A Failure of Capitalism: The Crisis of '08 and the Descent Into Depression, by Richard A. Posner, Harvard University Press, 346 pages, $29.95
During the current financial crisis, it has become de rigueur at financial conferences to open with economist jokes. Here is a personal favourite: A man walked into a bar holding an alligator. He asked the bartender, "Do you serve economists here?" The bartender said, "Yes, we do!"
"Good," replied the man. "Give me a beer, and I'll have an economist for my alligator."
The past 12 months have been very bad for economists, which may come as a surprise. After all, we have never seen so many economists get so many column inches, minutes on television and generally reverential treatment. The credit crisis has even created its own cadre of semi-celebrity economists, such as Nouriel Roubini and Simon Johnson, as well as reinforcing the status of others, such as Nobel Prize-winning economist and New York Times columnist Paul Krugman.
Despite the newfound celebrity status of some of its practitioners, all is not well in econo-land. Economists are being ridiculed for failing to identify this crisis in its formative period over the past decade. Most famously, U.S. central banker Alan Greenspan missed it repeatedly on the way up, contributed to its severity and then confessed more recently to a "flaw" in his thinking.
As the prolific Judge Richard Posner points out in A Failure of Capitalism , his new book on the crisis, economists failed us. As late as September, 2007, we had the University of Chicago's Robert Lucas saying he was "skeptical" that the subprime mortgage crisis would "contaminate the whole mortgage market." A year later, Lucas, and other economists, denied that we were in a recession, even though it would turn out shortly thereafter that we had been in one for almost 10 months.
Economists also tore themselves to public shreds during debate over the past 12 months about what to do. More stimulus or less stimulus? We had prominent economists arguing both sides. Lower interest rates or higher interest rates? Again, economists on either side. Deflation or inflation as the major concern? You guessed it: economists on both sides of the question. The list went on and on, and it became publicly and embarrassingly obvious that economics, outside of a few basic pricing, trade and profits tenets, has so little consensus as to make astrologers look predictable when it comes to policy prescriptions.
There are yawning fault lines in the field, most of which date back to the Great Depression and before, and while some economists had pretended that things were resolved - we're all Keynesians now - it has become clear that little of importance has been resolved, the discipline is in severe distress and economics' privileged policy position is threatened.
Enter Judge Posner. A brilliant conservative user of economic thinking, Posner is a leader in the so-called "law and economics" movement, applying economic methods to the analysis of new and existing laws. For his part, he considers this downturn a "depression."
While he is not the first to use the d-word, he is, to my knowledge, the most sober-minded and respected thinker to publicly deem this downturn something more than the ubiquitous and clunky construction, The Most Severe Recession Since the Second World War (TMSRSSWW).
His conclusion, in short, is that, in the United States, this crisis was caused by a combination of things: an asset bubble in housing; low personal savings; high levels of personal indebtedness; low (and negative real) interest rates in the early part of the decade; excessive securitization; and an inflow of foreign capital that masked the savings problem for too long. The situation was made worse, Posner argues, by confused and inconsistent government actions as the crisis deepened, like saving Bear Stearns in March while letting Lehman Brothers fail in September. All of these factors are lucidly explained in the book, and well worth reading for the particulars of how they conspired to create this mess.
Granted, I don't agree with all of it. For example, Posner's view is that it was clear which brokers should be saved and which ones shouldn't. That is too easy, in retrospect. This was a fast-moving situation and there were a central banker, in Ben Bernanke, and a treasury secretary, in Henry Paulson, who, while smart and experienced, were making it up as they went along, unsurprising given the unprecedented nature of the crisis. It is facile now to say, as Posner does, that we should have saved Lehman, because doing otherwise would lead to immense disruption. As Michael Milken, the disgraced former financier, is fond of saying to economists, "You get full points for telling me these things before they happen."
All of this, however, puts Posner in something of a box. While far from doctrinaire, he is a card-carrying Chicago-school conservative, albeit one who practises within the confines of law rather than in orthodox economics. Nevertheless, having rightly savaged economics and its practitioners, whether in government, industry or academia, for their errors and model failings in missing the current crisis, where does that leave him? After all, the credibility of law and economics, as a movement, comes in large part not just from using the methods of economics in its analysis, but in the credibility of economics as a discipline from which to build legal theory. If we have shown economics to be ad hoc and markets to be largely psychology experiments, where does that leave Posner himself?
Not surprisingly, he has an answer. A subtext throughout the book is that, despite all the clamour and crisis, investors are rational. At one point, he says it is "risky but not irrational to follow the herd. ... That is why buying a stock when others are buying it and thus forcing up its price is not irrational."
He continues, "The line between the rational and the irrational is at best unclear, and this is one reason for not placing much emphasis on the irrational aspects of economic behaviour."
It is a remarkable statement. Why? Because you might more credibly argue the opposite. If the line between rational and irrational behaviour is unclear, and if the consequences of market failures as a result of irrational behaviour are so dire, should we not place most of our emphasis on the irrational aspects of human economic behaviour? In other words, given the tendency of humans to act in strange, panicky and unpredictable ways, should we not construct markets and regulations that prevent humans from hurting one another, and hurting the rest of us?
That is, in essence, the argument made by Nassim Taleb, of The Black Swan fame: that because we know so little about markets, and because humans are so unpredictable, our emphasis should be on protecting ourselves and our financial systems from their self-destructive tendencies, many of which are driven by nutty humans doing nutty things.
It is a delicate balancing act. Posner believes in the importance and utility of economic methods, but he needs to find a way to make sure that the current crisis, with its inevitable fallout for economics, doesn't contaminate all of economics, turning it into a subset of psychology. In that, I think he fails. His book has many strengths, including the most lucid and dispassionate explanation of this crisis currently in print, as well as some brief but sensible policy prescriptions. But the genie is out of the behavioural finance bubble, and no redefinition of "rational" will put it back in. While that is probably good for the health of future markets, economics and economists will never be the same.
Paul Kedrosky is a senior fellow with the Kauffman Foundation, an analyst for CNBC television, a columnist for TheStreet/RealMoney, and the author of the popular business blog Infectious Greed.