Has the Market Economy Failed? Posner

I agree with Becker that the effect of the financial crisis on capitalism will depend on the severity of the crisis. Very few people are committed in an emotional sense to a free-market ideology; if the free market seems not to be working, the population and its political representatives will cast about for an alternative. In this longish comment, I respond briefly to some of the readers’ comments on my last week’s post, bring up to date my discussion of the financial crisis, and in closing return to the question whether capitalism has "failed." 1. Several comments note that there were a number of other prophets of doom besides Nouriel Roubini. Here is one: "When the downturn in house prices occurs, many homeowners will have mortgages that exceed the value of their homes, a situation that is virtually certain to send default rates soaring. This will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse, a government bailout (similar to the S&L bailout), involving hundreds of billions of dollars, would be virtually inevitable." Dean Baker, "The Menace of an Unchecked Housing Bubble," The Economists' Voice, vol. 3, issue 4, article 1. Given the multitude of warnings from respectable sources, it is puzzle why the warnings did not stimulate a serious effort to evaluate the health of the financial services industry and the adequacy of regulation. Part of the answer may lie in a perceptive comment by reader Jamison Davies. He reminds us that "Important to [Roberta] Wohlstetter's argument [about why the Japanese attack on Pearl Harbor achieved surprise] is the concept of the 'signal-to-noise' ratio, i.e. the amount of useful information being taken in compared to the information that is false, misleading, or irrelevant. It turns out that earlier concerns about inflationary spikes may have just turned out to be background 'noise'…as well as other economic issues, but ex ante it is extremely difficult to tell what data will be predictively useful and what is just noise." Davies adds that "the difficulty in early warning, among other things, is that if you give correct warning and act in response to that warning, the attack will likely not materialize (i.e. if the US knew Japan was about to attack Pearl Harbor our defensive preparations would prevent Japan from following through). This means that successful warnings are undercounted because the catastrophe never emerges. This tends to weaken early warning systems as they are perceived to be ineffective even though they may have averted serious problems." Davies points out that "the economic analogy is regulation. Regulations were seen as unnecessary and dismantled because there had been no crises, but policymakers failed to consider that there may have been no crises precisely because of the regulation." Another comment quotes economist Thomas Sowell as saying: "Failure is an important part of the success of the capitalistic system.”"The commenter adds that in "the free market system, companies that are seriously mismanaged in one way or another will fail, and these failures make room for the ones that are well managed." All true, but in the current crisis many seriously mismanaged firms will be saved by the government, and many firms that are not mismanaged will fail because of the effect of the mismanagement of other firms on consumer demand and the credit market. 2. In earlier posts Becker and I have discussed whether the financial crisis is a liquidity crisis, a solvency crisis, or both. At this writing it seems that it is more a solvency crisis than a liquidity crisis. The initial bailout plan--to buy the sick assets of banks, such as their mortgage-backed securities--was premised on the assumption that the crisis was one of inadequate liquidity: uncertainty or perhaps even unreasoning fear was preventing the sale of bank assets at prices that reflected their "true" value. If this was incorrect--if the problem was not that the banks' sick assets were frozen but that the banks were undercapitalized--the plan would be unsound: either the government would pay the actual, low value of the assets, in which event the banks would have no more capital than before, or it would overpay and thus be giving the banks a gift at taxpayers’ expense. The plan was quickly altered (the U.S. embarrassedly taking its cues from the prime minister of England) from a purchase of assets to a contribution of capital in which the government would receive interest-bearing preferred stock in exchange. A disturbing note is Secretary of the Treasury Paulson's plea to the banks who have received the capital contribution to lend it out rather than hoard it. What is disturbing is that since banks are in the business of lending and do not receive a return on money that they hoard, they don't need prodding to make loans unless the risks are too great. The risks remain too great unless the capital infusion ($250 billion split among nine banks) is large enough to make the banks adequately capitalized. With the recession/depression spreading and deepening, the risks of lending are growing and so the banks need a bigger capital cushion than when the economy was booming. It will not be prudent for them to lend unless either they have that cushion or the government guarantees the repayment of the loans they make. 3. The severity of the recession/depression precipitated by the financial crisis cannot yet be gauged accurately. One reader amusingly cites the prediction of "Scholars of Astrology" that the economy will recover in seven months. If so, the crisis will not provoke a serious rethinking of the nation's commitment to a market economy. But if the recovery takes substantially longer--if, as seems possible, we are in the midst of the most serious depression since the Great Contraction of 1929 to 1933 (and why has the word "depression" become unmentionable? Why does everyone except me prefer the anodyne euphemism "recession?)--then that commitment will come under fire. Should it? There are three basic types of economy (with many intermediate possibilities, of course): a pure free-market economy; a regulated market economy; and socialism. In the first, all economic ordering is left to private action: money is private, contracts are enforced not by legal means but by concern with reputation and threats of retaliation, caveat emptor prevails, and the role of government is limited to providing internal and external security against violence. In such a world there are, for example, no restaurant inspectors, and if you get ill eating in a restaurant you have no legal recourse; but restaurants might form voluntary associations that would conduct inspections, and careful consumers would patronize only the members of reputable such associations. Very few economists support so lean a system of government. Virtually all support a regulated market system in which, for example, victims of food poisoning have tort remedies but systems of restaurant inspection are also instituted, to back up those remedies in recognition that most incidents of food poisoning are not serious enough to warrant the expense of bringing a lawsuit and that many restaurants operate on a shoestring budget and could not pay a substantial tort judgment. An alternative to inspectors might be requiring anyone entering the restaurant business to post a substantial bond and allowing the successful plaintiff in a tort suit against a restaurant to recover his attorneys’ fees. But these are simply alternative methods of regulation rather than a recursion to a pure free-market economy. Given the history of economic failure under socialism, we should exhaust the possibilities for adopting more effective regulations of the financial-services industry before jettisoning our regulated market system in favor of a socialist one. That is so obvious as not to require argument. What is less obvious is why so many people think that the financial crisis is proof that a market economy does not work and thus we need fundamental change rather than merely incremental regulatory reform. The answer lies in what conservative economists used to call the "Nirvana fallacy." This is the idea that any failure of the economy to attain optimality is a "market failure" that warrants government intervention. Conservative economists pointed out that the proper comparison is never between the operations of the actual market and an unattainable theoretical perfection, but between market-directed and government-directed or -regulated allocations of resources in particular economic settings. Market failures are ubiquitous, as the current crisis demonstrates. The crisis is not primarily a result of government actions. The quasi-governmental status of Fannie Mae and Freddie Mac and the pressures exerted on them by Congress to facilitate home ownership by insuring risky mortgages were contributing factors to the crisis, but the basic causes were misassessment by the industry of the risks associated with extremely high levels of borrowing, misunderstanding of risk by home buyers encouraged by real estate brokers, mortgage brokers, and banks, conflicts of interest by rating agencies, corporate compensation policies that truncated downside but not upside risk, and the private costs of disinvesting in an industry undergoing a bubble (the housing industry) before the bubble bursts, since until that moment the profits from riding with the bubble will be increasing. An additional factor was government inaction, but the failure of government to intervene in a market that is failing obviously presupposes rather than illustrates market failure. In contrast, gratuitous government intervention when there is no market failure is a genuine example of government failure. So a confluence of market failures has created an economic crisis, and the challenge is to develop regulatory responses that reduce the cost (net of the direct and indirect costs of the regulations themselves) of such failures. Complacency on the part of some economists and politicians about the efficiency of the market system, and specifically an exaggerated belief in the robustness of financial markets, have created the impression that the current crisis is a crisis of capitalism rather than just another demonstration of the radical imperfection of human institutions--including the market.

Comments

[Tim]

"the U.S. embarrassedly taking its cues from the prime minister of England"

I have a lot of time for your comments, but please try to get the name of the country right - it undermines your credibility when you get simple facts wrong.

He is the Prime Minister (in capital letters) of Great Britain, not just England.

[Scott Wortley]

Judge Posner,

One minor correction - the plan to contribute capital came from the Prime Minister of the UK, not just England. Like the Prime Minister I'm a Scot and we tend to get prickly about that sort of thing. The proposal in the UK stemmed from serious capitalisation problems for the two Scottish banks.

Scott Wortley

[Jeremy Goodridge]

Great post. Thank you so much for your extreme reasonableness and rationality and for being so free of ideology. It's a rarity in today's debates.

Jeremy Goodridge

[Ivan]

Prof. Posner,
your description of "pure market economy" is seriously misleading. Why do you ascribe tort protection of consumer only to "regulated market economy" ? Or you just unintentionally make impression that under free market there is no legal protection, by saying that "if you get ill eating in a restaurant you have no legal recourse;(is that mean that in regulated market you can have recourse against bad quality food?) while in reality you don't think so? Are you suggesting here that under "regulated" market you have a guarantee that you will eat always good food in every restaurant, or you are suggesting that under free market you have no legal right to sue them if they poison you, i.e. threaten your physical integrity? If first, you are wrong from obvious reasons; if second you are wrong because legal protection is assumed as regular feature of free market economy. If consumer can prove that he was poisoned by restaurant he will sue the restaurant both in free market and "regulated" economy. You seem to employ favorite tactic of all supporters of government interventionism - mixing legal protection of life, liberty and property with government meddling and control (like government inspectors in restaurants). Those are not the same sorts of "regulation" - protection of individual is a part of free market system, and it isn't some addittional government regulation, in the sense inspectors are.

More generally, concerning financial crisis, you contradict to yourself, when analyzing "nirvana fallacy". You correctly point out that one cannot compare actual market, including all its imperfections, with imagined perfect world, but only with the world of government action, or intervention, to correct those market "failures". But, two sentences later you assume, without any argument that
"So a confluence of market failures has created an economic crisis, and the challenge is to develop regulatory responses that reduce the cost (net of the direct and indirect costs of the regulations themselves) of such failures."

But, how do you know that ANY government regulation will improve the things, and that what we need i to "develop regulatory response"? maybe we need "de-regulatory response". Isn't that textbook example of Demsetz's Nirvana Fallacy? Why do you not take into account possibility that maybe, just maybe, government regulation can be part of the problem, not of the solution, and that deregulation, i.e. move into direction of more free-market financial system would be much better than additional government regulation. Burden of proof is on you, but you just suppose, without ANY argument, that some sort of additional government meddling is a solution. What kind of analysis support your belief?

[Jim]

Balancing the interests of capitalism and democracy is the dilemma to be solved by any enlightened society. That has been demonstrated by both of their failures. There are those who regardless of how much wealth is accumulated will still pursue more to the detriment of society. Without regulation, that one-sidedness will eventually lead to revolution and loss of freedom. Pick your poison.

[Ivan]

Just one more point.

If we can estimate costs of regulation ex ante, then we must be able to estimate cost of investment of particular kind, to predict new financial and industrial developments in the future, price movements and so on. But, if we can do all of this we do not need market anymore! We can return to socialism of Soviet style. They also believed they can predict everything better than market.

I think that experiences with financial crises attests that we cannot estimate costs of regulation on future economy. Actually, we have no clue about what problems will occur in the future. Financial regulation is always addressing past crisis.

[David Caroline]

I agree with the previous post regarding the fact that your description of a pure market economy as one in which there is no legal recourse for being sickened by food in a restaurant is well beyond what a true free-market should look like. I can not conceive of a healthy free-market without a vibrant tort system. Even in a pure free market there must be recourse for a consumer harmed by a person or business.

[Ivan]

Jim, what is democracy? Democracy, in my view, is system of constitutional government with limited influence on economy. Such kind was envisioned by American Founding Fathers. Socialist enemies of free society use the term to describe plunder by political means, through taxation, redistribution and pervasive regulation. Under "enlightened society" socialists usually think "we, enlightened elites who now better than ordinary people what are they interests, and who now better than people what they ought to buy and sell, how and how much. And we'll impose on them our grand vision of society.".

I don't think that is is "balancing democracy and capitalism", but destroying the free society with the cynical excuse of its improving.

Wealthy people do not "pursue more on detriment of society". At the contrary, they profit only by serving the people. Politicians and regulators how use monopoly of power to destroy the wealth by pervasive regulations and high taxes pursue their interests "on detriment of society".

[Ivan]

Jim, what is democracy? Democracy, in my view, is system of constitutional government with limited influence on economy. Such kind was envisioned by American Founding Fathers. Socialist enemies of free society use the term "democracy" to describe plunder by political means, through taxation, redistribution and pervasive regulation. Under "enlightened society" socialists usually think "we, enlightened elites who know better than ordinary people what are they interests, and who know better than people what they ought to buy and sell, how and how much. And we'll impose on them our grand vision of society.".

I don't think that is is "balancing democracy and capitalism", but destroying the free society with the cynical excuse of its improving.

Wealthy people do not "pursue more on detriment of society". At the contrary, they profit only by serving the people. Politicians and regulators how use monopoly of power to destroy the wealth by pervasive regulations and high taxes pursue their interests "on detriment of society".

[Kevin]

Perhaps the worst consequence of the current crisis (and Bush’s policies in general) is the ammunition it gives free-market critics. Free-market capitalists ran wild, the critics say, and ruined our financial system along with millions of retirement accounts. And thus anti-free-marketers often convert the ignorant with arguments that contains half truths.

Sure, stiffer oversight may have prevented the subprime meltdown. But the reason we needed regulation is the federal government's intervention in the mortgage market. The federal government, starting with the Clinton administration and continuing with the Bush administration, pushed Fannie to offer mortgages to those in the subprime category. (See http://query.nytimes.com/gst/fullpage.html?res=9c0de7db153ef933a0575ac0a96f958260&sec=&spon=&pagewanted=all.) Financial firms bought up subprime-based securities with the implicit guarantee that government would back the loans if they failed. The federal government, through bad intervention, created a serious moral hazards problem.

The free market, then, did not create the meltdown. Because our system is largely a free-market system, though, and Bush pursued some free-market polices (e.g., lower taxes, free trade agreements), many incorrectly conclude that laissez-faire policies are culpable. In reality, we cannot say that unregulated, free-market policies fail because we lack sufficient evidence.

I agree with your second-sentence assessment: few people are emotionally committed to free-market ideology. Still, nearly all Americans are emotionally committed to freedom. If more people read the works of Milton Friedman, Kenneth Arrow, Howard Brown et al., they would recognize the close connection between free markets and freedom and, perhaps, feel a stronger commitment to free-market principles.

[neilehat]

As for the breakdown of economic orders, it is fair enough. Although, I would go one step further. Let's call the completely open free economy, "Anarcho-Capitalism". And we certainly all know about the "Freedom" of Anarchy (where's Hobbes?). As for Socialism or the Command Economy, it does have a problem with the allocation of resources and production during times of peace. Whereas, during War, a Command Economy is essential too make sure that resources and production are allocated properly and aimed at the necesssary elements to support the War effort. So "Socialism" does have it's place. As for the intermediate form, a regulated Capitalism lying somewhere in between, is probably the best solution as the Judge points out.

!"NEWSFLASH"!

The A.P. releases report about potentially illegal Lobbying by Freddie Mac, i.e. "Stealth Lobbying" dating back to at least 2005 to try and kill a Senate Committee sponsored Bill aimed at creating greater oversight and regulation of the Home Mortgage Industry. Essentially, trying to "bribe" Republican Senators not to approve or bring to the floor the Republican sponsored Bill.

The Judge is right, the Nation has got a bigger problem than just the meltdown in the Banking and Financial Industry. How does one properly regulate, when the fundamental regulating process has been corrupted? Perhaps, while fixing this "Crisis of Capitalism" we also need to go in and clean out "K Street" in Washington D.C. while we're at it.

[Zach]

Prof. Posner-

Thank you for the reasonable post.

However, I have a concern. There are few, if any, people who would advocate for a socialist state, even if there is a significant recession. I think you are presenting a false dichotomy between extreme capitalism and communism.

Neither option is being considered! Rather, the question is: do you want a pseudo-socialist European state or an unregulated Chicago School-style capitalism? That is the question on the table. This is not a crisis of capitalism, merely a crisis of laissez-faire economic policies.

To present the “boogeyman” of socialism is to make a straw-man argument that does little to discuss the real issues.

[DanC]

I compared the Financial mess to Katrina on another Blog

My question is this like Katrina? i.e experts for years warned that a direct hurricane hit on New Orleans would have catastrophic consequences. This was not a big secret. Yet the safety measures taken were often superficial and inadequate to meet the potential challenge. Even residents of New Orleans, who should have been most aware of the potential consequences, discounted the risks.

Can the government prevent occasional severe hurricanes? No. Can they take steps to minimize the damage? Yes. But what is the optimal level of expenditures to protect against damaging storms? And can individuals do a better job of protecting assets then the government?

One of the problems with hurricane damage is the moral hazard of government bailouts. Residents in hurricane areas may take greater risks because they feel confident that the government will bail them out in the worst case scenario. We see to see some of the same risk with our current financial disaster, especially with regard to Fannie and Freddie.

I could go on with the analogy. But the point is many people knew that the financial system would be unable to withstand a direct hit. Safety measures were inadequate to deal with the risks, at least with the benefit of hindsight. Under pressure weaknesses became very obvious. Politicians had choices on how to prioritize government dollars, but they choose to emphasize politically advantageous expenditures over security.

[DanC]

Why did I not heed the warnings? Three years ago the AP had a story that I think came from the Milwaukee Journal about a real estate conference. One speaker, some past president of some professional group of mortgage lenders made dire predictions about the real estate market. He talked about increasing defaults and warned that as ARMs were starting to reset the default rate would quickly accelerate. He warned of the trillions in loans that were in danger of going bad and warned that the crisis would dwarf the S&L.

His reasoning seemed so sound, that I was nervous. I talked with two reporters for the Wall Street Journal about the article. I did some research on my own and the guy's numbers looked like they were correct.

So why didn't I act in accordance with this information. I am a passive investor for the most part. Index funds with a boring if generally accepted allocation.

I assumed that the coming storm might make the seas choppy, but I had faith that financial institutions must be at least as aware of these issues as I was. Two months, six months, nine months passed and I could not see evidence that the smart money was worried. Indeed the market was going up. So I stopped worrying.

I had considered buying a contrarian fund to hedge against a possible downturn. But most of the financial hedging strategies that I know are harder to implement in a typical 401K. If the money was in a traditional pension, I would assume that the managers would have taken more prudent steps to hedge the fund.

So I wonder how much the growing use of 401K is affecting the stability of the market. As larger and larger sums are held outside of the traditional pension system, and given to individuals to invest, are some market stabilizers being lost?

I understand that the marginal buyer sets the price, but what happens when the marginal buyer is taking increasing risks and the typical 401K owner lacks the ability to hedge.

[DanC]

BTW my comments above assumes that the movement of the stock market will become more volatile then the changes in the economy, ie if 401K investors have less ability to hedge against a crisis.

The failure of the financial institutions to manage their firms would still be the root cause of the problems in the current economy.

[Taylor J. Simpson]

Brilliant post. Further testament to the fact that Judge Posner is one of the most valuable minds in this country. A million thanks if you read this, sir. You're an inspiration.

[Taylor J. Simpson]

Brilliant post. Further testament to the fact that Judge Posner is one of the most valuable minds in this country. A million thanks if you read this, sir. You're an inspiration.

[Taylor J. Simpson]

Brilliant post. Further testament to the fact that Judge Posner is one of the most valuable minds in this country. A million thanks if you read this, sir. You're an inspiration.

[Brian Davis]

Dan, the typical 401(k) today is in some kind of diversified managed fund - the employee's contributions, that is. Employer contribs may still be weighted in favor of employer stock. But let's assume optimal diversification. Good article in today's WSJ about what stock fund managers are doing to survive the volatility and cash-outs: "sell the rallies." It can't be much different or less brutal right now in the 401(k) world. True enough, selling into the rallies enables fund managers to meet redemptions and switches to different funds/managers, but suppose you're left with other people's cash and a responsibility to put it back to work. It's a treacherous landscape. People are down 25%-30% on the year and growing impatient. Most folks at or close to retirement who were counting on eternal capital gains and some dividends, besides real estate appreciation, are now on their backs. A paid-off home mortgage and Social Security look better every day.

[Dr P K Rao]

Judge Posner,
I believe that an extension of the logic of 'managed' economy concept fits somewhere between rudderless free capitalism and regulated economy/market, and that is what remains a rather robust prescription for sustainable and efficient functioning of a developed economy as in the US. This is predicated on limited self-discipline of economic agents operating under a free market system, and rather incomplete specification of laws and contracts. A mechanism of pragmatic supervision (which I called 'prudent regulation' in my book "Development Finance") remains a perennial requirement for now and into the future.

[bob]

I agree with Zach. I think you massively underestimate the affinity of average people of all political stripes to regulated free markets. As one example, name any politician who has proposed abandoning a regulated free market system, other than with regard to the temporary capital injections into financial institutions.

I believe what you refer to as "socialism" is actually what I think most people would understand as "communism," but I would be interested in hearing what you think distinguishes the two. Which countries today do you view as having a socialist system?

I also think you fail to distinguish between the American-style less-regulated free market and the European-style more-regulated free market with a bigger social safety net, which is where the whole ballgame is played.

(Your discussion of unregulated free markets is interesting but not especially useful other than for pointing out that those claiming to support completely free markets are mostly right-wing liars or anarchists. Read David Boaz at Cato claiming that the problem is that we still have yet to implement a true free market economy.)

[DanC]

Brian,

Even I, with a collection of index, foreign, bonds, etc was technically diversified but few of my accounts are really actively managed. My point was that I had wanted to short my positions because I was afraid of the housing bubble and its affect on my portfolio.

If I had wanted to insure against that potential risk that I saw coming, it would be difficult for me and most people. However a good manager of pension plan should have been able to do it a lot easier.

While I can create a portfolio with a ten year outlook, I'm not sure how I can easily take short positions, buy insurance on my portfolio when I see a storm on the near horizon.

Perhaps you are correct that the managed funds inside of 401K plan could have done this, but it doesn't seem like they did. Why they did not do it would be interesting to know. Did they not see the danger, did they not think it would affect their fund, or do they just keep a long term view and discount potential blips along the way.

Still, I would have liked to have had portfolio insurance for my 401K during the current mess. I think smart managers of large positions should have see the bubble risk and bought portfolio insurance.

Perhaps the stock market would have been less volatile. Attacks on the financial system and calls for rather extreme measures would have been muted. And people might have more faith in markets, if they knew how to use them to hedge risk.

But I could be wrong

[nathan]

As for noise, life is difficult when signals are mixed-up. Do Stan O'Neal, Jeff Skilling and George Bush all have Harvard degrees? You would think they are not generators of noise.

[Robert tuosto]

Dear Judge Posner:
A "regulated market economy" is almost a contradiction in terms; I would suggest that there is either full laissez-faire capitalism or statism (with the degree of governmental intrusion to be decided upon). The American economy, technically speaking, is not capitalist but statist. There presently exists in our country a greater degree of capitalism and a lesser degree of statism relative to Western Europe but, again, this is a matter of degree.
Otherwise, a great article.

[neilehat]

DanC, For the individual investor, the new exotic Financial Instruments, that allows for hedging and the like to protect asset income only works for what I call "Portfolios of Scale". This scale begins in the millions and runs out to the trillions/quadrillions of dollars. Remember, they only work if the portfolio does not contain quantities of "gilded paper" or "pigs in the poke". Which is what the current meltdown is all about. The problem is, that most of these new financial instruments do not have real or tangible assets backing their value. Like natural resources or capital equipment and production capabilities. So, hence, their loss of value when their perceived value crashes. So you see, it's really all about an "Economy of Fantasy" - "never mind the facts, live the fantasy".