The Financial Crisis and the Real Economy
posted by Frank Pasquale
Judge Richard Posner’s upcoming book A Failure of Capitalism: The Crisis of ’08 and the Descent Into Depression looks to be a fascinating take on the financial crisis. Posner concedes that “The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.” As Robert Solow concludes, “If I had written that, it would not be news. From Richard Posner, it is.” Reviewing Posner’s book, Solow characterizes uncertainty as to asset values as the heart of the current crisis:
Many highly leveraged financial institutions—banks, hedge funds, and insurance companies among them—have dug themselves into . . . interconnected holes. They have borrowed from other financial institutions to make complicated bets on risky assets, and they have lent to other leveraged financial institutions so that those institutions could make complicated, risky asset bets. These are the “toxic assets” that weigh down the balance sheets of banks. No one knows for sure what anyone else is worth: they own assets of uncertain value, including the debts of other institutions that own assets of uncertain value.
One of Posner’s solutions to that problem, outlined in a preview of a chapter of the book, is to vastly increase regulators’ ability to understand what is going on in the financial sector:
[F]inancial regulators [have not been able to force] disclosure of information that might have revealed how risky the financial system had become. A focus of reform, therefore, should be the creation of a centralized, unitary financial-intelligence apparatus in government that would have complete and continuous access to the books of all financial institutions. This sounds simple but the details would be complex . . . .
Why would the “details be complex?” I sense that the same problems that confront search engine regulation would arise here: both the shadow banking system and traditional financial institutions would try to characterize key activities as trade secrets, and would resist any regulation designed to expose them to scrutiny. In the national security context, the FISA court arose in order to balance executive prerogatives to state secrecy against judicial monitoring of potential misuse of law enforcement authority. Perhaps something like it could be devised to balance proprietary interests in secret bank practices against the public need to guard against systemic risk.
On the other hand, I’m not terribly enthusiastic about such a compromise because government has already invested so much in the leading banks in an opaque way. I’m also broadly skeptical of views like Posner’s because they seem to assume that the crisis in the financial sector can somehow be abstracted away from larger crises in our economy. As James K. Galbraith notes, it’s not just the banks that are hurting:
[The crisis is not] merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. . . . .But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. . . . The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true—what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor. . . .
Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not.
[T]he big problem [is]: How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation?
Today the largest problems we face are energy security and climate change. . . . And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years. . . . Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments.
Merely restoring “business as usual” in the financial sector is a surefire way to avoid solving any of these problems. Companies driven by quarterly earnings figures do not have the foresight or incentive to build a sustainable infrastructure. Moreover, the cheap credit that our “financial engineers” excelled at providing (with help from the Fed and the Chinese Communist Party) have served merely to mask the deeper problems in our economy:
Lax regulation and uncommon stupidity and greed on Wall Street are the primary forces behind the current financial nightmares, but the free market did try to find a solution to the deeper financial calamity affecting millions of American workers. Good regulations and alert regulators . . . would have prevented Wall Street from taking such extreme risks in pursuit of high profits, but regulation would also have shut off Americans’ access to cheap credit, thereby forcing us to face the hard fact that our form of capitalism simply cannot deliver the goods. . . .
Our debt crisis is the result of a connected set of choices that America has made in public and private life. The first choice is the attempt to use private debt to maintain consumption levels in the face of stagnant or declining inflation-adjusted incomes. The second set of choices was: (1) our collective decision to cut taxes without cutting our demand for public services and thereby committing the federal government to borrow money more or less forever and (2) our refusal to use the borrowed money for sensible public purposes—such as improving the competitive capacities of the economy by fixing our rotting transport, power, and water management systems or increasing the quantity and quality of essential public goods like schools and health care.
In other words, the financial crisis is but one part of a larger economic crisis, whose resolution will depend on how we answer several key questions. Can the US’s manufacturing base be restored? Will Americans commit to long-term solutions designed to create useful technology? Can we stop pretending that the uncoordinated choices of millions (recently piling into McMansions, Hummers, and doga) will lead to sustainable solutions to the energy, environmental, and public health crises we face? Brave answers to those questions can lead to a stronger real economy that can in turn support a strong financial sector. Even the wisest legal reform cannot lead to a financial sector capable of revivifying a moribund real economy.
May 2, 2009 at 4:08 pm
Posted in: Economic Analysis of Law
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