A Failure of Capitalism

The Crisis of '08 and the Descent into Depression

Richard A. Posner

• Publisher: Harvard University Press
• Year: 2011
• ISBN:
  9780674252844
• Topic: Economics
• Subtopic: Economic Conditions
• Index: Economics

The financial and economic crisis that began in 2008 is the most alarming of our lifetime because of the warp-speed at which it is occurring. How could it have happened, especially after all that we've learned from the Great Depression? Why wasn't it anticipated so that remedial steps could be taken to avoid or mitigate it? What can be done to reverse a slide into a full-blown depression? Why have the responses to date of the government and the economics profession been so lackluster? Richard Posner presents a concise and non-technical examination of this mother of all financial disasters and of the, as yet, stumbling efforts to cope with it. No previous acquaintance on the part of the reader with macroeconomics or the theory of finance is presupposed. This is a book for intelligent generalists that will interest specialists as well.Among the facts and causes Posner identifies are: excess savings flowing in from Asia and the reckless lowering of interest rates by the Federal Reserve Board; the relation between executive compensation, short-term profit goals, and risky lending; the housing bubble fuelled by low interest rates, aggressive mortgage marketing, and loose regulations; the low savings rate of American people; and the highly leveraged balance sheets of large financial institutions.Posner analyzes the two basic remedial approaches to the crisis, which correspond to the two theories of the cause of the Great Depression: the monetarist—that the Federal Reserve Board allowed the money supply to shrink, thus failing to prevent a disastrous deflation—and the Keynesian—that the depression was the product of a credit binge in the 1920s, a stock-market crash, and the ensuing downward spiral in economic activity. Posner concludes that the pendulum swung too far and that our financial markets need to be more heavily regulated.

1

The Depression and Its Proximate Causes

A SEQUENCE of dramatic events has culminated in the present economic emergency: low interest rates, a housing bubble, the collapse of the bubble, the collapse of the banking system, frenzied efforts at resuscitation, a drop in output and employment, signs of deflation, an ambitious program of recovery. I need to trace the sequence and explain how each stage developed out of the preceding one. This chapter opens with a brief sketch of the basic economics of depression and of fighting depression and then turns to the particulars of this depression.

Suppose some shock to the economy—say, a sudden fall in the value of people’s houses and securities—reduces the value of personal savings and induces people to spend less so they can rebuild their savings. The demand for goods and services will therefore fall. Before the shock, demand and supply were both X; now demand is X − Y. How will suppliers respond? If—a critical assumption—all prices, including the price of labor (wages), are completely flexible, suppliers, including suppliers of labor—workers—will reduce their prices in an effort to retain as many buyers as possible. With consumers saving more because they are buying less, and at lower prices, interest rates—earnings on savings—will fall because there will be a savings glut. The lower interest rates will induce borrowing; and with more borrowing and lower prices, spending will soon find its way back to where it was before the shock. One reason this will happen is that not all consumers are workers, and those who are not, and whose incomes therefore are unimpaired, will buy more goods and services as prices fall.

The flaw in this classical economic theory of the self-correcting business cycle is that not all prices are flexible; wages especially are not. This is not primarily because of union-negotiated or other employment contracts. Few private-sector employers in the United States are unionized, and few non-unionized workers have a wage guaranteed by contract. But even when wages are flexible, employers generally prefer, when demand for their product drops, laying off workers to reducing wages. Think of all the financial executives who have been laid off even while bonuses—often amounting to half the executive’s pay—were being cut, sometimes to zero.

There are several reasons that employers prefer layoffs to cutting wages. (1) Layoffs reduce overhead expenses. (2) By picking the least productive workers to lay off, an employer can increase the productivity of its workforce. (3) Workers may respond to a reduction in their wages by working less hard, or, conversely, may work harder if they think that by doing so they may reduce the likelihood that they will be laid off. (4) When the wages of all workers in a plant or office are cut, all are unhappy; with layoffs, the unhappy workers are off the premises.

If wages fall far enough, many workers will lay themselves off, finding better uses of their time (such as getting more schooling) than working for a pittance—and they may be workers whom the employer would have preferred to retain.

The reasons for employers’ preference for layoffs are attenuated when instead of a worker’s wage being cut he is reduced from full-time to part-time status. He is still part of the team; and he may be able to assuage his distress at his lower wage by adding another part-time job and thus restoring his full income. So reductions from full-time to part-time employment are more common than wage cuts. Similarly, a reduction in bonus is less demoralizing than a cut in salary. There is less expectation of receiving a bonus than of continuing to receive one’s base salary, and so there is less disappointment when the bonus is cut.

When, in order to reduce output from X to X − Y in my example and thus restore equilibrium, producers and other sellers of goods and services, such as retailers, begin laying off workers, demand is likely to sink even further; that is, Y will be a larger number. Unemployment reduces the incomes of the formerly employed and creates uncertainty about economic prospects—the uncertainty of the unemployed about whether and when they will find comparable employment, the uncertainty of the still-employed about whether they will retain their jobs. Workers who are laid off spend less money because they have less to spend, and those not laid off fear they may be next and so begin to save more of their income. The less savings, especially safe savings, people have, the more they will reduce their personal consumption expenditures in order to increase their savings, and therefore the more that output will fall. Interest rates will fall too, but many people will be afraid to borrow (which would increase economic activity by giving them more money to spend). So spending will not increase significantly even though low interest rates reduce the cost of consumption; people will want to have precautionary savings because of the risk that their incomes will continue to decline.

Still, the downward spiral is unlikely to become uncontrollable even without radical government intervention unless the shocks that started the economy on the path to depression either were extremely severe or, because of widespread over-indebtedness, created default cascades that reduced banks’ capital to a point at which they could no longer lend money in quantity. For then consumers who wanted to borrow to maintain their level of consumption could not do so, and their inability to borrow would accelerate the fall in demand for goods and services. Commercial activity would fall dramatically; it depends vitally on credit, in part just because costs of production and distribution are almost always incurred before revenues are received.

With demand continuing to fall, sellers lay off more workers, which exerts still more downward pressure on demand. They also reduce prices in an effort to avoid losing all their customers and be stuck with unsalable inventory. As prices fall, consumers may start hoarding their money in the expectation that prices will keep falling. And they will not borrow at all. For with prices expected to keep falling, they would be paying back their loans in dollars of greater purchasing power because the same number of dollars will buy more goods and services. That is deflation—money is worth more—as distinct from inflation, in which money is worth less because more money is chasing the same quantity of goods and services.

With demand continuing to fall, bankruptcies soar, layoffs increase, incomes fall, prices fall further, and so there are more bankruptcies, etc.—the downward spiral continues. Adverse feedback loops—“vicious cycles” in an older vocabulary—are a formula for catastrophe; other examples are pandemics and global warming. Irving Fisher, writing in the depths of the Great Depression, said that a depression was “somewhat like the ‘capsizing’ of a ship which, under ordinary conditions, is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but, instead, a tendency to depart further from it.”

So it is not really the initial shock to a robust system that is the main culprit in a depression; it is the vulnerability of the process by which the system adjusts to a shock. This makes the adequacy of the institutional response to that vulnerability critical.

One institutional response to a deflationary spiral is for the Federal Reserve to increase the supply of money, so that a given number of dollars doesn’t buy more goods than it used to. The Federal Reserve creates money in various ways. The most common one, but not the most intuitive, is by altering the federal funds rate; I discuss that later. Another way is by buying federal securities, such as T bills (T for Treasury), from banks. The cash the banks receive from the sale is available to them to lend, and loan proceeds, deposited in the borrower’s bank account, increase the number of dollars available to be spent. Fearing deflation, the Federal Reserve has been expanding the money supply in the current crisis, but with limited success. Because banks are on the edge, or even over the edge, of being insolvent, they are fearful of making risky loans, as most loans in a depression are. So they have put more and more of their capital into short-term securities issued by the federal government—securities that, being backed by the full faith and credit of the United States, are safe.

The effect of competition to buy these securities has been to bid down the interest rate on them virtually to zero. Short-term federal securities that pay no interest are the equivalent of cash. When banks want to hold cash or its equivalent rather than lend it, the action of the Federal Reserve in buying cash-equivalent securities does nothing to increase the money supply. So the Fed is now buying other debt, and from other financial firms as well as from banks—debt that has a positive interest rate, the hope being that if the Federal Reserve buys the debt for cash the seller will lend out the cash in order to replace the interest income that it had been receiving on the debt. But this program has not yet had a great deal of success either. If people and firms are extremely nervous about what the future holds for them, low interest rates will not induce them to borrow.

If monetary policy does not succeed in equating demand to supply by closing the gap between demand of X − Y and supply of X, maybe government spending can do the trick. The government can buy Y worth of goods and services, thus replacing private with public demand, or it can reduce taxes by Y (or give people after-tax income in some other form, such as increased unemployment benefits), so that people have more money to spend, or it can do some of both. Whichever course it follows, it will be engaged in deficit spending. The buying part of the program, like the tax cuts, can be financed only by borrowing (or by the Federal Reserve’s creating money to pay for the program) and not by taxing, for if financed by taxation it would not increase aggregate demand; it would inject money into the economy with one hand and remove it with the other. (It was always obvious that the government could reduce unemployment by hiring people; what makes it a device for fighting a depression is doing so without financing the program by means of taxes.) At this writing, Congress is on the verge of enacting a massive deficit-spending program involving public spending on infrastructure improvement and other public-workstype projects, plus tax cuts and other subsidies.

Such is the anatomy of depression, and of recovery from depression. But there are different types of depression or recession and we must distinguish among them. In the least interesting and usually the least serious, some unanticipated shock, external to the ordinary workings of the market, disrupts the market equilibrium. The oil-price surges of the early and then the late 1970s, and the terrorist attacks of September 11, 2001 (which deepened a recession that had begun earlier that year), are illustrative. The second type, illustrated by the recession of the early 1980s, in which unemployment exceeded 10 percent for a part of 1982, is the induced recession. The Federal Reserve broke what was becoming a chronic high rate of inflation by a steep increase in interest rates. In neither type of recession is anyone at fault, and the second was beneficial to the long-term health of the economy.

The third and most dangerous type of recession/depression is caused by the bursting of an investment bubble. It is depression from within, as it were, and is illustrated by both the depression of the 1930s and the current one, though by other depressions and recessions as well, including the global recession of the early 1990s. A bubble is a steep rise in the value of some class of assets that cannot be explained by a change in any of the economic fundamentals that determine value, such as increased demand due to growth in population or to improvements in product quality. But often a bubble is generated by a belief that turns out to be mistaken that fundamentals are changing—that a market, or maybe the entire economy, is entering a new era of growth, for example because of technological advances. Indeed that is probably the main cause of bubbles.

A stock market bubble developed in the 1920s, powered by plausible optimism (the years 1924 to 1929 were ones of unprecedented economic growth) and enabled by the willingness of banks to lend on very generous terms to people who wanted to play the stock market. You had to put up only 10 percent of the purchase price of the stock; the bank would lend the rest. That was risky lending, since stock prices could and did decline by more than 10 percent, and explains why the bursting of the stock market bubble in 1929 precipitated widespread bank insolvencies. New profit opportunities and low interest rates had led to overindebtedness, an investment bubble, a freezing of credit when the bubble burst because the sudden and steep fall in asset prices caused a cascade of defaults, a rapid decline in consumption because people could not borrow, and finally deflation. Overindebtedness leading to deflation was the core of Irving Fisher’s theory of the Great Depression, and there is concern that history may be repeating itself.

The severity of the 1930s depression may have been due to the Federal Reserve’s failure to expand the supply of money in order to prevent deflation, a failure connected to our adherence to the gold standard: a country that allows its currency to be exchanged for a fixed amount of gold on demand cannot increase its money supply without increasing its gold reserves, which is difficult to do. The United States went off the gold standard in 1933, and there was an immediate economic upturn. Yet the depression persisted until the United States began rearming in earnest shortly before it entered World War II; its persistence may have been due to the Roosevelt Administration’s premature abandonment of deficit spending, employed at the outset of the Administration along with the abandonment of the gold standard with apparent success in arresting the economic downturn.

There was a smaller bubble, in stocks of dotcom, telecommunications, and other high-tech companies, in the late 1990s. But its bursting had only a modest adverse effect on the economy as a whole, as did the sharp drop in the stock market triggered by the terrorist attacks of September 11, 2001.

The current economic emergency is similarly the outgrowth of the bursting of an investment bubble. The bubble started in housing but eventually engulfed the financial industry. Low interest rates, aggressive and imaginative marketing of home mortgages, auto loans, and credit cards, diminishing regulation of the banking industry, and perhaps the rise of a speculative culture—an increased appetite for risk, illustrated by a decline in the traditional equity premium (the margin by which the average return on an investment in stocks exceeds that of an investment in bonds, which are less risky than stocks)—spurred speculative lending, especially on residential real estate, which is bought mainly with debt. As in 1929, the eventual bursting of the bubble endangered the solvency of banks and other financial institutions. Residential-mortgage debt is huge ($11 trillion by the end of 2006), and many defaults were expected as a result of the bubble’s collapse. The financial system had too much risk in its capital structure to take these defaults in stride. The resulting credit crisis—a drastic reduction in borrowing and lending, indeed a virtual cessation of credit transactions, for long enough to disrupt the credit economy seriously—precipitated a general economic downturn. The downturn depressed stock prices, which exacerbated the downturn by making people feel poorer; for when they feel poorer, even before they become poorer, they spend less, as a precaution.

As the downturn deepened, bank solvency received a second shock: the default rate on bank loans secured by assets other than residential real estate rose because many borrowers were in financial straits. It is expected to rise further. The financial industry is beginning to resemble an onion: one peels successive layers of debt and wonders whether there is any solid core at all.

How severe is the economic downturn, and how much worse is it likely to get? If one looks only at statistics for 2008 (as we are still in the first quarter of 2009), the situation does not look too terrible: an unemployment rate of 7.2 percent and a gross domestic product (the market value of the nation’s total output of goods and services) that in the last three months of 2008 was 3.8 percent below its level in the corresponding period the previous year. But these snapshots of the economy are incomplete; there is also an $8 trillion decline in the value of traded stocks since 2007 to be reckoned with, together with an estimated $2 trillion of losses by American banks. The snapshots are also misleading. At the beginning of 2008, the unemployment rate was below 5 percent, and few observers think that it has plateaued at 7.2 percent. And when discouraged workers and workers involuntarily working part-time rather than full-time are added to the “officially” unemployed, we discover that the percentage of underutilized workers increased from 8.7 percent in December 2007 to 13.5 percent a year later, implying a significant drop in income available to buy goods and services. The 3.8 percent decline in gross domestic product is also misleading, because the figure is likely to grow and because it would have been 5.1 percent had production for inventory been excluded. The buildup of inventory was the unintended result of an unanticipated fall in demand. Carrying charges for inventory are considerable, and the built-up inventories are likely to be liquidated at very steep discounts, which by pulling down the price level will increase the danger of a deflation. Until they are liquidated, moreover, production will be depressed, since sales from inventory are substitutes for sales of newly produced goods.

The distinguished macroeconomist Robert Lucas estimates that in 2008 the gross domestic product was 4.1 percent below where it would have been in an average year (that is, 4.1 percent below the long-term trend line of gross domestic product, which is upward), and that if one may judge from consensus forecasts of economic activity it will be 8.3 percent below the trend line in 2009. That is nothing to write home about if your benchmark is 1933 (34 percent), but it is greater than in any year since the end of the Great Depression. Another ominous sign is that almost every estimate of the economic situation has later been revised downward, which feeds pessimism both directly and by revealing that financial experts have an imperfect grasp of the situation; if they don’t know what’s happening, they’re unlikely to be able to provide much guidance to arresting the downward spiral of the economy.

Personal consumption expenditures and consumer prices are falling significantly, which is uncharacteristic of mere recessions and is worrisome because deflation can greatly darken the economic picture. The consumer price index (seasonally adjusted) stopped rising in September 2008 and then fell 1.0 percent in October, 1.7 percent in November, and .7 percent in December. Another symptom of deflation is that many employers are cutting wages as well as laying off workers. This is an unusual response to economic adversity but makes sense in a deflation, when the purchasing power of money increases because prices are falling. For then a reduction in nominal wages need not mean a reduction in purchasing power (real wages). Indeed, unless nominal wages are cut in a deflation workers will be receiving higher wages in real terms—and for an employer to pay his workers more in an economic downturn would be anomalous.

What is important is not the price declines for the last three months of 2008 as such but whether they w...