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Capitalism in Crisis
It's hard to run a safe banking system when the central bank is recklessly easy.
he current economic crisis so far eclipses anything the American economy has undergone since
the Great Depression that "recession" is too tepid a term to describe it. Its gravity is measured not
by the unemployment rate but by the dizzying array of programs that the government is deploying
and the staggering amounts of money that it is spending or pledging -- almost $13 trillion in loans,
other investments and guarantees -- in an effort to avoid a repetition of the 1930s.
David Klein
Much of this sum will not be spent (the guarantees), and probably most will eventually be
recovered. But a commitment of such magnitude -- stacked on top of enormous budget deficits
enlarged by sharply falling federal-tax revenues -- could lead to high inflation, greatly increased
interest costs on a greatly increased national debt, much heavier taxes, the restructuring of major
industries, and the redrawing of the line that separates business from government.
How did this happen? And what is to be done?
The key to understanding is that a capitalist economy, while immensely dynamic and productive, is
not inherently stable. At its heart is a banking system that enables large-scale borrowing and
lending, without which most businesses cannot bridge the gap between incurring costs and
receiving revenues and most consumers cannot achieve their desired level of consumption. When
the banking system breaks down and credit consequently seizes up, economic activity plummets.
Lending borrowed capital -- the essence of banking -- is risky. That risk is amplified when interest
rates are very low, as they were in the early 2000s because of a mistaken decision made by the
Federal Reserve under Alan Greenspan to force interest rates down and keep them down.
Because houses are bought with debt (for example, an 80% first mortgage on a house), low
interest rates spur demand for houses. And because the housing stock is so durable a surge in
demand increases not only housing starts but also the prices of existing houses. When people saw
house prices rising -- and were assured by officials and other experts that they were rising because
of favorable "fundamentals" -- Americans decided that houses were a great investment, and so
demand and prices kept on rising.
In fact, prices were rising because interest rates were low. So when the Federal Reserve (fearing
inflation) began pushing interest rates up in 2005, the bubble began leaking air and eventually
burst. It carried the banking industry down with it because banks were so heavily invested in
financing houses.
The banking crash might not have occurred had banking not been progressively deregulated
beginning in the 1970s. Before deregulation banks were forbidden to pay interest on demand
deposits. This gave them a cheap source of capital, which enabled them to make money even on
low-risk short-term loans. Competition between banks was discouraged by limits on the issuance of
bank charters and by (in some states) not permitting banks to establish branch offices. And
nonbank finance companies (such as broker-dealers, money-market funds and hedge funds) did
not offer close substitutes for regulated banking services.
Those days are gone. Had Americans' savings not become concentrated in houses and common
stocks, the banking meltdown would have had less effect on the general economy. When these
assets -- their prices artificially inflated by low interest rates -- fell in value, credit tightened and
people felt (and were!) poorer. So people reduced their spending and allocated more of their
income to precautionary savings, including cash, government securities and money-market
The Fed tried to encourage lending by once again pushing interest rates way down. But the banks - their capital depleted by the fall in value of their mortgage-related assets -- have hoarded most of
the cash they've received as a result of being able to borrow cheaply, rather than risk lending into a
depression. Their hoarding, like that of consumers, is entirely rational, but it inhibits investment as
well as consumption.
With easy money failing to do the trick, the government began lending large sums of money directly
to banks. It also tried to bypass the banks in its efforts to stimulate consumption and employment
by implementing tax cuts, benefits increases and public-works projects hard hit by unemployment.
Though the banks are continuing to hoard bailout money and the stimulus program is just beginning
to be implemented, these and other recovery programs have probably slowed the downward spiral.
It's not too soon, therefore, to derive some important lessons from the economic crisis:
First, businessmen seek to maximize profits within a framework established by government. We
want businessmen to discover what people want to buy and to supply that demand as cheaply as
possible. This generates profits that signal competitors to enter the market until excess profit is
eliminated and resources are allocated most efficiently. Financial products are an important class of
products that we want provided competitively. But because risk and return are positively correlated
in finance, competition in an unregulated financial market drives up risk, which, given the centrality
of banking to a capitalist economy, can produce an economic calamity. Rational businessmen will
accept a risk of bankruptcy if profits are high because then the expected cost of reducing that risk
also is high. Given limited liability, bankruptcy is not the end of the world for shareholders or
managers. But a wave of bank bankruptcies can bring down the economy. The risk of that
happening is external to banks' decision-making and to control it we need government. Specifically
we need our central bank, the Federal Reserve, to be on the lookout for bubbles, especially
housing bubbles because of the deep entanglement of the banking industry with the housing
industry. Our central bank failed us.
The second lesson is that we may need more regulation of banking to reduce its inherent riskiness.
But now is not the time for that: There is no danger of a renewed housing or credit bubble in the
immediate future. The essential task now is to recover from the depression. That requires, as John
Maynard Keynes taught, a restoration of business confidence. Investment is inherently uncertain,
and it is even more uncertain in a depression. Anything that amplifies this uncertainty slows
recovery by making businessmen more likely to freeze and hoard rather than venture and spend.
Reregulating banking, hauling bankers before congressional committees, passing laws tightening
credit-card lending, and capping bonuses all impede recovery. All that is for later, once the
economy is back on track. For now such measures are just distractions.
Moreover, it is unclear how banking should be regulated. Banking in the broad sense of financial
intermediation (borrowing capital in order to lend or otherwise invest it) is immensely diverse. It is
also international. If one nation reduces the riskiness of its banking industry, business will flow to
other nations, just as a bank that decides to be cautious will lose investors to its competitors
because of the positive correlation of risk and return. So international regulation of banking is
needed in principle, but international regulation tends to be lowest-common-denominator regulation
and so may be ineffectual.
Finally, let's place the blame where it belongs. Not on the bankers, who are not responsible for
assuring economic stability, but on the government officials who had that responsibility and failed to
discharge it. They failed even to develop contingency plans to deal with what everyone knew could
happen in a context of escalating housing prices (it had happened in Japan in the late 1980s and
the 1990s). Lacking such plans, the government responded to the crisis with spasmodic
improvisations, amplifying uncertainty and mistrust and thus retarding recovery.
And let's not forget to apportion some of the blame to the influential economists who assured us
that there could never be another depression. They argued that in the face of a recession the
Federal Reserve had only to reduce interest rates and flood the banks with money and all would be
well. If only.
Mr. Posner is a federal circuit judge and a senior lecturer at the University of Chicago Law
School. He is the author of the just-published "A Failure of Capitalism: The Crisis of '08 and
the Descent into Depression" (Harvard University Press).