Response to Comments--May 16 to May 26

There were a number of interesting comments; rather than try to respond to them individually, I will group them into themes and respond to each theme.

One theme is that, contrary to my argument, the unhappy situation of the economy today should not be viewed as a "failure of capitalism" but as a failure of government. In fact both characterizations are correct, because capitalism and government cannot be separated. You cannot (here I part company with "anarcho-capitalists," such as David Friedman) have capitalism without a government, specifically a central bank with discretionary authority over the money supply and a regulatory regime for financial intermediation (banking in a broad sense). The money supply has to be geared to the amount of output--otherwise you have inflation if the ratio of money to output rises sharply or deflation if it falls sharply, and both are destructive; and because output varies unpredictably, a constant growth rate in the money supply will not avoid inflation or deflation.

And you have to have regulation of banking because banking is inherently risky (it involves lending borrowed capital, and the only way to create a spread between the cost of borrowing and the return from lending is to lend at a greater risk than that borne by the suppliers of capital to you, as by borrowing short and lending long), because the risks are not independent (that is, they are not idiosyncratic risks of particular banks), and because a failure of the banking industry freezes economic activity (which depends on credit), precipitating a severe recession or depression. So if one wants to have monetary stability and a safe banking system, one needs a central bank and a bank regulatory regime: one needs, in short, governmental controls over the economy. They are intrinsic to functioning capitalism.

What is not intrinsic to capitalism is subsidizing home ownership, whether through the mortgage-interest deduction from the income tax or the subsidization of risky mortgages by government-sponsored enterprises (Fannie Mae and Freddie Mac). I don't defend our housing policies--on the contrary. But neither do I think they are major causes of our current economic distress.

I do worry about the "moral hazard" problem--that is, the tendency of insurance to encourage risky behavior. If banks expect to be bailed out by government if they get into trouble, they will take greater risks than otherwise and get into more trouble. But we must be precise about the problem. Bailouts generally are quite painful for shareholders and management, as the financial institutions that have received government loans during the present crisis have learned to their sorrow. The principal beneficiaries of the bailouts are unsecured bondholders of the bailed-out firms, who would take a bath if the firms they lent to went bankrupt. If they think the government will bail out those firms, the firms will be able to borrow at lower cost than their competitors, and the lenders will be less vigilant in policing the borrowers' conduct.

The answer to this moral hazard problem is regulation. Any insurer has a right to take measures to reduce moral hazard, and an interest in doing so. Bank deposits are federally insured, which protects banks against runs and reduces the incentive of depositors to monitor the banks' behavior, so federal regulators, in their capacity as insurers concerned with moral hazard resulting from the insurance, try to prevent banks from taking excessive risks. If "too big to fail" operates to insure other lenders to banks, namely bondholders, then we have a further moral hazard problem to which regulation must attend.

One comment attributes our economic situation to the high oil prices last summer, and another to China's export-first economic policies, which resulted in a flood of cheap imports to the United States and a huge Chinese dollar surplus invested in the United States, which tended to keep interest rates down. I am more sympathetic to the first suggestion than to the second. I think the high oil prices, besides reducing Americans' wealth and thus making them more vulnerable to an economic downturn, fooled the Federal Reserve into keeping interest rates higher than necessary to prevent the recession that turned into a depression, because it worried that oil prices were creating a danger of inflation. The Federal Reserve raised interest rates too late to prevent the housing bubble, and then lowered them too late to prevent the bursting of the housing bubble from bringing down the banking industry.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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