America Spirals into Depression

A Review of Richard A. Posner’s A Failure of Capitalism

Richard Allen Posner is currently a judge on the U.S. Court of Appeals for the Seventh Circuit in Chicago. He is a Senior Lecturer at the University of Chicago Law School. Posner is very influential in the movement of law and economics, and he has written more than 2500 published judicial opinions.

BY MAHEEN MUSTAFA

America is, economically, at its lowest point since the Great Depression of 1930. Unemployment rates have increased more than they ever did after the Depression. The level of economic activity has dropped dramatically. In effect, there is “a steep reduction in output that causes or threatens to cause deflation.”1 A Failure of Capitalism, written by Richard A. Posner, is an informative book which goes in depth to explain the conditions of the current crisis of 2008. People have begun to cut down their spending and save for the future. Economic activity has dropped dramatically. In order to attain a large return, lenders take huge risks by lending a large sum of money; however, the failure of the borrower to return back money to the lender has major consequences. But the best way to get a large return is to take a great risk. Recognition of this current recession came a little late despite numerous attempts of journalists to warn the economists. The government kept on overlooking these minor warnings until the fall of 2008, in which the American economy seemed to be collapsing. The failure of the government to prevent this sort of a collapse causes the public to blame the government for their country’s economic condition. The government may have committed an enormous mistake in overlooking the warnings, but it cannot be entirely blamed. It was the “domino effect” that started with the fall of one individual firm which eventually caused the economic recession America is in.

There have been numerous assumptions as to what really led to the Crisis of 2008; however, the real causes are “low interest rates, collapse of the banking system, a drop in output and employment, a housing bubble, the collapse of the bubble, signs of deflation, [and] an ambitious program of recovery.”2 Low interest rates attracted more people to take loans. Banks took risks by lending because many of the borrowers had an unstable future ahead; if conditions persisted, they would not have been able to pay back. Yet big risks lead to big profit. When the government thought lending could be a great risk to the economy, it froze lending, leading to the Credit Crunch. This drop in economic activity and decline in the stock market started the downward spiral. The government cannot be blamed for this action since the immediate cause of this depression is the “confluence of risky lending with inadequate personal savings, so that when the risks materialized, causing bank insolvencies and a fall in demand for goods and services because credit was difficult to obtain, people couldn’t reallocate savings to consumption,” which led to the fall in demand and thus generated a downward spiral in employment and output.3 Another reason for this decrease is that when there is a fall in stocks and housing, people begin to save and try to build up their savings and immensely cut their expenses. Thus, there is a decrease in economic activity. What they should do, according to the author, is save money when the economy flourishes, and spend it when it’s deteriorating. Although the economy will benefit from this, it might not be beneficial to the individual. According to statistics in 2008, the American economic situation did not seem too vulnerable. Unemployment rate was 7.2 percent and the gross domestic product –“the market value of the nation’s total output of goods and services”— was 3.8 percent below average.4 On the other hand, in the Depression of 1930, the unemployment rate was 25 percent, and the decline of a gross domestic product was 34 percent. But these current rates seem to be at their highest since the Great Depression and if the trend continues, they would be much higher in the year 2009. The housing bubble formed, meaning that there was a steep rise in the prices of houses. Many were unable to recognize the bubble. Bubbles tend to greatly inflate and they eventually burst. When the housing bubble burst, prices fell 20 percent. This led to inflation.

Leverage means to fund a company that is under a fine amount of debt. Along with increasing risk for lenders, it increases the chance of the return they would get. “Incentive to take risks that is created by executive over-compensation in publicly held companies has been a factor in the financial crisis”: private companies did not do as badly in the downturn as the large publicly financial firms have done.5 “The greater the gains are from taking risks that enable very high short-term profits, and the better cushioned the executive is by his severance package against the cost of losing his job, the more risks he rationally will take”: the scarcity of savings combined with a highly leveraged bank is all that is needed for a recession to turn into a depression.6 Housing bubble and risky lending could have been avoided by forceful regulation by the government and elimination of tax benefits for homeowners. Posner believes that the recession was not a result of “too much government, but of too little: not of intrusive, heavy-handed regulation of housing and finance, but of deregulation, hostility to taxation and to government in general, and a general laissez-faire attitude, ‘conservative’ in a currently prevailing sense of the word.”7 Conservatives prefer low taxes and do not appreciate government interference in any form. Government is the first one whom people blame for all their problems; the only fault on the government’s part is that it failed to do anything about the depression America was spiraling into. Of course the actions of any individual firm cannot lead to an event such as the recession, but “the aggregate self-interested decisions of these institutions produce the economic crisis by a kind of domino effect that only government can prevent— which it failed to do. That was a grave government failure, which allowed a failure of the financial market to produce disastrous consequences for society as a whole.”8

Financial collapses are difficult to predict due to uncertainty. However, Nouriel Roubini, who was a professor at New York University, accurately predicted what has now occurred. He made predictions about the upcoming economics and observed how the combination of low interest rates and the deregulation of banking could lead to some sort of recession. The predictions came true by the time an article of his was published in Time magazine. Posner mentions that the article reported that “in September 2006—two years before the financial crisis but after the bursting of the housing bubble—Roubini had announced that a crisis was brewing.”9 Another cause of the depression was “blindness to warning signs” of a crisis.10 He continued to be ignored; it seemed as if “the magnitude of the crisis was largely invisible to government, the business community, and most economists, even specialists in financial economics and in macroeconomics.”11 In August 2007, the Federal Reserve was actually predicting a future of economic expansion; the only thing that they were mildly concerned about was inflation due to an increase in the sense in the consumer price index. To prevent inflation, they began to reduce the federal funds rate and made extra credit available for banks. They then enacted a tax rebate bill of $168 billion. All these measures were taken too late and now began to raise the fear of a mild recession. “It was not until the fall of 2008 that the government discovered that the banking industry was in dire financial straits”—had they listened to Roubini and the other predictors, the situation would have been much better.12

The government responded to this brewing recession through five phases: three phases of bailout, an “easy money” phase, and a phase of stimulus. The first bailout phase was the $700 billion Troubled Asset Relief Program. The main conception of the bailout phases was that “the government would buy the banking industry’s sick assets—the assets, notable mortgage-backed securities, the value of which had been made uncertain by the collapse of the housing bubble.”13 Then they would invest directly in the major banks which bolstered their solvency and gave the government preferred stock, which is “debt rather than equity” that has no date of maturation.14 “Bad” securitization debt, owned by banks, was also bought by the government who put it in a “bad bank”—in other words, the U.S. treasury. This cleaned the banks’ balance sheets, making them appear safe. The third phase of bailout was the federal loan to General Motors and Chrysler in December 2008 to prevent them from going bankrupt. In the fourth phase, the “easy money” phase, the Federal Reserve declared that it would buy $800 billion of private debt in November 2008. The purpose was “to increase the amount of money in circulation in order revive borrowing and thus avert a decline in personal consumption expenditures and hence in output.”15 The second bailout phase was closely related to the fourth phase because it bailed out the automakers. This bailout failed because it divided control of the Auto industry among manufacturers, and the failure of the fantasized idea that “Congress plus the president together could revitalize the domestic auto industry.”16 The fifth phase, stimulus, was the American Recovery and Reinvestment Act of 2009 that was proposed by Democratic congressmen. It authorized the federal government to spend $819 billion over a period of two years. About one-third of the stimulus package is “earmarked for tax reductions and the rest is split between public-works programs.”17 With the help of these five phases, the government hoped to “restore balance…by using its fiscal powers to augment demand and…to stimulate producers to restore output to where it was before the depression.”18 The problem is that most certainly, “many of the projects in the stimulus program will yield costs in excess of their benefits.”19

Richard Posner has a deep interest in economy. He searches for vast amounts of knowledge, transforms it in his own words, forms his opinions, and then presents it to the world to help explain to the people the phase through which they are going. Capitalism is a term that refers to the private ownership of capital. Although he understands that the government played a partial role in leading U.S. to this position, he believes that it is not entirely their fault. Posner believes it is “a market failure. The government’s myopia, passivity, and blunders played a critical role in allowing the recession to balloon into a depression, and so have several fortuitous factors. But without government regulation of the financial industry, the economy would still, in all likelihood, be in a depression.”20 It was a sequence of events that caused America to be where it is. He was referring to events like low interest rates, collapse of banking system, housing bubbles, resuscitation attempts, drops in output and employment, deflation signs, and the program of recovery. Basically, he thinks “the financial crisis is indeed a crisis of capitalism rather than a failure of government.”21 Because capital was not regulated wholly by the government, and because of deregulation by the government, America spiraled into recession; this proves capitalism to be a failure.

Richard M. Solow, a nobel-prize-winning-economist, wanted an overview of what is currently going on in the economic crisis. He needed to know what the main people involved did and are doing to prevent this recession, or rather come out of it. According to him, Posner’s book A Failure of Capitalism fulfills that need. He believes Posner “has depicted his thoughts in a clear and understandable manner.”22 Due to some unnecessary repetition and prolonged paragraphs, he thinks “it often seems that this book was dictated in a hurry.”23 However, the prose is lively, plainspoken, and readable. Paul Kedrosky, an author, analyst, and columnist, believes that Posner was “the most sober-minded and respected thinker to publicly deem this downturn something more than the ubiquitous and clunky construction, The Most Severe Recession Since the Second World War.”24 However, he disagreed with Posner about how easy it was to decide which brokers should have and should not have been saved. Although his book has many strengths like a clear explanation of the current crisis along with some brief and sensible policy prescriptions, according to Kredosky, he “fails to find a way to make sure that the current crisis, with its predictable outcome for economics, doesn’t contaminate all of economics, turning it into a subset of psychology.”25

Learning about the current Crisis of 2008 through Posner’s perspective was very interesting. Although there were some sentences left hanging, this book provided an overall idea of what is going on in the economic world. Economic terms are introduced and defined for the reader as well, like leverage, default, and mortgage-backed securities. He takes a very complicated subject and feeds it to the reader through a writing style that is very easy to comprehend. There were many repetitions of thoughts throughout the book but they helped to reiterate the main idea he was trying to portray. He writes, “I have tried to be simple without being simplistic—to write for generalists but also to suggest points that may interest specialists.”26

The depression of 1930’s involved a horrendous increase in the cost of products. Similar to the current crisis, it was a global recession, causing it to be harder to attain money by foreign borrowing. He exaggerates the faults of the Great Depression by stating that “without the depression there might have been no Nazi Germany and no World War II.”27 Unemployment rates and the gross output value, as stated earlier, were very high during the 1930’s as compared to the crisis of 2008. Although rates seem to be quite low compared to the Great Depression, this is the lowest they have been since then. America now also has a huge national debt of more than $13 trillion to repay. Also, the inflation rate seems to be increasing as well. The government has taken various measures to help resolve issues. Economists are entirely depending for those actions to work out for the best.

The housing bubble started to inflate as early as the year 2005. Since then, the United States economy has been plummeting, yet it seemed to be doing so invisibly. There had been many hints and predictions that warned economists and the government of what they should be expecting in the future. They failed to act quickly, thus letting America enter an era of recession. “The combination of a dearth of safe savings with a banking industry that is highly leveraged” turned a recession into a depression.27 If the industry pulls back from lending, the consumers will have a hard time borrowing to maintain their lifestyles and consumptions. If economists fail to prevent a steep fall in their personal consumption expenditures, they might tip the economy into deflation. Deflation could be the result of deep price discounts through which stores attempt to attract enough customers. The crisis of 2008 resulted from the lack of government regulation, hostility to taxes and government, and the support of laissez-faire. These ideas were appealing to conservatives who believe in minimal government regulation and low taxes. There are still various theories as to what actually triggered the recession. Yet Posner is an individualist who believes it was the failure of capitalism.

Endnotes

Student Bio

Maheen Mustafa was born in Pakistan and came to the United States in 2003. Listening to music is one of her favorite hobbies. She also enjoys spending time with friends and family and enjoying the outdoors. She plans on going to medical school in the future to become a physician.