Legal Commentary

The Financial Crisis: the Role of Government--Posner

By Richard Posner

I agree with Becker that capitalism will survive the current financial crisis, even if it leads to a major depression (which it may not). It will survive because there is no alternative that hasn't been thoroughly discredited. The Soviet, Maoist, "corporatist" (fascist Italy), Cuban, Venezuelan, etc. alternatives are unappealing, to say the least. But capitalism may survive only in damaged, in compromised, form--think of the spur that the Great Depression gave to collectivism. The New Deal, spawned in the depression, ushered in a long era of heavy government regulation; and likewise today there is both advocacy and the actuality of renewed regulation. I would like to examine the possibility that government is responsible for the current crisis; for if it is, this would be a powerful intellectual argument against re-regulation, though not an argument likely to have any political traction.

I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity). Leverage enables greatly increased profits in a rising market, especially when interest rates are low, as they were in the early 2000s as a result of a global surplus of capital. The mistake was to think that if the market for housing and other assets weakened (not that that was expected to happen), the lenders would be adequately protected against the downside of the risk that their heavy borrowing had created. The crisis erupted when, because of the complexity of the financial instruments that were supposed to limit risk, the financial industry could not determine how much risk it was facing and creditors panicked. Compensation schemes that tie executive compensation to the stock prices of the executives' companies but cushion them against a decline in those prices (as when executives are offered generous severance pay or stock options are repriced following the fall of the stock price) further encouraged risk taking. Moreover, even when businesses sense that they are riding a bubble, they are reluctant to get off while the bubble is still expanding, since by doing so they may be leaving a lot of money on the table. Finally, if a firm's competitors are taking big risks and as a result making huge profits in a rising market, a firm is reluctant to adopt a safe strategy. For that would require convincing skeptical shareholders and analysts that the firm's below-average profits, resulting from its conservative strategy, were really above-average in a long-run perspective.

It should be noted that because of the enormous rewards available to successful financiers, the financial industry attracted enormously able people. It was not a deficiency in IQ that produced the crisis.

Becker makes incisive criticisms of the government's responses to the crisis. He points out that those responses create moral hazard, specifically a bias toward financing enterprise by bonds rather than by stock because the government's bailouts are limited to the bondholders and other creditors; create additional moral hazard because the responses include extending government insurance of deposits to money market funds; impede hedge funds by forbidding short selling, which enables the funds to hedge their risks; reduce information about stock values (another consequence of forbidding short selling); increase regulation of financial markets, which will carry with it the usual heavy costs of heavy-handed regulation; blur the role of the Federal Reserve Board by increasing its powers and duties; and increase the federal deficit.

But here is a remarkable thing about these responses. To a great extent they are not responses by government, really, but by the private sector. Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition of short selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis. In effect, the government's power to repair the crisis that Wall Street created has been delegated to Wall Street.

It is true that the top financial officials of our government have usually come from the financial industry or academia. The difference is how recently Bernanke and especially Paulson were appointed, how heavily they are relying on financial experts from the private sector rather than on civil servants, and how small a role the politicians in Congress and the White House have played in shaping the response to the crisis.

I do not criticize the delegation of the handling of the crisis to (in effect) the finance industry. I imagine that Bernanke and Paulson and their private-sector advisers are the ablest crisis managers whom one could find. I merely want to emphasize that the financial crisis is indeed a "crisis of capitalism" rather than a failure of government, though it will not and should not lead to the displacement of free-market capitalism by an alternative system of economic management. But it is already shifting the boundary between the free market and the government toward the latter.

Full post as published by Becker-Posner Blog on September 21, 2008 (boomark / email).