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How to Understand the Disaster

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Susan Walsh/AP Images
Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke at a congressional hearing on oversight of the federal government’s intervention at AIG, Washington, D.C., March 24, 2009

To make progress in that direction requires some understanding of the origins of the current mess. I once saw a hospital discharge diagnosis that read “sepsis of unknown etiology”; that sort of thing will not help in this case. The need is not only for a clear picture of what happened but for an assessment of the motives and actions of the main players, the causes and consequences of what they did, and the ideas and institutions that encouraged, inhibited, and shaped the outcomes. Richard Posner’s book is intended to fill that need, in clear and understandable language. I think it is at best a partial success; it gets some things right and some things wrong, and the items on both sides of the ledger are important.

More striking than what the book says is who says it. Posner is a judge of the US Court of Appeals for the Seventh Circuit, and so preeminently a lawyer. In addition, he is an apparently inexhaustible writer on…nearly everything. To call him a polymath would be a gross understatement. A partial list of his publications in the past ten years alone includes How Judges Think; Law, Pragmatism and Democracy; Frontiers of Legal Theory; the seventh edition of his Economic Analysis of Law (first published in 1973); the third edition of Law and Literature; three volumes of essays on The Economic Structure of Law; and books on plagiarism, constitutional aspects of national emergencies, the election of 2000, the US domestic intelligence system, countering terrorism, public responses to the risk of catastrophe, the Clinton impeachment, dealing with the AIDS epidemic, and, significantly, Public Intellectuals: A Study of Decline. There is a prehistory of still more books, and many articles in legal and other periodicals.

Judge Posner evidently writes the way other men breathe. I have to say that the prose in this book often reads as if it were written, or maybe dictated, in a great hurry. There is some unnecessary repetition, and many paragraphs spend more time than they should on digressions that seem to have occurred to the author in mid-thought. If not exactly chiseled, the prose is nevertheless lively, readable, and plainspoken. The haste may have been justified by the pace of the events he aims to describe and explain. Posner has an extraordinarily sharp mind, and what I take to be a lawyerly skill in argument. But I also have to say that, in some respects, his grasp of economic ideas is precarious. In his book on public intellectuals, Posner blames the decline of the species on the universities and their encouragement of specialization. I may be acting out that conflict. Remember that even hairsplitting is not so bad if what is inside the hair turns out to be important.

The plainspokenness I mentioned is what makes this book an event. There is no doubt that Posner has been an independent thinker, never a passive follower of a party line. Neither is there any doubt that his independent thoughts have usually led him to a position well to the right of the political economy spectrum. The Seventh Circuit is based in Chicago, and 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. Here is one of several statements he makes:

Some conservatives believe that the depression is the result of unwise government policies. I believe it is a market failure. The government’s myopia, passivity, and blunders played a critical role in allowing the recession to balloon into a depression, and so have several fortuitous factors. But without any government regulation of the financial industry, the economy would still, in all likelihood, be in a depression; what we have learned from the depression has shown that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails. The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.

If I had written that, it would not be news. From Richard Posner, it is. The underlying argument—it is not novel but it is sound—goes something like this. A modern capitalist economy with a modern financial system can probably adapt to minor shocks—positive or negative—with just a little help from monetary policy and mostly automatic fiscal stabilizers: for example, the lower tax revenues and higher spending on unemployment insurance and social assistance that occur in a weakening economy without any need for deliberate action. 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. One such characteristic is asymmetric information: some market participants know things that others don’t, and can turn that knowledge into profit. Another is the capacity of financial engineering to produce securities so complicated and opaque—for example, collateralized debt obligations and other exotic derivatives—that almost no one in the market can understand their implications. (Insiders still have an exploitable advantage.)

Yet another characteristic is the inevitability of market imperfections, so that what is essentially the same object can sell for two or more different prices; or so that some market prices can be manipulated by large, informed operators; or so that some markets take a long time to match supply and demand. And yet another is the possibility that large financial institutions can raise large sums of credit, in amounts and ways that can affect the whole system, without anyone taking account of, or feeling responsible for, the systemwide effects.

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.” Suppose I have $100,000 of my own, and I see an opportunity to earn a 10 percent return. If it pans out, I make $10,000; if it earns nothing, I have my original stake. If it loses money, that comes out of my initial capital. But I have a shot at something bigger. I can borrow $900,000 at, say, 5 percent interest, and invest the whole million. If it earns the expected 10 percent, I have $1,100,000; I can pay off my debt, plus interest of $45,000, and have $155,000 left. I have earned 55 percent on my money. Only in America! Of course, if the investment earns zero, I must still pay back my borrowing, with interest, which leaves me with $55,000. I have lost almost half of my capital; and it could be worse. Risk cuts both ways. What I have just described is 10-to-1 leverage; the size of the total bet is ten times my equity.

In the past, 10-to-1 leverage would have been about par for a bank. More recently, during the housing bubble that preceded the current crisis, many large financial institutions, including now-defunct investment banks such as Bear Stearns and Lehman Brothers, reached for 30-to-1 leverage, sometimes even more. So suppose I borrow $2.9 million to go with my very own $100,000—leverage of 29 to 1. I can buy $3 million of whatever asset I fancy. If it earns 10 percent, I repay the $2.9 million plus $145,000 in interest and go home with $255,000, having earned a mere 155 percent on my own capital. But now, if the investment earns zero, I have an asset worth $3 million and liabilities of $3.045 million. I am, to coin a phrase, bankrupt. And this is when I have invested in an asset that is worth, at the end of the year, exactly what I paid for it at the beginning. If I had bought a piece of a complicated package of subprime mortgages, as many investors did, it might be worth less than I paid for it a year ago. In fact, there might be no takers at all. There is no way of knowing what the package of mortgages might be worth in a couple of years; when it comes to raising more cash to cover my debt, it is worth essentially nothing, i.e., it can neither be sold nor used as collateral. Whoever lent me the $3.045 million, including interest, has lost the whole thing.

Why did I do such a risky and, as it turned out, stupid thing? Well, it had worked in the past, and made a lot of money for many people. If I had backed off, others would probably have continued to make money for a while. I would have looked like a fool, and very likely an unemployed fool.

This sob story is just the beginning. Many highly leveraged financial institutions—banks, hedge funds, and insurance companies among them—have dug themselves into similar, interconnected holes. They have borrowed from other financial institutions to make complicated bets on risky assets, and they have lent to other leveraged financial institutions so that those institutions could make complicated, risky asset bets. These are the “toxic assets” that weigh down the balance sheets of banks. No one knows for sure what anyone else is worth: they own assets of uncertain value, including the debts of other institutions that own assets of uncertain value.

All those banks and others are now unwilling to lend to one another because they fear that the potential borrower is already broke and will be unable to repay. And so the credit markets freeze up and ordinary businesses that need credit for ordinary business purposes find that they cannot get it on any reasonable terms. This is what happened in September 2008 when the commercial paper market—the market for daily business borrowing—ceased to work. The breakdown of the financial system exacerbates the recession; many who want to buy or build cannot get credit with which to do so. The recession then endangers the solvency of more financial and nonfinancial borrowers and worsens the state of the financial system.

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