Posner on Morality and the Downturn

Here is the best one-paragraph summary of the depression/recession that I've seen.

It's by Richard Posner in an interview with Dwyer Gunn at the Freakonomics blog at the New York Times Online. I'll quote it in full.

Q: What caused the financial crisis? Was it the government’s fault?

A: The government was the facilitator of the crisis, in the following sense. Banking (broadly defined to include all financial intermediation) is inherently risky because it involves borrowing most of one’s capital and then lending it, and the only way to create a spread that will pay the bank’s expenses and provide a return to its owners is to take more risk lending than borrowing — for example, borrowing short (short-term interest rates are low, because the lender has little risk and great liquidity) and lending long (so the lender has greater risk and less liquidity). The riskiness of banking can be reduced by regulation. But as a result of a deregulation movement that began in the 1970’s, the industry was largely deregulated by 2000. Then the Federal Reserve mistakenly pushed down and kept down interest rates, which led to a housing bubble (because houses are bought with debt) and in turn to risky mortgage lending (because mortgages are long term and there is a nontrivial risk of default); and when the bubble burst, it carried the banking industry down with it. The effect on the nonfinancial economy was magnified by the fact that Americans had little in the way of precautionary savings built up. Their savings were concentrated in risky assets like houses and common stock. When the value of those savings fell steeply, people’s savings were inadequate, so they curtailed their personal consumption expenditures, precipitating a fall in production and sales, a rise in unemployment (which made the still-employed want to save even more of their income, lest they lose their jobs too), and, in short, the downward spiral we’re still in.

That's pretty good, I think. Clear, concise and doesn't take too many shortcuts that rely on special knowledge. But then he goes on to say something pretty enlightening about the moral outrage that's been directed at the "excessively risky behavior" of some in the financial community. It's a problem of regulation, not greed. And the regulation is consistent with Adam Smith.

Part of maximizing profits, however, is taking a certain risk of bankruptcy; it does not pay for a firm to reduce that cost to zero. Banking occupies a strategic role in the economy because of the importance of credit to economic activity; borrowing to spend increases consumption — it is how we shift consumption from future to present....

Moreover, banking is the main instrument by which the Federal Reserve creates money, and by doing so reduces interest rates (provided inflation is not anticipated; for if it is, long-term interest rates will rise), which in turn spurs economic activity. By buying government bonds, it pours cash into banks, both directly, when it buys the bonds from banks, and indirectly, when it buys the bonds from private owners but the owners deposit the cash they receive from the purchase into their bank accounts.

When banks start to hoard cash because their solvency is impaired, the money they receive from the Federal Reserve’s purchasing activity does not spread into the rest of the economy. That is why a cascade of bank bankruptcies is far more serious than a cascade of, say, airline bankruptcies. But a rational businessman does not, indeed cannot afford to, consider the cost of bankruptcy to the economy as a whole as distinct from the cost to his firm. So the rational banker will take more risk than is optimal from an economy-wide standpoint. That is the logic of profit maximization, as explained long ago by Adam Smith: the businessman cares about his costs and his revenues, but not about the costs and revenues incurred or received elsewhere in the economy. He is not an altruist. The responsibility for preventing the collapse of the banking system is the government’s, and it has been shirked, with extremely serious consequences.

That is quite an indictment of the regulatory bodies. Does it let the bankers off too easily? Or does he make a good point about risk and limiting risk? For one, this seems to only apply to risk taking and not to the big bonuses which were also a source of moral outrage.

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