« Self-Regulation Doesn't Work | Main | links for 2009-04-21 »

Monday, April 20, 2009

Solow: How to Understand the Disaster

Robert Solow reviews Richard Posner's A Failure of Capitalism: The Crisis of '08 and the Descent into Depression:

How to Understand the Disaster, by Robert M. Solow, NY Review of Books: ...Judge Posner ... has an extraordinarily sharp mind... But I also have to say that, in some respects, his grasp of economic ideas is precarious. ...Posner has taught at the University of Chicago. Much of his thought exhibits an affinity to Chicago school economics: libertarian, monetarist, sensitive to even small matters of economic efficiency, dismissive of large matters of equity, and therefore protective of property rights even at the expense of larger and softer "human" rights.

But not this time, at least not at one central point, the main point of this book. ... The underlying argument—it is not novel but it is sound—goes something like this. A modern ... economy ... can probably adapt to minor shocks ... with just a little help from monetary policy and ... automatic fiscal stabilizers... It is easy to be lulled into the comfortable belief that the system can take care of itself if only do-gooders will leave it alone. But that same financial system has intrinsic characteristics that can make it self-destructively unstable when it meets a large shock. ...

In that kind of world, imagine a period of low interest rates. Once a set of profit opportunities is found, big operators will be tempted to borrow so that they can play with much more than their own capital, and thus make very large profits. This has come to be called "leverage." ...

In the past, 10-to-1 leverage would have been about par for a bank. More recently,... many large financial institutions ... reached for 30-to-1 leverage, sometimes even more. ... [I]t is leverage that turns large banks and financial institutions into ninepins that cannot fall without knocking down others that cannot fall without knocking down still others. That seems to be the key to the potential instability of an unregulated financial system. It happens without any of the private actors violating the canons of self-interested rationality. ...

It is a noteworthy intellectual event that Posner has come to this understanding and expressed it forcefully and fearlessly. This same understanding must ... be the key to designing regulations that can reduce the frequency of financial crises like the current one...

There are ... weaknesses in Posner's remarks... For example, more than once he says that the various antirecessionary measures—like fiscal stimulus, bailouts—are very "costly" and "may do long-term damage to the economy." He does not explain what these costs and damages are. Sometimes he seems to have budgetary costs in mind. But bailouts are mostly transfers from one group in society to another... They are certainly not ethically satisfying transfers, but it is not clear how they do long-term damage to the economy. The components of a fiscal stimulus package are costs to the federal budget; but to the extent that they put otherwise unemployed labor and idle industrial capacity to work, they do not impoverish the economy; in fact, they enrich it. ...

There is an even odder chapter called "A Silver Lining?" In it Posner flirts with the idea that a recession, even a depression, has a good side. It weeds out inefficient firms and practices. This is a little like saying that a plague is not all bad: it cleans up the gene pool. No doubt there is some truth to this idea of a purifying effect. But the notion that it could possibly compensate for years of lost output and lost jobs seems wholly implausible. There is certainly no calculation of economic costs and benefits behind the thought of a "silver lining." I think it is another example of overemphasis on minor gains in efficiency and neglect of first-order facts.

Posner's chapter on "The Way Forward" is all of sixteen pages long, and fairly disorganized... This means he does not seriously try to imagine ... an effective regulatory regime... It seems to me that effective limits on leverage ... are basic to controlling the potential instability of the financial system. ...

The financial system does have a useful social function to perform, and that is to make the real economy operate more efficiently. Some human institution has to collect a nation's savings and put them at the disposal of those who have productive ways to use them. Risks arise in the everyday business of economic life, and some human institution has to transfer them to those who are most willing to bear them. When it goes much beyond that, the financial system is likely to cause more trouble than it averts. I find it hard to believe ... that our overgrown, largely unregulated financial sector was actually fully engaged in improving the allocation of real economic resources. It was using modern financial technology to create fresh risks, to borrow more money, and to gamble it away....

Greed and foolhardiness were not invented just recently. The problem is rather that Panglossian ideas about "free markets" encouraged, on one hand, lax regulation, or no regulation, of a potentially unstable financial apparatus and, on the other, the elaboration of compensation mechanisms that positively encouraged risk-taking and short-term opportunism. When the environment was right, as it eventually would be, the disaster hit.

    Posted by on Monday, April 20, 2009 at 05:22 PM in Economics, Regulation | Permalink  TrackBack (0)  Comments (26)

    TrackBack

    TrackBack URL for this entry:
    https://www.typepad.com/services/trackback/6a00d83451b33869e201157032f287970b

    Listed below are links to weblogs that reference Solow: How to Understand the Disaster:


    Comments

    Feed You can follow this conversation by subscribing to the comment feed for this post.