Posner on the financial crisis

In a number of previous posting I have noted that many commentators hold agencies of the government largely responsible for the current financial crisis. But not all commentators do. One person who does not is, perhaps surprisingly, Richard Posner.

In an essay, The Financial Crisis: the Role of Government, at the Becker-Posner Blog, Posner argues that the current crisis is not the result of government actions. He writes

I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity). Leverage enables greatly increased profits in a rising market, especially when interest rates are low, as they were in the early 2000s as a result of a global surplus of capital. The mistake was to think that if the market for housing and other assets weakened (not that that was expected to happen), the lenders would be adequately protected against the downside of the risk that their heavy borrowing had created. The crisis erupted when, because of the complexity of the financial instruments that were supposed to limit risk, the financial industry could not determine how much risk it was facing and creditors panicked. Compensation schemes that tie executive compensation to the stock prices of the executives' companies but cushion them against a decline in those prices (as when executives are offered generous severance pay or stock options are repriced following the fall of the stock price) further encouraged risk taking. Moreover, even when businesses sense that they are riding a bubble, they are reluctant to get off while the bubble is still expanding, since by doing so they may be leaving a lot of money on the table. Finally, if a firm's competitors are taking big risks and as a result making huge profits in a rising market, a firm is reluctant to adopt a safe strategy. For that would require convincing skeptical shareholders and analysts that the firm's below-average profits, resulting from its conservative strategy, were really above-average in a long-run perspective.

When discussing the government's responses to the crisis Posner says,

But here is a remarkable thing about these responses. To a great extent they are not responses by government, really, but by the private sector. Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition of short selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis. In effect, the government's power to repair the crisis that Wall Street created has been delegated to Wall Street.

Posner ends his article by saying

I do not criticize the delegation of the handling of the crisis to (in effect) the finance industry. I imagine that Bernanke and Paulson and their private-sector advisers are the ablest crisis managers whom one could find. I merely want to emphasize that the financial crisis is indeed a "crisis of capitalism" rather than a failure of government, though it will not and should not lead to the displacement of free-market capitalism by an alternative system of economic management. But it is already shifting the boundary between the free market and the government toward the latter.

I still find myself with questions as to the actions of the financial regulators and central banks. As Arnold Kling has noted

Government regulators can be faulted for two things. First, they enabled the private sector delusions. Regulators did not sound warnings about credit scoring, and they issued only minor scolding on derivatives.

Second, government operated under the delusion that low-down-payment mortgages are a good thing. I have coined the expression "home borrower" to describe someone who puts little or nothing down to buy a home. Government encouraged home borrowing, and that made the bubble inflate higher on the way up and crash harder on the way down.

Along with this it should be noted that the central bankers could have popped the property bubble before it grew too big. But they didn't. Also there were the incentives created by legislation. The 'anti-redlining' laws, for example. Such regulations set out to stop lenders refusing loans to people who happened to live in a poor part of town. That gave millions of poor people access to home loans – but at the expense of the institutions taking on riskier customers. Then there was the implicit government guarantee on Fannie Mae and Freddie Mac. Seemingly insulated from all harm, they became reckless - an example of moral hazard. They constructed a giant pyramid of debt on a very small base of capital. So I feel Posner maybe underestimating the responsibility of the government for the crisis we now face.