Posner Rebutted

Jeffrey Friedman, editor of Critical Review, wrote a review of Judge Richard Posner’s A Failure of Capitalism for The Weekly Standard published yesterday. In the review, Friedman critiques Posner’s abandonment of true free market principles, writing:

A Failure of Capitalism contains a devastating rebuttal of widely popular “irrational exuberance” explanations of the crisis. This leaves Posner to solve the puzzle of why rationally self-interested bankers seemed to ignore risk. But in the real world of contemporary capitalism, rational self-interest does not conform to the patterns it would follow under “a laissez-faire economic regime.” Instead, rational self-interest follows the tens of thousands of pages of the tax code; it follows the millions of pages of the regulatory code. And these tortuous legal pathways are largely overlooked by Posner.

Thus, he argues that the most important risky behavior prompted by the banks’ compensation structures was that bankers increased their leverage ratios. But banks’ leverage ratios are regulated by law, and this law, unmentioned by Posner, was probably the main cause of the crisis.

I think Friedman’s take is a bit harsh, though accurate on this point. He does point out, accurately, that Posner makes many good points and provides a balanced account for what happened. Friedman gave Posner an advance read and the judge offered a corresponding response:

Friedman I think agrees, at least about regulation (he doesn’t mention monetary policy at all), as when he remarks that banks’ leverage ratios are regulated by law and “this law, unmentioned by Posner, was probably the main cause of the crisis.” The decision by the SEC in 2004 to allow broker-dealers (Merrill Lynch, Goldman Sachs, Lehman Brothers, etc.—major components of the “shadow banking” system, which played a bigger role in the financial collapse than the commercial banks) to increase their leverage is an example of excessive deregulation, which was indeed, as I emphasize throughout the book, a main cause of the crisis. […]

I agree that the tax laws are among the deep underlying causes of the economic crisis, in particular the deductibility of mortgage and home-equity interest (but not other interest) from personal income tax, which encourages risky investment in housing, and the favorable treatment by the tax code of debt versus equity, which encourages leverage. I do not dwell on these causes of the crisis in my book because they will not be changed. In contrast, improvements in monetary policy and in regulation are at least within the realm of the possible, though perhaps unlikely.

I’m glad to hear that Posner agrees tax laws were among the causes of the crisis. But I think Friedman brings up a good point that Posner too readily dismisses. Knowing the causes of the crisis may not change them, but it will change our response to the crisis. Our view of the crisis shapes how we will form fiscal policy, monetary policy, and regulatory policy—not just now, but for years to come.

Furthermore, I think Posner’s response misses Friedman’s point that government incentives drove Wall Street behavior. Wall Street should have been able to overcome those incentives, so they do share partial blame. But deregulation (which was hardly “excessive”) didn’t force anyone to do anything. Just like the tax laws, they created a scenario where stuff could have happened, but a more open system with opportunities is different from a system with perverse incentives.