The Rational Crisis - Richard Posner takes on the financial meltdown.

Coming from a leading free-marketer, Richard Posner’s new book may look at first glance like a confession of intellectual defeat. Actually, it is closer to healthy self-criticism. Capitalism, writes Posner, should be not rejected but repaired. Posner has joined the still-modest number of scholars who try to understand their mistakes without jettisoning their entire system of beliefs. Former Federal Reserve chairman Alan Greenspan became a member of this group after publicly admitting some months back that he had overrated the financial markets’ capacity to self-regulate. Posner, however, goes much deeper: his book offers a sophisticated explanation of what he sees as an approaching, if unacknowledged, depression—one that will last for some years and deeply threaten our society.

To grasp the depth of Posner’s arguments, I suggest reading the book twice—and that won’t be a hardship, since it is relatively short, fluently written, and devoid of jargon and mathematical formulae. A first read brings no major surprises: Posner provides a thorough account of how the United States, in preferring speculation to savings, inflated the real-estate bubble, and of how the bubble’s burst imperiled the entire financial system—leading Posner to call it a depression instead of a recession. He regards recessions as normal features of a capitalist economy, the occasional responses to external shocks (oil price hikes, for example) or internal ones (as when innovation displaces industries and workers). In a depression, by contrast, the whole economy spirals downward, and investments and innovation stop.

Though Posner is a jurist rather than an economist by training, he sees the big picture better than many economists do. Yet writing in the aftermath of financial meltdown, he yields to the temptation to build causal arguments ex post facto. Was it really that evident when Lehman Brothers went bankrupt last fall that a global stock-exchange crash would occur? Eventually, like a newborn Keynesian, Posner blames the crisis on an absence of regulation and sees more regulation as the cure, overlooking how heavily regulated the markets already were. Certainly the existing regulations weren’t adequate, but to this day, no one knows for sure what the right regulatory approach would be.

On a second reading, one begins to realize that Posner’s book is an explosive manifesto in the ongoing philosophical feud among economists between rational-action theorists and behaviorists. This may sound arcane and tangential—but it’s central. Today, free-market economists and the politicians who more or less follow their lead split into two leading schools of thought. On one side, the rational-action theorists, led by Chicago economist Gary Becker, think of individuals as behaving rationally, with their own best interests in mind; each of us acts to maximize his profit, based on the available information. A stock trader, for example, will deliberately take huge risks if he believes that he can earn a sizable profit. To act “greedy” is rational when the bonus system common to financial firms rewards such greed.

Behaviorists, on the other hand, based on some still-limited psychological experiments and brain scans, conclude that individuals are moved more by passions—Keynes called them animal spirits—than by reason. (Nobel Prize–winning psychologist Daniel Kahneman is the founding father of this school, and Robert Frank, author of the just-published The Economic Naturalist, is its best public advocate.) We thus are prone to make financially unsound choices that eventually work against our best interests. Rational-action theorists are inclined to let individuals choose what’s best for them in slightly regulated markets where information flows abundantly. Behaviorists suggest strong government regulations to protect people against their own instincts.

Not surprisingly, Posner sides with the rational-action theorists (he and Becker author a weekly blog, applying the theory to all manner of things). He shows how unbridled rationality could lead us into a depression, without making any psychological or moralistic judgment about it. We’ve already seen how rational-action theorists view stock traders’ behavior as rational within the context of the bonus incentive. Bankers, for their part, may have provoked the crisis by excessive fund leveraging and hazardous credit: these were rational choices, from their perspective. If bankers hadn’t joined the bubble, their customers would have fled, attracted by competitors offering higher returns. Bankers knew that they ran the risk of bankruptcy someday in the future: they weren’t stupid, Posner reminds us. They understood that the bubble would eventually burst, but the risk of bankruptcy is part of a banker’s entrepreneurial existence. It was rational to accept that risk when the returns were high: at the end of the day, or at the end of the year, the banker might lose his company, but if his personal savings were massive enough, he had no rational reason to care.

What about subprime lenders, mortgage buyers, and credit-card consumers? When credit was so cheap and real-estate values endlessly climbing, they would have been irrational not to join the fray. According to Posner, then, each economic actor acted rationally within a dangerous framework. Who was responsible for the outcome, then? Those who designed the rules, he argues, not those who played by them.

Posner proposes two explanations for the regulators’ failure. First, he indicts economists as a profession: they neglect to study depressions because they’re such rare events. It’s quite true that most economists, the free-marketers at any rate, acted as if depressions could never occur again—a “fatal conceit,” as Hayek might have put it.

Second, Posner argues, free-market economists have been too ideological in their commitment to a deregulation-first approach. They mistakenly argued that deregulation of the financial markets would have the same beneficial effects as deregulation within the real economy, such as in the airlines or telecommunications industries. Posner is right about this: financial markets and the real economy do not follow the same logic, as Yale’s Benoit Mandelbrot and Columbia’s Rama Cont (not cited by Posner, unfortunately) have demonstrated. The real market, Mandelbrot shows, follows rather predictable rules, while the financial markets obey a law of “wild randomness” or the Black Swan Effect, a term coined by Nassem Taleb, a Mandelbrot disciple. Financial markets therefore require prudent regulation in order to limit, to the extent possible, the most extreme consequences of wild randomness.

If an imaginary trial took place to adjudicate responsibility for the financial crisis, Judge Posner (he sits on the U.S. Court of Appeals) would most certainly exonerate the business community, which acted rationally, in his view. The economists would go free on bail and under probationary warning to modify their theories. The politicians would be blamed for failing to prepare any contingency plans—and they still don’t have a clear one, Posner complains. His own suggestion is that the United States should build the equivalent of a financial CIA to protect the market against major threats. He cites a historical precedent: when the Japanese attacked Pearl Harbor, no institution was in charge of putting together the myriad of scattered data that were available and that might have, once gathered, served as a warning.

Beyond Posner’s remarkable book, one is tempted to add a general commentary on all that has been published on the current crisis. Most commentators, motivated by science, ideology, angst, or revenge, try to explain the crisis as if it had to happen. They selectively find in the recent past the logical causes that inevitably led to the crisis. This approach recalls what the French historian Fernand Braudel criticized in studies of the eighteenth century that viewed the French Revolution as inevitable. The revolution, Braudel argued, could very well not have happened at all; history follows no necessity. The same applies to economics. Crises aren’t doomed to happen. Depressions remain unpredictable by definition; they obey only wild randomness. The I-told-you-so pundits fall into a logical trap, confusing failures in capitalism, which happen and will continue to happen, with the notion that they had to happen. Yet only Karl Marx believed that capitalism was fated to disappear in a final crisis, and he was more a messiah than a scientist. We should explore the way out of the current crisis with humility and caution.

Guy Sorman, a City Journal contributing editor, is the author of numerous books, including the forthcoming Economics Does Not Lie.

The free market does not inherently prefer “speculation” to savings. This is, in any case, a false dichotomy. Speculation is something one can do with savings: it means just a risky gambling with money, which must be saved first in order to play the game. People go for risk only if the potential payoff is large. They do this especially when more reasonable, lower-risk investments are made unproductive.

One reason we have so little saving is that the government and the Federal Reserve system have made sure that IT SELDOM PAYS. Why should someone want to save money in order to earn 0.02% interest? And then when you do earn the interest, it is taxed rather heavily in one way or another! It is perfectly rational to figure that instead of locking up your money is an account which pays almost nothing, it is better to spend it on imported flat-screen TVs and other such enjoyable toys.

In order to make up for this, the Fed floods the country with fiat money. The government runs programs designed to provide loans at artificially low rates, sluiced into politically favored areas. The government has long indulged in the fallacy that this activity was free, and risk-free, because they would “guarantee” the loans. Hence we had the subsidizing of low interest rates for homes (Fannie Mae and Freddie Mac), tax-breaks for mortgage payments, and the student-loan program, &c. This misallocates capital, and together with the government discouragement of savings, almost guarantees that there is less available for industrial development. Of course, it doesn’t help much when the Obama administration ignores the law and stiffs debt holders who had invested in Chrysler and GM, and then demonizes them as selfish “speculators.”

The government policy now is neo-Keynesian: that is, it believes that the economy is stimulated by “demand” in the form of money. The Obama advisors scoff at “supply side” economics, the reasonable idea that productivity is what makes an economy go.

It you really believe that inflating the currency causes production and wealth, kindly pay a visit to Zimbabwe.

If running large deficits really helps the economy, why are we set to run a Federal deficit this year of only a mere two trillion, when we should do better with four, or eight trillion deficit? Might as well get some real, high-test stimulus, if we’re going to do it.

Posner has joined the still-modest number of scholars who try to understand their mistakes without jettisoning their entire system of beliefs. Former Federal Reserve chairman Alan Greenspan became a member of this group after publicly admitting some months back that he had overrated the financial markets’ capacity to self-regulate.

How about Greenspan's mistake in artificially lowering interest rates? That wasn't a failure to regulate, but a failure of the regulators.

How about the Community Reinvestment Act's outcome leading regulators to pressure lending institutions into unsound, speculative loans? That wasn't a failure to regulate, but a failure of the regulators.

How about Freddie and Fannie backing, buying, and bundling the crap paper? Wait! That was a failure to regulate. That was a failure to regulate government sponsored entities, run by political hacks with an agenda, but backed by the taxpayer. Or maybe that was a failure to regulate?

In a depression, by contrast, the whole economy spirals downward, and investments and innovation stop.

If this turns into a depression (i.e., 10% drop in the GDP), the blame lies entirely at the feet of Obama and the Keynesian/Socialists who created a crisis of uncertainty. Obama is changing the rule of law to suit his ideological whim (e.g., pushing the first-in-line bondholders to the back of the line, letting judges artifically change the rule of law in bankruptcy, etc.). In this environment, capital heads for the safety of the sidelines. How can one invest when the rules are unknown? This is the same problem we had in the 30s when Roosevelt kept changing the rules of the game.

Though Posner is a jurist rather than an economist by training, he sees the big picture better than many economists do.

A "big picture" lawyer who knows "big picture" economics suggests Keynesian meddling. Isn't this an anti-trust guy who seeks to destroy or break up overly successful businesses?

Posner blames the crisis on an absence of regulation and sees more regulation as the cure,

Wrong, wrong, wrong, wrong, wrong. That's the sophomoric response of a leftist. The politization of regulation is not the same as its failure.

overlooking how heavily regulated the markets already were. Certainly the existing regulations weren’t adequate, but to this day, no one knows for sure what the right regulatory approach would be.

Better analytically. Score one for the reviewer.

Behaviorists, on the other hand, based on some still-limited psychological experiments and brain scans, conclude that individuals are moved more by passions—Keynes called them animal spirits—than by reason. (Nobel Prize–winning psychologist Daniel Kahneman is the founding father of this school, and Robert Frank, author of the just-published The Economic Naturalist, is its best public advocate.) We thus are prone to make financially unsound choices that eventually work against our best interests. Rational-action theorists are inclined to let individuals choose what’s best for them in slightly regulated markets where information flows abundantly. Behaviorists suggest strong government regulations to protect people against their own instincts.

In short, free market economists believe people can make their own decisions. The other guys (e.g., the Lord Obama) think they're smarter than the rest of us and need to "protect" us from our own bad decisions.

Bullchips! This can only happen if the government is creating an irrational environment, which places the blame, not on people, but the government.

Bankers knew that they ran the risk of bankruptcy someday in the future: they weren’t stupid, Posner reminds us. They understood that the bubble would eventually burst, but the risk of bankruptcy is part of a banker’s entrepreneurial existence. It was rational to accept that risk when the returns were high: at the end of the day, or at the end of the year, the banker might lose his company, but if his personal savings were massive enough, he had no rational reason to care.

Wrong. The bankers assumed the government would support them. They assumed they "were too big to fail," which had been orchestrated as policy by the Fed. In short, rationality's failure is, in fact, government's.

Posner proposes two explanations for the regulators’ failure. First, he indicts economists as a profession: they neglect to study depressions because they’re such rare events.

This is probably true. We don't have much data on recessions and the Great Depression was skewed when the war led Roosevelt to quit meddling as much, put capable me in positions of power, and establish certainty in the economic rules. Even so, there are plenty of economists who are studying the depression. Spend some time at econtalk.org and you can listen to a number of podcasts on the subject.

Second, Posner argues, free-market economists have been too ideological in their commitment to a deregulation-first approach.

Deregulation of the financial markets would work, but only if accompanied by clarity. The problem is companies like Goldman Sachs attempt to manipulate the markets while also buying/using political influence to hide their actions. This is not the free market, but the politically corrupt market, a la Enron.

The real market, Mandelbrot shows, follows rather predictable rules, while the financial markets obey a law of “wild randomness” or the Black Swan Effect, a term coined by Nassem Taleb, a Mandelbrot disciple. Financial markets therefore require prudent regulation in order to limit, to the extent possible, the most extreme consequences of wild randomness.

Aiiieeeee! The "too big to fail" philosophy of Greenspan's Fed directly led to the Black Swan Effect.

Most commentators, motivated by science, ideology, angst, or revenge, try to explain the crisis as if it had to happen. They selectively find in the recent past the logical causes that inevitably led to the crisis. This approach recalls what the French historian Fernand Braudel criticized in studies of the eighteenth century that viewed the French Revolution as inevitable. The revolution, Braudel argued, could very well not have happened at all; history follows no necessity. The same applies to economics. Crises aren’t doomed to happen. Depressions remain unpredictable by definition; they obey only wild randomness. The I-told-you-so pundits fall into a logical trap, confusing failures in capitalism, which happen and will continue to happen, with the notion that they had to happen. Yet only Karl Marx believed that capitalism was fated to disappear in a final crisis, and he was more a messiah than a scientist. We should explore the way out of the current crisis with humility and caution.

Bingo. This didn't have to happen. And it didn't have to last, but Obama will do his best to make a V shaped recession into a U shaped one. Worse, once his stimulus takes effect it will be a W shaped economy (or, UU). History will record Obama as the most economically illiterate and damaging president in history (unless he succeeds in totally destroying the country and we become a socialist state where Big Brother writes the books).

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.