fruitful discussions of a number of the issues that I cover in

the book, and Laura Bishop, Ralph Dado, Justin

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PREFACE

Larry Bernstein, Michael Boudin, Nathan Christensen, Kenneth Dam, Benjamin Friedman,

Rebecca Haw, Ashley Keller, William Landes, Jon- athan Lewinsohn, Jennifer Nou, Charlene Posner,

Eric Posner, Kenneth Posner, Raghuram Rajan,

Andrew Rosenfield, Andrei Shleifer, and Luigi Zingales gave me extremely helpful comments on a previous draft Friedman’s help with my project deserves a special acknowledgment I also owe spe- cial thanks to Aronson, my editor at the Harvard

University Press, for his encouragement and deft

management of this project, as well as for many in- sightful comments None of the above is responsi- ble for the errors that remain

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I

The Depression and Its Proximate Causes

A SEQUENCE of dramatic events has culminated in the present economic emergency: low interest rates, a housing bubble, the collapse of the bubble,

the collapse of the banking system, frenzied efforts at resuscitation, a drop in output and employment,

signs of deflation, an ambitious program of recov-

ery I need to trace the sequence and explain how each stage developed out of the preceding one This chapter opens with a brief sketch of the basic economics of depression and of fighting depression and then turns to the particulars of this depression Suppose some shock to the economy—say, a sudden fall in the value of people’s houses and se- curities— reduces the value of personal savings and induces people to spend less so they can rebuild their savings The demand for goods and services

will therefore fall Before the shock, demand and