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After the Fall

What really caused the financial crisis?

Sep 21, 2009, Vol. 15, No. 01 • By JEFFREY FRIEDMAN
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A Failure of Capitalism

The Crisis of '08 and the
Descent into Depression

by Richard A. Posner

Harvard, 368 pp., $23.95

As we would expect from Richard Posner, the distinguished and polymathic writer, law professor, and circuit court judge, his book on the financial crisis is thoughtful, rigorous, and balanced.

It has also been hailed as "an event" by some on the left, such as Nobel laureate economist Robert Solow, in whose eyes it marks the conversion of Posner, a former free-marketeer (albeit no ideologue), to the tenets of progressive common sense. For this volume claims that, since 2008, we have been experiencing "a failure of capitalism," and Posner's takeaway point is that "we need a more active and intelligent government to keep our model of capitalism from running off the rails."

Strictly speaking, Posner is right: We would need an active and intelligent government to keep the model of capitalism used by Posner from running off the rails. But in truth, Posner's model tells us little about the real world factors that produced the financial crisis. And once we take account of facts that Posner overlooks, it seems that the cause of the crisis was not the "laissez-faire economic regime" that Posner imagines might have been responsible, but the legal regulations that actually shaped the behavior of our banks.

Many different economic models can explain what might have caused the crisis. But readers will want to know what actually did cause the crisis. Posner tells us much about the economics of depressions in the abstract, the economics of housing in the abstract, the economics of banking in the abstract, and the economics of corporate compensation in the abstract. All of this economic theory is valuable; but in principle, most of it could have been written in 1999, 1989, or 1939--any time after Keynes's General Theory appeared in 1936. (Posner is a recent convert to Keynes's macroeconomics.) What A Failure of Capitalism lacks is evidence showing that any of these theories explains the crisis of 2008.

The heart of Posner's case against "capitalism" is the following theory, which has been embraced by no less than the president of the United States: Perverse incentives, created by banks' executive-compensation systems, caused the crisis. As Posner puts it, bank executives' pay was structured so that bankers would think to themselves,

when the bubble bursts you'll be okay because you have negotiated a generous severance package with your board of directors. .  .  . The board will have hired a compensation consultant who will have advised generosity in fixing the compensation of senior management and as part of that largesse will have recommended that senior executives receive a fat severance package (a "golden parachute") if they are terminated.

Moreover, according to Posner, subordinate employees had essentially the same incentives as top executives. Subordinates received bonuses for making money but were not penalized for losing it.

The theory is perfectly logical, and it might explain the crisis, but Posner does not show that it actually does explain the crisis.

For one thing, he doesn't show that all banks used the same compensation system and paid the same bonuses for risk-taking. There are, in fact, differences among banks' compensation systems, so Posner might have been able to test his theory by seeing if the banks that took more risks were the ones that provided bigger golden parachutes or paid higher bonuses. But Posner treats "banks" as a homogeneous lump. This makes it difficult for him to check his theory against reality.

Moreover, despite having written the bible of the "law and economics" movement--his 1973 treatise Economic Analysis of the Law--Posner tells us too little about the many laws that regulate real world capitalism, which surely must have affected bankers' behavior. For instance, some of the investment banks that avoided mortgage-backed securities, such as Brown Brothers Harriman, are structured as partnerships; this encourages prudence because each partner has a lot at stake if the firm goes under. As the huge law firms demonstrate, partnerships need not be small--there can be hundreds or thousands of partners. But Richard Rahn has pointed out that the tax code--not capitalism--discourages partnerships in banking and other industries.