September 10, 2009

Under Discussion:A Failure of Capitalism: The Crisis of ‘08 and the Descent into Depression. Richard A. Posner. Harvard University Press (2009). 346 pages.

Richard Posner tells us that capitalism has failed, but his own book leads to an entirely different conclusion.

Posner, a noted federal appeals court judge, helped found the “€œlaw and economics”€ movement. This movement views law as a way to maximize economic efficiency. Because of his activities in this movement, as well as his status as a leading light of Chicago School economics, Posner acquired a reputation as a defender of the free market. Is it not big news, then, when a champion of capitalism must admit that something is wrong with capitalism?

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But matters are not what they seem. Posner never was an unalloyed supporter of the free market, and his book does not show that capitalism has failed. True enough, Posner sometimes has opposed excessive government regulation, but he has never defended the free market consistently. Quite the contrary, Posner, a self-proclaimed “€œpragmatist,”€ has always readily jettisoned the free market, and a free society more generally, when he thought it necessary. In his Not a Suicide Pact, for example, he urges that even the slight possibility that we may be subject to terrorist attacks justifies massive intrusions on civil liberties.

More important than mistaken ideas about Posner, though, are mistaken ideas about capitalism, as these can lead to serious policy blunders. Posner says that capitalism has failed:

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 allowing the recession to balloon into a depression, and so have several fortuitous factors. But without any government regulation of the financial industry the economy would still, in all likelihood, be in a depression; what we have learned from the depression has shown that we need a more active and intelligent government to keep a capitalist economy from running off the rails.

Posner’s opinion goes directly against the evidence his own book provides. The crisis began, as everyone knows, as a collapse in the housing market. Investment in real estate, through complicated derivatives and other schemes, spread through the entire economy, so that problems in housing could not be contained. The result was a general crisis.

Posner rightly draws an analogy with the American economy in the 1920s:

A stock market bubble developed in the 1920s, powered by plausible optimism (the years 1924 to 1929 were ones of unprecedented economic growth) and enabled by the willingness of banks to lend on very generous terms to people who wanted to play the stock market. … The current economic emergency is similarly the outgrowth of the bursting of an investment bubble. The bubble started in housing but eventually engulfed the financial sector, becoming a credit bubble.

How then should we explain this crisis? Is it not obvious that we should look for a theory that takes depression to be the outcome of an investment bubble? Posner ignores so evident a point, surprisingly for someone often viewed by his acolytes as a veritable genius. He says, first, that we lack a good theoretical account of the origins of depressions:

At the root of the economics profession’s failure to anticipate and respond decisively to the depression is the fact that the study of depressions is not a very satisfactory branch of economics… As [Nobel Laureate] Robert Lucas has explained, discussing the Great Depression… “€˜We just don”€™t have a decent theoretical model.”€™

But “€œwe”€ lack such a model only if we are Chicago School followers like Lucas or Keynesians like Paul Krugman. There is another account on offer, of which Posner shows himself fitfully aware but never discusses in detail.

Instead, he concentrates almost entirely on the Keynesian and monetarist accounts, deemed by their own advocates to be theoretically unsatisfactory:

The two basic remedial approaches correspond to two theories of the cause of the great depression: the monetarist, that it was caused by the Federal Reserve’s allowing the money supply to shrink, causing deflation”€”and the Keynesian”€”that private demand for goods and services fell drastically in the wake of the stock market crash and the bank insolvencies triggered by it and that the resulting diminution in the money supply resulted from, rather than caused, the reduction in economic activity.

He barely mentions “€œa third causal theory … that the depression was the product of a credit binge in the 1920s,”€ even though this theory gets right, by Posner’s own showing, that both the Great Depression and our current crisis stem from investment booms. He calls this theory by name, the Austrian theory, only once in the entire book.

The essentials of the theory are readily explained. People decide how much to spend on current consumption, and how much to invest, according to their rate of time preference, that is, their preference for present over future goods. The rate of time preference, according to Ludwig von Mises, is the principal component of the rate of interest. As Mises and F. A. Hayek explained, an expansion of bank credit can push the rate of interest below the rate that people’s time preference determines. If the interest rate thus falls, investors will be induced to expand. Money is available; why should they refuse? Additionally, a boom in consumption goods may also occur. When the credit expansion ceases, as it eventually must, these investments prove incapable of being sustained. They must be liquidated, and the process of doing so is precisely the depression.

This account raises a new question: How are the banks able to expand the supply of money? The answer lies in a combination of fractional reserve banking, the ability of banks to issue money in excess of reserves deposited, with the coordination of all banks through the Federal Reserve System. This permits a bank to issue money without fear that customers of other banks, demanding redemption in a quantity too great for it to meet, will force it into insolvency. The bank knows that the system will bail it out in case of an emergency of this kind.

If one accepts the Austrian theory, Posner’s claim of a “€œfailure of capitalism”€ cannot be sustained. The Federal Reserve System is hardly the product of the free market; how then can an investment boom and ensuing depression that its monetary policy makes possible be blamed on capitalism? In a free market, as Mises and Murray Rothbard have argued, money would be a commodity, probably gold, and government manipulation of the money supply could not occur.

Posner offers no arguments against this intellectually satisfying theory. Quite the contrary, he inadvertently lends it support. A common objection to the theory is that prospective investors would be reluctant to proceed, once they became aware that the Fed was attempting to fuel a boom. Would they not realize in advance that investments financed through credit expansion could not be sustained?

Posner convincingly argues that investors who take the proffered money have not been bowled over by emotional contagion but act rationally:

Emotion does play a role in the behavior of businessmen and consumers, as of all human beings, but it is not necessarily or even typically irrational. It is a form of telescoped thinking, like intuition, and it is often superior to conscious analytic procedures. … [I]n settings of profound uncertainty, it may be impossible to do better than to assume that tomorrow will be like today. … It is difficult to second-guess the market”€”before the fall the existence of a bubble could only be suspected, not confirmed.

Of course, Posner has not written this to support the Austrian theory. He is a defender of old-style Chicago School economics, which assumes that people act rationally in their self-interest. He vigorously contests behavioral economics, now fashionable and even ensconced at Chicago itself in the person of Richard Thaler, which contends that human behavior often violates the constraints of reason. But whatever his motives, Posner has done Austrian economics a considerable service!

Posner raises one objection to the Austrian theory:

To blame the government for the depression is questionable. … [E]ven without the Federal Reserve’s loose monetary policy in the early 2000s there would have been enough capital, supplied by the Chinese and others, to keep interest rates low.

But there is all the difference in the world between an increase in capital investment and bank credit expansion. An increase in investment, so long as it is not financed by bank credit expansion, does not artificially lower the rate of interest in a way that leads to business collapse down the road.

The free market has not failed; it has not been tried. But what do we do now? It will come as no surprise that Posner disagrees with the Austrian remedy. As Mises and Rothbard see matters, the government should do nothing. The depression is the process by which the economy rights itself. Bad investments need to be eliminated: for the government to attempt to prop them up would initiate a new artificial boom. The necessary liquidations cannot be indefinitely postponed.

Posner sees danger in such a “€œhands-off”€ policy. Liquidation may result in, horrible dictu, deflation, that supreme evil:

As the price level declines and expectations of a further decline form, consumers may begin to hoard money, expecting it to buy more in the future. … And investors may hoard money too, hoping to buy assets more cheaply as prices continue down. … [I]f consumers and investors hoard, credit will dry up almost completely because borrowing in a deflation is expensive even at a zero interest rate.

But Posner admits that this dire downward cycle will come to an end:

Eventually deflation will bottom out.  As income shrinks, consumers will not be able to hoard cash; they will have to start spending everything they have. As spending picks up, producers will hire more workers, so incomes will rise. A virtuous cycle will be under way.

Why, then, involve the government? Posner answers that the process of market correction takes too long: “€œBut the process of recovery will be protracted because it will begin from an extremely low level.”€

The historical record does not bear out Posner here. Two recent excellent books, Tom Woods’s Meltdown and Robert Murphy’s The Politically Incorrect Guide to the Great Depression and the New Deal, tell a different tale. In the period 1920-21, America went through a depression so short-lived that most people are unaware of its existence. Woods remarks:

By the middle of 1920 the downturn in production had become severe, falling by 21 percent over the following twelve months. Conditions were worse than they would be in 1930, after the first year of the Great Depression. Yet scarcely any American even knows that such a slowdown occurred. That’s probably because, compared to the Great Depression of the 1930s, it was so short lived. … [T]he market was allowed to make the necessary corrections, and in no time the economy was back setting production records again.

Government intervention to help the economy recover is not only unnecessary, it’s harmful. Posner notes some of the bad consequences of the measures he nevertheless recommends:

Programs to transfer wealth are very difficult to abolish because interest groups form about them. That is why there is a danger of excess demand after the depression ends. But perhaps we can”€™t afford to look ahead that far. [!]

As if this were not bad enough, Posner points out that excessive government spending may overshoot the mark and lead to inflation. Would we not be better off, then, to ignore the interventionist nostrums peddled by this pragmatist-utilitarian tinkerer and take our chances with freedom?


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