I agree with Posner that the future of free market policies in the United States has been damaged by the financial crisis, and by the continuing rise in unemployment and slowdown of the American (and world) economy. The degree of damage, however, will be determined by the length and severity of this recession. If the recession does not develop into a deep and prolonged depression, there will not be a sizable retreat from the market policies that have been in effect.
The big victory of Senator Obama and the Democratic Party was not a referendum on free market policies. Rather it reflected the continuing unpopularity of the Iraq war and of the Bush administration, and months of growing concern about foreclosures, rising unemployment, and the weak economy. American voters seem to want greater regulation of the financial sector, not an abandonment of policies that generally have supported the private sector and competition. This is reflected in the economists Obama has appointed to top positions in his administration. These economists, such as Larry Summers and Paul Volker, have generally recognized the importance of competition as a way to regulate market behavior.
Nevertheless, in light of the severity of the financial crisis, greater regulation of financial institutions is merited. The challenge is to find regulations that would significantly reduce the probability of future financial crises without discouraging the valuable contributions commercial banks, investment banks, and other financial institutions make to risk management and the financing of home ownership and business investments.
Several changes do seem likely to be beneficial. Greater capital requirements (relative to assets) for all financial institutions, including investment banks and hedge funds, would help banks better weather runs on their assets. Greater transparency in the information financial institutions provide about their assets would also be useful, although modern assets are often so complicated that transparency will not always be easy to achieve. Fully privatizing Fannie Mae and Freddie Mac would help reduce the flow of mortgages to unqualified homeowners. Incomes of many fund managers and private equity leaders rose enormously, but it is difficult to prevent that from happening again without introducing controls over their salaries, stock options, and bonuses. The greatest challenge is to find ways to reduce the type of private risk-taking in which the taxpayer bails out failure, although greater capital requirements would help.
Posner advocates a pragmatic approach to the evaluation of public policies. Up to a point that approach is fine if it just means a careful consideration of all the available evidence relevant to proposed policies, including knowledge built up from the successes and failures of past policies and actions. But facts themselves are silent without being guided by an analytical framework or theory, so pragmatism is not sufficient to provide important insights into the desirability of various public policies. Conservatism, liberalism, and various combinations of these positions provide different frameworks to interpret the facts.
Posner agrees that a theoretical framework is crucial for interpreting evidence because knowledge about how particular policies worked in the past or might work in the future is seriously incomplete. This knowledge has to be supplemented with predictions about how particular policies would affect the operation of the economy, especially over aspects of the economy where evidence about behavior is very incomplete. These predictions can only come from a theory about behavior and markets that sheds light on the behavior that is not directly observed.
To take a concrete example, the consequences of imposing minimum capital requirements relative to assets on all financial institutions, including hedge funds and private equity companies, depends not only on how such a requirement would affect the operation of the financial system, but also how it would affect investments, employment, and other aspects of the real economy. To understand these consequences requires a theory of the effectiveness of competition in this sector, and an analysis of whether the present financial crisis would have been much milder if capital requirements had already been in place.
The general point I am making is that an economic theory of how markets operate is necessary to evaluate any significant new regulations and other government policies for financial markets (and more generally, for other markets as well, such as the subject of our blog two weeks ago on whether a bailout of the auto industry is justified). Some retreat from free market conservatism is to be expected an s a result of the crisis, but it would be a serious mistake if the analysis of financial and other markets that becomes dominant in Washington gives insufficient weight to the enormous contributions of business competition in raising human welfare.