"The Half-Scientific Half-Witchcraft Discipline of Macroeconomics"

The quotation is from a review by J. Bradford DeLong, a well-known macroeconomist at Berkeley, of Sidelsky's great biography of John Maynard Keynes. Riding his witch's broomstick, DeLong has written a review of my book A Failure of Capitalism for his blog, The Week. The review, called "The Chicago School is Eclipsed," appeared on May 29 and can be found at www.theweek.com/article/index/97134/The_Chicago_School_is_eclipsed (visited June 10, 2009).

I have been attacked from the Right as an apostate to conservative economics, for I blame our economic crisis on poor management of monetary policy by the conservative icon Alan Greenspan and on excessive deregulation and lax regulation of financial intermediation, I criticize Milton Friedman, Robert Lucas, and other prominent monetarists, and I embrace Keynes, among other heresies. Professor DeLong, however, attacks me from the Left. Here is the opening paragraph of his review:

Richard Posner, leader of the Chicago School of Economics and Fourth Circuit Court of Appeals judge, uses his new book, "A Failure of Capitalism," to try to rescue the Chicago School's foundational assumption that the economy behaves as if all economic agents and actors are rational, far-sighted calculators. In some sense, Posner must try. For without this underlying assumption, the clock strikes midnight, the stately brougham of Chicago economic theory turns into a pumpkin, and the analytical horses that have pulled it so far over the past half- century turn back into little white mice.

I am not in fact "leader of the Chicago School of Economics" and I am not a judge of the Fourth Circuit. (Later in his review DeLong calls me "one of America's leading public intellectuals," with "very wide" influence--both of which statements are incorrect.) I also am not committed to the "foundational assumption" that DeLong states. But neither do I believe, as he does, that our economic crisis was the result of the "irrationality"--indeed the "financial lunacy"--of the owners and managers of commercial banks and other financial intermediaries.

As evidence that it was, DeLong offers four examples, one of which, however--the overcommitment of GM and Chrysler to gas guzzlers--is irrelevant to the behavior of the financial industry. His first example, typical of the three that are drawn from that industry, is that "It was not rational for Bear-Stearns CEO James Cayne, with his own $1 billion fortune on the line, to allow his firm to become hostage to the excessive risks taken by his subordinates in the mortgage markets." But did he know that his subordinates were taking "excessive risks"? And what does the term mean, exactly? Suppose he thought there was a 1 percent chance that he would lose his fortune, and a 99 percent chance that he would double it. Would taking that chance be irrational? DeLong does not define "irrationality" or "lunacy" and his review does not answer the questions I have put

He is troubled that I should blame the crisis primarily on the combination of too-low interest rates in the early 2000s (Greenspan's mistake) and financial deregulation, because this means that "What is needed, Posner implies, was a Daddy State in the early 2000s that would have kept interest rates high, kept the recovery from the 2001 recession much weaker, and kept unemployment much higher," and also "have restricted financial innovation." Yet he criticizes the rapid growth of derivative markets (that growth was "absurd"),"high-leverage portfolio strategies," and securitization--all instances of financial innovation--and he is silent on the relation between low interest rates and the housing bubble. He seems to think that full employment can be achieved by low interest rates without sparking inflation, for he is critical of "prohibit[ing] the Federal Reserve from seeking full employment through low interest rates." I venerate Keynes, but one of the least persuasive suggestions in the General Theory is that a policy of low interest rates can lead to a perpetual boom, ending the business cycle and wiping out involuntary unemployment.

Yet, inconsistently with his hostility to "a Daddy State," De Long in the review advocates far more extensive regulation of financial intermediation than I do. He commends venture capitalists and hedge funds for having a larger equity stake in their investments--that is, for being less highly leveraged than banks. (He regards 30 to 1 leverage as excessive, though banks with 20 to 1 leverage are regarded, though perhaps not by him, as well capitalized.). And yet at the same time he wants "every financial institution" to be organized in the form of "a bank holding company regulated by the Federal Reserve" with 10 or even 20 percent of its liabilities required to be kept in an account at a federal reserve bank, which would be the equivalent of cash (well, not quite, because the Federal Reserve is experimenting with paying interest on banks' excess reserves--i.e., lendable cash). Venture capital firms and hedge funds are "financial institutions," and so DeLong's analysis implies that they should be forced into the bank holding company mold.

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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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