The Crisis of Capitalist Democracy

Richard A. Posner

• Publisher: Harvard University Press
• Year: 2010
• ISBN:
  9780674056794
• Topic: Economics
• Subtopic: Economic Conditions
• Index: Economics

Following his timely and well-received A Failure of Capitalism, Richard Posner steps back to take a longer view of the continuing crisis of democratic capitalism as the American and world economies crawl gradually back from the depths to which they had fallen in the autumn of 2008 and the winter of 2009.By means of a lucid narrative of the crisis and a series of analytical chapters pinpointing critical issues of economic collapse and gradual recovery, Posner helps non-technical readers understand business-cycle and financial economics, and financial and governmental institutions, practices, and transactions, while maintaining a neutrality impossible for persons professionally committed to one theory or another. He calls for fresh thinking about the business cycle that would build on the original ideas of Keynes. Central to these ideas is that of uncertainty as opposed to risk. Risk can be quantified and measured. Uncertainty cannot, and in this lies the inherent instability of a capitalist economy.As we emerge from the financial earthquake, a deficit aftershock rumbles. It is in reference to that potential aftershock, as well as to the government's stumbling efforts at financial regulatory reform, that Posner raises the question of the adequacy of our democratic institutions to the economic challenges heightened by the greatest economic crisis since the Great Depression. The crisis and the government's energetic response to it have enormously increased the national debt at the same time that structural defects in the American political system may make it impossible to pay down the debt by any means other than inflation or devaluation.

I.
AN ANALYTIC NARRATIVE OFTHE CRISIS

1

THE CALM BEFORE THE STORM:

2001-2006

Low interest rates in the early 2000s set the stage for the economic collapse from which we are now gradually recovering. It was low interest rates that caused housing, stock market, and credit bubbles. The bursting of the bubbles brought on the depression. Low interest rates alone would not have had such consequences, though they would have produced inflation in one form or another. Had banking been safe, the bursting of the housing and stock bubbles would not have brought down the banks, and we would have been spared a depression.

Banking used to be safe. Made safe in reaction to the Great Depression of the 1930s, which had featured a banking collapse, banking became unsafe as a result of a financial deregulation movement that began in 1980, that culminated in 1999 with the repeal of a major 1930s banking reform (the Glass-Steagall Act), and that was succeeded by a brief, disastrous era of lax regulation, regulatory complacency, regulatory inattention, and regulatory ineptitude. The combination of low interest rates and inadequate banking regulation proved lethal. The contribution of low interest rates, and the responsibility for those rates, are the subject of this chapter. The failures of banking regulation are for later.

Low interest rates encourage people to borrow—and banks to borrow, so that they can relend. As interest rates fell sharply in 2001 and remained very low until some months after a gradual rise began in 2004—for part of this period short-term interest rates were actually negative after adjustment for inflation—the amount of debt in the economy soared. Much of it went into the purchase of houses, a product bought mainly with debt (traditionally consisting of a mortgage equal to 80 percent of the purchase price). With the cost of debt such a big part of the price of a house, low interest rates increased the demand for housing. That led to an increase in housing starts. But because the housing stock is so durable, a steep increase in the demand for housing cannot be satisfied just by the construction of additional houses. Instead, with more people wanting to buy houses, the price of existing houses was bid up. As prices rose, many homeowners borrowed against their home equity—whether by increasing their first mortgage or taking out a second mortgage or a home-equity loan—to finance the purchase of other goods. This increased the amount of debt that people had, but they did not feel over-indebted because their principal asset—their house—was rising in value. Instead they felt wealthier, and so saved less. And so as a further consequence of low interest rates, rising housing and stock prices were accompanied by a decline in the personal savings rate.

Rising prices made houses seem a good investment. This attracted more buyers, and lenders too, because when house prices are rising, defaults are rare—a homeowner who has trouble making his monthly mortgage payments can sell his house for a profit rather than having to default and face foreclosure. And with the perfection, as it seemed, of debt securitization (discussed in the next chapter) as a method of optimally distributing risk, even mortgages that seemed extremely risky could be marketed. So credit standards for mortgage lending declined, which further increased the demand for housing; neither lack of money for a down payment nor a poor credit rating based on past difficulty in handling credit was any longer an insurmountable obstacle to buying a house.

Thus housing prices were rising because housing prices were rising—a spiral engendered by low interest rates. Prices continued rising until March 2006—and immediately began to fall. Mortgage interest rates had risen, owing to belated moves by the Federal Reserve, which feared inflation, though not in houses or other assets, to raise interest rates. The rise in interest rates made the purchase of a house a more costly undertaking, so the demand for houses fell, and therefore housing starts and housing prices fell. As housing starts fell, builders’ incomes declined and unemployment in construction rose, while as prices of existing homes fell, homeowners—whose house was usually their principal asset—felt poorer and so reduced their spending if they could. Some homeowners abandoned their house because the unpaid principal amount of their mortgage exceeded the diminished market value of the house, making it seem a bad investment. These abandonments depressed housing prices further. People who had thought they could afford to buy a house because they would be able to refinance the mortgage at a lower interest rate after a rise in the value of the house gave them a substantial equity were shocked to discover not only that the value of their house had fallen rather than risen, but that lenders had raised credit standards because of the rising defaults. Many homeowners who had financed their house with an adjustable rate mortgage could not afford the reset rate because of their financial distress. And although housing prices were falling, demand for houses remained weak, because houses no longer seemed a good investment.

The ingredients of a recession (a mild depression) were present; why it should have brought down the banking system is considered in the next chapter. For now I want to consider why interest rates fell and then rose in the early 2000s and whether the rise and fall in housing prices really was—as I intimated when I said that “housing prices were rising because housing prices were rising”—a bubble phenomenon.

There are two theories about the pattern of interest rates in the early years of the decade. One is the “global savings glut.” This is a misleading term, because it implies that the world as a whole can have a surplus of saving over spending. The surplus money that some countries accumulate by exporting more than they import, so that they receive money in addition to goods in exchange for their exports, is offset by the deficits of their trading partners, which pay for the goods they import with a combination of their own exports and the money they pay to make up the difference between what they buy and what they sell.¹ China, along with some other developing countries, plus Germany, Japan, and the oil-exporting nations of the Middle East, were the savers, and the United States and some other wealthy countries—but the United States most of all—the borrowers of the savers’ excess money.

Why some countries should want to export more than they import and so increase their money reserves rather than the goods enjoyed by their citizens is something of a puzzle, unless, as in the case of countries such as the Middle East oil-producing countries, which produce far more than their populations can consume, their domestic markets are too small to absorb imports commensurate with the countries’ output. In some of the export first countries, the population is exceptionally thrifty; it wants to hold large money balances rather than spend on consumption goods. (The standard example is Japan, although Japan’s personal savings rate has been declining steadily since the early 1990s and is now about the same as the U.S. rate.) In other countries, such as Germany, the country’s comparative advantage is the production of goods in strong demand in foreign countries. Many developing countries want to have large dollar balances as a buffer against financial crises such as those that swept East Asia in 1997, when weaknesses in the countries’ economies caused huge withdrawals of money invested in them, causing economic distress.² If money starts flowing out of a country, interest rates will rise to ration a diminishing amount of money available to domestic businesses and individual borrowers; and as I’ll be emphasizing, a rise in interest rates (at least if the rise is “real,” rather than simply compensation for current or expected inflation) reduces economic activity.

China has the greatest imbalance of any major nation between exports and imports, in part because it has fixed an artificial rate of exchange between its currency and the American dollar that makes its currency cheap and the dollar expensive; the result is that China’s exports to the United States are cheap and its imports from the United States dear.³ As a result of its trade imbalance with this country, China owns more of our foreign debt than any other country—some $800 billion (though Japan is close behind).

What reasons could China have for such an old-fashioned policy (“mercantilism”—the maximization of a nation’s cash or cash-equivalent reserves—famously attacked by Adam Smith more than two hundred years ago)? The immense exports that China’s skewed exchange policy has fostered provide employment for a large number of Chinese. Their wages are low, but at least they have jobs. Of course, they might have jobs if the dollar were cheaper relative to Chinese currency. China would import more and export less. It would manufacture less, not only because of greater competition from imported manufacturers and reduced foreign demand for its manufactures, but also because many workers would be required for the expanded system of domestic distribution that would be necessary if domestic consumption soared. It would also manufacture a different mixture of goods, because of competition from imports. But above all it would need a much more elaborate system of wholesale and retail distribution, and perhaps a different commercial culture. The transition to a consumer society with its credit cards and product warranties and malls and the rest would be difficult; in the interim, unless the transition were very gradual, there would be widespread unemployment—shifting employees from manufacturing to distribution, or from one type of manufacturing to another, doesn’t happen overnight. And China doesn’t have the kind of social safety net that we do, to catch the unemployed before they reach the bottom. Because of the limitations of domestic consumption, Chinese are great savers, and this relieves the pressure the government would otherwise feel to provide social services. That provision might strain the government’s administrative abilities. Moreover, China has a long history of political instability, of which its current government is acutely conscious; and there is tension between China’s dictatorial communist government and its largely free-enterprise economy. Finally, the domestic Chinese economy is dominated by state-owned companies, and the government doesn’t want to expose them to foreign competition. For all these reasons, the Chinese government is reluctant to take chances on changing the economy from one of producing manufactured goods for export to one of manufacture and distribution primarily for domestic consumption.

The dollar-surplus countries, like China, bought with their dollars bonds from the U.S. Treasury and other U.S. owners of debt, and as a result the U.S. money supply expanded. With more money available for lending, interest rates fell. In addition, because much of the foreign demand for U.S. securities was demand by foreign governments for Treasury securities, the yield on those securities fell, and this drove other investors to riskier securities,⁴ such as the mortgage-backed securities that played a starring role in the financial collapse.

When capital inflows from abroad increase the ratio of money in circulation in the United States to goods and services bought in the United States, the result is inflation unless the Federal Reserve withdraws money from the economy. It does this (and the converse, which is to pump money into the economy to prevent deflation—negative inflation) by what are called “open market operations.” An understanding of those operations is fundamental.

Suppose the Fed wants to increase the amount of money in circulation. It used to do this by buying very short-term securities (the equivalent of bonds) that are issued by the Treasury Department to help finance the federal government’s operations. The money that the Fed pays the bank or other seller of these securities, when deposited in the seller’s bank account, expands the amount of money that the bank can lend. The more money lent, the lower the interest rate. The Federal Reserve creates the money with which to buy securities by a bookkeeping entry that increases the amount of cash reserves shown on the books of Federal Reserve banks, which in this respect can be thought of as branch offices of the Fed. It thus creates money out of nothing.

If the Fed wants to reduce the money supply, then instead of buying Treasury securities it sells them, thus withdrawing money from circulation. There is now less money in bank accounts, so the supply of lendable funds is diminished and as a result interest rates are higher. With interest rates higher, fewer loans are demanded and supplied, and so there is less money in circulation.

Nowadays the Fed doesn’t actually buy and sell securities in its normal open market operations, but instead borrows and lends them by means of “repos” (repossession agreements). In a repo the borrower, instead of posting the security as collateral for the loan, sells the security to the lender but agrees to repurchase it at a specified future time (usually a very short time—from a day to three months) at a specified higher price. The difference between the price at which the borrower sells the security and the price at which he buys it back from the lender is the lender’s compensation for having given the borrower the use of the lender’s cash in the interim. The “seller” of the security is thus actually a borrower, which is what I have been calling him, and the “buyer” a lender, and the security that is sold and then repurchased is really the collateral for a loan, since the “buyer” will retain it only until he gets his cash back.

The repo form of lending is a detail so far as open market operations are concerned—there is little difference between the Fed’s buying a security for cash and lending the cash with the security as collateral. But it is an important detail, because, as we’ll see in the next chapter, repos are an important instrument in modern finance and played a role in the financial collapse.

I have said that the Fed engages in open market operations to influence the interest rate. But there are many different interest rates. Interest rates are determined by liquidity preference (the desire to have cash or its equivalent), credit risk (the risk that the borrower will default), and the risk of a change in the real value (purchasing power) of money due to inflation or deflation. In general, the longer the term of a loan, the higher the interest rate, because the lender is giving up liquidity (the cash he lent is tied up until the loan is repaid) and because default risk and inflation risk are greater the longer the loan is outstanding.

But in normal times (these are not normal times), the Federal Reserve gears its open market operations to regulating only one interest rate, and that is the “federal funds” or “overnight” rate. This is the rate at which banks make very short-term loans to each other secured by Treasury bills. The Fed focuses on this single, benchmark rate in order to make it easier for the private sector to assess the direction of monetary policy and hence interest rates in general.

Interbank lending is common because banks need “reserves” (cash) in order both to make loans and to satisfy regulatory requirements. Requiring banks to keep some of their capital in the form of cash reduces the risk of a bank’s going broke should its loan portfolio or other assets lose value unexpectedly. Because cash does not earn interest, banks want to hold as little as possible except when they have a loan to make. So it makes sense that rather than accumulating cash they borrow the needed cash from another bank when the customer for a loan appears.

Similarly, a bank is usually happy to lend cash to another bank rather than let it sit idle, earning no interest. The bank might have received an influx of deposits at a time when the demand for loans by that bank was weak. Indeed, it is because receiving capital in the form of deposits and lending the capital are not coordinated that interbank lending is important to the efficient allocation of bank capital. When in September 2008 it became obvious that the banking industry had serious liquidity and solvency problems, banks became fearful about lending to each other because they were uncertain whether the borrower would repay, and the sharp drop in interbank lending that resulted disrupted the efficient allocation of bank capital. By aggressively increasing bank balances by means of open market operations and the purchase of other debt (“credit easing”), the Federal Reserve staved off a complete collapse of bank lending. But because lending remained constrained as a consequence of the gathering depression and the banks’ solvency concerns, most of the cash that the Fed pumped into the banking system remained on the banks’ books as excess reserves,⁵ that is, as cash in excess of the amount required by the regulatory authorities to provide a margin of safety.

Interbank lending may seem too remote from mortgage lending for an interbank interest rate such as the federal funds rate to affect the mortgage interest rate, especially since the scale of open market operations required to raise or lower the federal funds rate is small in relation to the overall quantity of credit transactions. Moreover, it is a “notional” rate—a target rate announced by the Fed. Banks aren’t required to lend to each other at that rate, a point that turned out to be important in the financial crisis.

But there are a number of ways in which changes in that rate affect other interest rates, including mortgage interest rates:

1. When the Fed buys short-term Treasury securities (or acquires them in repos), this increases the demand for and hence price of bonds generally, and so interest rates fall. A bond’s price is inverse to its interest rate. The reason is that interest on a bond is specified as a percentage of its face value; that is why another name for bonds is “fixed-income securities.” If the face value of a bond is $100 and the interest rate specified in the bond is 5 percent a year, the owner of the bond will receive interest of $5 a year. Suppose that the Fed (or anyone else) decides to buy bonds. This will increase the demand for bonds and so push up the price. Suppose the price of the $100 bond is bid up to $125. If the bondholder sells at that price, the buyer will receive interest of only 4 percent a year ($5/$125). So by increasing the demand for bonds by buying Treasury securities, the Fed reduces interest rates.

2. More important—because of the small scale of open market operations (again, in normal times)—the Fed signals its expectations concerning inflation by the federal funds rate that it picks. When the rate is low, the Fed is saying it doesn’t fear inflation. That signal can be expected to reduce long-term interest rates, because such rates are strongly influenced by expectations concerning in...