Thursday, October 30, 2008

Speaking of Richard Posner

Richard Posner long broke the mold for federal judges who used to hibernate in their chambers, only occasionally emerging for group photos. Not only has he continued to write books, speak, and occasionally appear on television, throughout his judicial career, he now blogs with Nobel prize winning economist, Gary Becker, at The Becker-Posner Blog.

I find a recent entry fascinating, not so much for its predictable defense of capitalism and the free market economy, but for what Posner identifies as the causes of the current financial crisis. In his essay, "Has the Market Economy Failed?", Posner writes:
....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....


Scott Hankins said...

Unless I'm mistaken, I think I was in school at Oberlin with Richard and his twin Larry. Both have made names for themselves, and I think this is astute.


klady said...

Really! Does that mean I'm still a few years younger than you? ;)

Richard was born in 1939 according to wiki.

sharecropper said...

I heard a similar kind of thing from that woman who writes the financial stuff for Oprah, susie? The basic cause for the current financial crisis is the people, not the system.