Thursday, March 25, 2010

Not A Failure of Capitalism - A Failure To Understand Capitalism

I recently finished reading A Failure of Capitalism by Richard Posner. It is really a very good book, one of the best things I have read about the recent financial crisis. I recommend it highly to anyone who wants to understand how this all happened, and get some insight into the kinds of reforms that might make sense as a way of preventing a recurrence.

Before getting into the basic ideas of Posner's book, a bit of background. Posner is a Judge on the United States Court of Appeals for the Seventh Circuit, located in in Chicago. He is regarded as a leading libertarian conservative who was often on the "short list" of possible Republican nominees to the Supreme Court (although his generally libertarian instincts might make his positions on social issues unacceptable to the religious right). Generally speaking, he is not someone with whom I would ordinarily find a lot of ideological common ground (I once clashed with him in print over something he wrote about one of my cases). Before being appointed to the Federal Bench, Posner was a Professor at the University of Chicago law school, where he was one of the founders and leading proponents of the "law and economics" school of legal thought. This legal philosophy attempts to apply the libertarian economic philosophy of Milton Friedman and other leading lights of the Chicago school of economics to legal analysis. In essence, it is a legal philosophy grounded in principles of laissez faire economics.

Given Posner's intellectual background, A Failure of Capitalism is a remarkable work. It is, almost, a mea culpa for the financial collapse. Posner shows with clear-headed and irrefutable logic that the financial collapse and resulting economic depression - yes, Posner calls it a depression because of the potential danger of deflation, and not just a recession - is attributable to the failure of the U.S. government adequately to regulate financial institutions. The prime culprits in this debacle are (a) the Federal Reserve, particularly under the leadership of Alan Greenspan, at first for failing to recognize the existence of the real estate "asset bubble", and later for assuming that "market forces" would work everything out and that the financial system would correct itself without government intervention; and (b) the political leadership of both parties, including President Clinton and the Republican Congress, for enacting the Gramm-Leach-Bliley Act of 1999, which repealed the Glass-Steagall Act without implementing any alternative regime for regulating the financial industry.

Posner's step-by-step economic analysis of the forces that led to the collapse is a tour de force. I must confess that Posner's grasp of technical economic analysis exceeds my own; I could follow it as I was reading it, but I would be hard-pressed to reproduce it. In summary, Posner disposes of the many myths that have sprung up about the origins of the financial collapse:

1. Posner demolishes one of the right-wing's favorite hobby horses, namely, the claim that the Community Reinvestment Act was responsible for the financial collapse by promoting subprime mortgages for unworthy borrowers. In fact, this Act had a very limited scope and it had almost nothing to do with the events that led to the financial meltdown of 2008.

2. Posner offers a nice rejoinder to the conventional assertion that the financial collapse was attributable to too much "greed" on Wall Street. Posner argues that "Wall Street" acted exactly the way it is supposed to act, and that blaming the financial collapse on "Wall Street greed" would be like blaming a lion for killing a zebra - it is the nature of the beast. It is precisely for that reason that the government must regulate financial markets, and again, Posner demonstrates that the collapse was clearly the result of a massive regulatory failure.

3. Posner also dismantles the claim that the collapse was attributable to irrational, panicky behavior by financial institutions. Again, Posner's meticulous economic analysis shows that at every step of the way, financial institutions acted rationally, exactly the way you would expect them to act as rational profit-maximizers in a "free market" system - and that rational market-based behavior nevertheless resulted in a meltdown of the financial system.

In sum, Posner concludes that the financial collapse was attributable to the mistaken belief that markets are always self-correcting; that if financial institutions are left to their own devices such that market participants can act in an unregulated rational profit-maximizing manner, an end-result beneficial to society will be achieved; and that any form of governmental regulation is not only unnecessary, but harmful. Posner shows just how wrong these beliefs have proven to be, and that to the contrary, governmental regulation of the financial industry is essential. Having come to this realization, Posner therefore describes the financial collapse as "a failure of capitalism." It is here, however, that I part company with Posner.

By characterizing the financial collapse as a "failure of capitalism" Posner is accepting the idea that "capitalism" is at odds with government regulation. By promoting the very notion that the "free market" can be set up as something inconsistent with government regulation, so-called "libertarians" - often including Posner himself - have done the public an enormous disservice. The idea that capitalism is something that can exist without government regulation, and that any form of government regulation is inherently destructive of capitalism, is an idea that originated with the Austrian economists Ludwig Von Mises and Friedrich Hayek, got promoted in the U.S. by Milton Friedman and the rest of the Chicago school of economics, was popularized and dumbed-down in the trashy novels of Ayn Rand (of whom Greenspan was a devotee), and ultimately worked its way into mainstream politics through Ronald Reagan and Margaret Thatcher, who always spat out the word "government" as though it were the foulest sort of cuss-word imaginable. The consequences of this fundamental misunderstanding of the nature of capitalism have been dire indeed, ultimately bringing about the global financial meltdown of 2008, as Posner so forcefully demonstrates.

In many respects, it is a mistake to think of capitalism as an "economic" system at all. In reality, it is a legal/political system. Markets do not exist in a state of nature. Markets exist because governments establish laws and rules that make market transactions possible. Government is not the enemy of the free market; government is the creator of the free market.

To illustrate this, let's consider a very simple example of a market transaction that can be found in one version or another in virtually every basic economics textbook. Buyer wants some widgets; Seller has some widgets. They get together and they consummate a transaction at a price determined by the supply of available widgets and the demand for widgets among consumers. While this simple example might be helpful in understanding the principles of supply and demand, it only works in the Garden of Eden where widgets are simply lying about and nothing has to be done to produce them. The example has very little relevance to understanding the actual operation of capitalism.

Assume that Buyer wants widgets and Seller knows how to produce widgets and has the means to do so. Once again, they shake hands and agree upon a transaction at a price for the widgets determined by supply and demand. It will take about thirty days for Seller to produce and deliver the widgets. Suppose that as the thirtieth day approaches, something has happened that has affected the supply and demand for widgets, e.g., a war has broken out; or there has been a natural disaster; or there is a new craze making widgets more popular; or conversely evidence has come to light that widgets may cause cancer making them very unpopular; or there has been some technological breakthrough that makes it much cheaper to produce widgets, etc., etc. On the thirtieth day, Buyer may decide he no longer wants the widgets or at least he doesn't want them at the agreed-upon price, or on the other hand, Seller may decide that he no longer wants to sell the widgets at that price. If Buyer and Seller knew that all of these eventualities could happen and that the other side might renege on the deal, they probably would not have entered into the transaction in the first place. So, the government has to step in and set up a bunch of rules to determine when agreements between buyers and sellers either are or are not enforced. That is called the law of contracts, and without it, capitalism cannot exist.

Most libertarian conservatives would agree that it is appropriate for the government to enforce contracts and property rights, but not to do much of anything else. This restriction on the scope of appropriate governmental action, however, is entirely arbitrary. Indeed, it does not take very much imagination to see that there is a plethora of reasons why the government must be actively involved in laying out and enforcing rules in order to enable capitalism to work. Going back to my simple example of Buyer, Seller, and their widgets:

- Suppose Seller has built a factory to produce these widgets, but there are armed gangs roving the neighborhood who are threatening to damage the factory if Seller does not pay them protection money, which may make it difficult to deliver the widgets in thirty days. The government now has to step in and enforce some criminal laws.

- Suppose Buyer isn't sure that Seller is the best producer of widgets, so Seller gives Buyer some information about the quality of his widgets. It turns out that Seller's widgets are actually of very poor quality and that the information Seller gave to Buyer was not true. We now need the government to enforce some consumer protection laws.

- Suppose the workers in Seller's widget factory are not happy with the wages they are being paid and they want to form a union so they can get into a stronger position to negotiate with Seller. The workers are threatening a strike, which again may affect Seller's ability to deliver the widgets within thirty days. We now need some labor laws.

- Suppose Buyer has gone around and worked out a secret deal with everyone who might be in the market to buy widgets to ensure that no one will pay more than a particular price for widgets. Welcome to antitrust law.

- Suppose these widgets do cause cancer, and ultimate consumers of the widgets would like to get some redress against both Buyer and Seller for the damages they suffer. We now need products liability laws.

- Suppose Buyer and Seller are both concerned that they are going to be held liable for damages caused by the widgets, and if they are going to continue in this business, they'd like to do it in a way that limits their personal liability. Corporate law now comes into the picture.

- Suppose Seller decides that having set up a corporation to own and operate his widget factory, he can vastly expand the factory by soliciting additional investments in the corporation from members of the investing public. We now need a law of securities regulation.

- Suppose that the government that is making and enforcing all of these rules needs some money to fund itself, and it decides that it is appropriate for Buyer and Seller to bear some of the cost of operating the government. Now we need tax laws.

Obviously, I could go on spinning off examples like this for some time - indeed, law school is generally a three-year program. However, even this very simple example shows how absurd it is to think of capitalism as a system that can possibly exist without government regulation. The Reagan/Thatcher formulation of "markets good, government bad" is just childish poppycock - poppycock that has done a great deal of damage.

Thus, the concept of regulation vs. de-regulation represents a false choice. It is inevitable that you are going to have some kind of regulation in any capitalist society. The real question is whether you are going to have regulation that works as opposed to regulation that doesn't. The ultimate test is relatively simple to state, but very difficult to implement in practice: good regulation enables markets to function efficiently.

In an earlier post, I set forth the view that no one can seriously put forward the argument that socialism is a viable alternative to capitalism as a model for organizing a society's economic activities. The mistaken belief that any form of governmental activity is the equivalent of "socialism" is really the flip-side of the mistaken belief that "capitalism" means the absence of governmental activity.

So, Judge Posner, while you have written an outstanding book, I take issue with your title. It was not a "failure of capitalism" that nearly destroyed the global financial system; it was a failure to understand that capitalism necessarily requires governmental regulation in order to function.

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