Legal Commentary

Has the Market Economy Failed? Posner

By Richard Posner

I agree with Becker that the effect of the financial crisis on capitalism will depend on the severity of the crisis. Very few people are committed in an emotional sense to a free-market ideology; if the free market seems not to be working, the population and its political representatives will cast about for an alternative. In this longish comment, I respond briefly to some of the readers’ comments on my last week’s post, bring up to date my discussion of the financial crisis, and in closing return to the question whether capitalism has "failed."

1. Several comments note that there were a number of other prophets of doom besides Nouriel Roubini. Here is one: "When the downturn in house prices occurs, many homeowners will have mortgages that exceed the value of their homes, a situation that is virtually certain to send default rates soaring. This will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse, a government bailout (similar to the S&L bailout), involving hundreds of billions of dollars, would be virtually inevitable." Dean Baker, "The Menace of an Unchecked Housing Bubble," The Economists' Voice, vol. 3, issue 4, article 1. Given the multitude of warnings from respectable sources, it is puzzle why the warnings did not stimulate a serious effort to evaluate the health of the financial services industry and the adequacy of regulation.

Part of the answer may lie in a perceptive comment by reader Jamison Davies. He reminds us that "Important to [Roberta] Wohlstetter's argument [about why the Japanese attack on Pearl Harbor achieved surprise] is the concept of the 'signal-to-noise' ratio, i.e. the amount of useful information being taken in compared to the information that is false, misleading, or irrelevant. It turns out that earlier concerns about inflationary spikes may have just turned out to be background 'noise'…as well as other economic issues, but ex ante it is extremely difficult to tell what data will be predictively useful and what is just noise." Davies adds that "the difficulty in early warning, among other things, is that if you give correct warning and act in response to that warning, the attack will likely not materialize (i.e. if the US knew Japan was about to attack Pearl Harbor our defensive preparations would prevent Japan from following through). This means that successful warnings are undercounted because the catastrophe never emerges. This tends to weaken early warning systems as they are perceived to be ineffective even though they may have averted serious problems." Davies points out that "the economic analogy is regulation. Regulations were seen as unnecessary and dismantled because there had been no crises, but policymakers failed to consider that there may have been no crises precisely because of the regulation."

Another comment quotes economist Thomas Sowell as saying: "Failure is an important part of the success of the capitalistic system.”"The commenter adds that in "the free market system, companies that are seriously mismanaged in one way or another will fail, and these failures make room for the ones that are well managed." All true, but in the current crisis many seriously mismanaged firms will be saved by the government, and many firms that are not mismanaged will fail because of the effect of the mismanagement of other firms on consumer demand and the credit market.

2. In earlier posts Becker and I have discussed whether the financial crisis is a liquidity crisis, a solvency crisis, or both. At this writing it seems that it is more a solvency crisis than a liquidity crisis. The initial bailout plan--to buy the sick assets of banks, such as their mortgage-backed securities--was premised on the assumption that the crisis was one of inadequate liquidity: uncertainty or perhaps even unreasoning fear was preventing the sale of bank assets at prices that reflected their "true" value. If this was incorrect--if the problem was not that the banks' sick assets were frozen but that the banks were undercapitalized--the plan would be unsound: either the government would pay the actual, low value of the assets, in which event the banks would have no more capital than before, or it would overpay and thus be giving the banks a gift at taxpayers’ expense. The plan was quickly altered (the U.S. embarrassedly taking its cues from the prime minister of England) from a purchase of assets to a contribution of capital in which the government would receive interest-bearing preferred stock in exchange.

A disturbing note is Secretary of the Treasury Paulson's plea to the banks who have received the capital contribution to lend it out rather than hoard it. What is disturbing is that since banks are in the business of lending and do not receive a return on money that they hoard, they don't need prodding to make loans unless the risks are too great. The risks remain too great unless the capital infusion ($250 billion split among nine banks) is large enough to make the banks adequately capitalized. With the recession/depression spreading and deepening, the risks of lending are growing and so the banks need a bigger capital cushion than when the economy was booming. It will not be prudent for them to lend unless either they have that cushion or the government guarantees the repayment of the loans they make.

3. The severity of the recession/depression precipitated by the financial crisis cannot yet be gauged accurately. One reader amusingly cites the prediction of "Scholars of Astrology" that the economy will recover in seven months. If so, the crisis will not provoke a serious rethinking of the nation's commitment to a market economy. But if the recovery takes substantially longer--if, as seems possible, we are in the midst of the most serious depression since the Great Contraction of 1929 to 1933 (and why has the word "depression" become unmentionable? Why does everyone except me prefer the anodyne euphemism "recession?)--then that commitment will come under fire. Should it?

There are three basic types of economy (with many intermediate possibilities, of course): a pure free-market economy; a regulated market economy; and socialism. In the first, all economic ordering is left to private action: money is private, contracts are enforced not by legal means but by concern with reputation and threats of retaliation, caveat emptor prevails, and the role of government is limited to providing internal and external security against violence. In such a world there are, for example, no restaurant inspectors, and if you get ill eating in a restaurant you have no legal recourse; but restaurants might form voluntary associations that would conduct inspections, and careful consumers would patronize only the members of reputable such associations.

Very few economists support so lean a system of government. Virtually all support a regulated market system in which, for example, victims of food poisoning have tort remedies but systems of restaurant inspection are also instituted, to back up those remedies in recognition that most incidents of food poisoning are not serious enough to warrant the expense of bringing a lawsuit and that many restaurants operate on a shoestring budget and could not pay a substantial tort judgment. An alternative to inspectors might be requiring anyone entering the restaurant business to post a substantial bond and allowing the successful plaintiff in a tort suit against a restaurant to recover his attorneys’ fees. But these are simply alternative methods of regulation rather than a recursion to a pure free-market economy.

Given the history of economic failure under socialism, we should exhaust the possibilities for adopting more effective regulations of the financial-services industry before jettisoning our regulated market system in favor of a socialist one. That is so obvious as not to require argument. What is less obvious is why so many people think that the financial crisis is proof that a market economy does not work and thus we need fundamental change rather than merely incremental regulatory reform.

The answer lies in what conservative economists used to call the "Nirvana fallacy." This is the idea that any failure of the economy to attain optimality is a "market failure" that warrants government intervention. Conservative economists pointed out that the proper comparison is never between the operations of the actual market and an unattainable theoretical perfection, but between market-directed and government-directed or -regulated allocations of resources in particular economic settings. Market failures are ubiquitous, as the current crisis demonstrates. The crisis is not primarily a result of government actions. The quasi-governmental status of Fannie Mae and Freddie Mac and the pressures exerted on them by Congress to facilitate home ownership by insuring risky mortgages were contributing factors to the crisis, but the basic causes were misassessment by the industry of the risks associated with extremely high levels of borrowing, misunderstanding of risk by home buyers encouraged by real estate brokers, mortgage brokers, and banks, conflicts of interest by rating agencies, corporate compensation policies that truncated downside but not upside risk, and the private costs of disinvesting in an industry undergoing a bubble (the housing industry) before the bubble bursts, since until that moment the profits from riding with the bubble will be increasing. An additional factor was government inaction, but the failure of government to intervene in a market that is failing obviously presupposes rather than illustrates market failure. In contrast, gratuitous government intervention when there is no market failure is a genuine example of government failure.

So a confluence of market failures has created an economic crisis, and the challenge is to develop regulatory responses that reduce the cost (net of the direct and indirect costs of the regulations themselves) of such failures. Complacency on the part of some economists and politicians about the efficiency of the market system, and specifically an exaggerated belief in the robustness of financial markets, have created the impression that the current crisis is a crisis of capitalism rather than just another demonstration of the radical imperfection of human institutions--including the market.

Full post as published by Becker-Posner Blog on October 19, 2008 (boomark / email).