In spring 2010, I reviewed A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression (2009) by Richard A. Posner for editors of the Business History Review. Posner, a former professor of law at the University of Chicago, was a member of the U.S. Court of Appeals for the Seventh Circuit (Chicago). An extremely productive writer, Posner had already published more than forty books, including sixteen published by Harvard University Press. By any standard, Posner was a public intellectual whose ideas about how the American political economy worked, and how it ought to be made to work, had diffused into the realms of legal scholarship, courtroom advocacy, and print media, where more than fifty thousand newspaper stories included his name.
Posner's A Failure of Capitalism, I judged, contained few remarkable findings regarding the origins of the crisis of 2008. He cited low-interest rates, easy credit, bank deregulation, real estate speculation, subprime mortgages, and complex financial derivatives among the factors that led to bank failures and millions of home foreclosures. Yet according to Posner, the nation's financial actors, whether low-wage householders or top financial executives, were all rational economic actors. Who, Posner asked, could blame a family that “stretch[ed]” to own a home in a better school district? As well, who indeed could then reasonably assign blame to bankers such as Citigroup chair and CEO Charles O. Prince for securitizing that family's mortgage? “As long as the music is playing,” Prince told a Financial Times reporter in July 2007, “you've got to get up and dance.” The music, as I noted, had already stopped playing. The financial crisis of 2008 exploded into the worldwide Great Recession. In 2010, the unemployment rate in the United States reached 10 percent and was even higher among African Americans and white males who lacked a college degree. Home ownership and labor force participation rates never returned to pre-crisis levels. “Discouraged worker” and “deaths of despair” entered journalists’ vernacular as large number of Americans turned to alcohol, drugs, and suicide (Anne Case and Angus Deaton, Deaths of Despair and the Future of Capitalism [2020]).
The Great Recession also fostered a change in the nation's preeminent economic ideas. By 2009, Posner, a long-time fan of market-oriented economist Milton Friedman, had arrived at the startling conclusion that “laissez-faire capitalism failed us.” Posner had lost faith in an idea. We can read Posner's change of mind, alongside the disillusionment of ordinary Americans, as a point of departure to study the ideas of post-crisis policy intellectuals. What have they learned about the origins of the financial crisis and what policies do they advocate to prevent a similar tragedy? The deeply studied essays contained in Sharyn O'Halloran and Thomas Groll's impressive volume provide a mostly accessible illustration of that post-crisis discourse. O'Halloran and Groll organize the volume into five parts: “The Financial Crisis in Perspective,” “Creating the Right (Dis)incentives,” “Use and (Ab)use of Models in Predicting Financial Outcomes,” “Regulating for the Next Crisis?,” and “Origins of the Next Financial Crisis.” Their distinguished multinational authors include legal scholars like Kathryn Judge and John C. Coffee Jr., economists such as Glenn Hubbard, Anne-Laure Delatte, and Joseph E. Stiglitz, and former Congressman Barney Frank, the coauthor of the Dodd-Frank Act of 2010 (which was the government's major regulatory response to the 2008 crisis). Notably, Frank here defends his inability to reduce the number of bank supervisory agencies, arguing that “the political fight we had to get the substantive regulations done” evidenced how “we wouldn't have had the votes” to consolidate the regulators (p. 317). Politics, as Frank reminds us, was always at the forefront of the Great Recession. Accordingly, the authors in this volume are concerned with the structural origins of the crisis and with the policy responses that Frank and others fashioned to guide bankers and regulators during the next decade.
Scholars in this volume have achieved near unanimity regarding the origins of the financial crisis. The crisis, report O’ Halloran, Groll, and direct investment specialist Geraldine McAllister, started when “permissive regulations allowed banks to offer mortgages with small down payments to buyers who had insufficient income to afford them.” Additionally, “compensation practices at financial firms rewarded volume and short-term performance” (p. 2). But the boom was short lived. In August 2007, BNP Paribas officials stopped redeeming mortgage-backed securities as a result of a “complete evaporation of liquidity” (p. 5). That liquidity crisis quickly extended worldwide. During the weekend of September 12–14, 2008, treasury secretary Henry M. Paulson rejected financial assistance for Lehman Brothers. When Lehman filed for bankruptcy on September 15, bankers around the world stopped extending credit to one another. The crisis started among the unregulated (shadow) banks and extended into the securities operations owned by Bank of America, Citigroup, and other large banks.
The crisis, at its most basic, amounted to a run among bankers on overnight loans, called repurchase agreements (or repos). Bankers used repo funds to purchase the asset-backed securities that, as it turned out, contained increasing numbers of nonpaying mortgages. Well-informed bank executive such as J.P. Morgan Chase's Jamie Dimon lacked a clear picture of the number of nonperforming mortgages held by counterparty executives at Wells Fargo or Goldman Sachs. Finance professor Mark D. Flood identifies this limited knowledge as a type of “endogenous myopia” (p. 232). And yet, given the continuing absence of coordination among bank regulators, Secretary Paulson faced a situation where statistics about unpaid mortgages and murky reports about risky repos only slowly merged into a straightforward understanding of financial dangers. Such big-data problems persist to the present day, laments Flood, “creating a combinatorial explosion of joint risks to consider” (p. 232). Curiously, neither Posner nor the volume's thirty contributors seem to wonder about the historical origins of multiple bank regulatory agencies, whose staffs often worked independently and sometimes at cross-purposes. Just as much, the editors of After the Crash chose not to consider the historically contingent ability of bankers to create repurchase agreements on such a wide basis and in the near dark.
The talented authors in this volume set about the business of recommending fixes for the nation's jerry-built financial architecture, which is where the consensus ends. Whether economic models could be made more robust serves as one point of debate. According to Stiglitz, the idea that wide distribution of risky assets would mitigate against a financial crisis was wrong, since it led to “amplification . . . through contagion” (p. 168). Regulators “steeped in market fundamentalism,” he adds, believed that bankers were alert to the risks (p. 171). In truth, no one had sought to abolish federal bank regulations and return bankers to a state of nature. Market fundamentalism served as one part of the language through which regulators and bankers negotiated and litigated about bank rules, starting in the 1960s and extending up to the Dodd-Frank Act. I describe this rhetorical style as “market talk” (Mark H. Rose, Market Rules [2019]). As well, one must wonder how conscientious regulators or bankers could have possibly been alert to risks tucked away among multiple counterparties operating around the globe. As a way around this dilemma, Columbia University finance professor Emanuel Derman seeks improved use of models. For Derman, the efficient markets model needs to be rejected, since it “assumes . . . stock prices behave like smoke diffusing through a room” (p. 193). Models are only metaphors, which “mask as well as expose risk” (p. 197). Ultimately, Derman urges model builders to recognize the intellectual attraction of their models and their potentially far-reaching effects.
The politics of writing financial regulation renders such an optimistic approach unlikely. Dodd-Frank's authors, for example, sought to achieve an improved alignment between executive compensation and bank shareholders’ interests. However, Coffee reports that shareholders’ concerns about short-term payoffs stand in opposition to reformers’ interest in achieving system-wide stability. No matter, because a DC circuit court struck down that provision. In similar fashion, the Volcker Rule, a better-known part of Dodd-Frank's 2,300 pages, prohibited banks from engaging in proprietary trading—and according to Coffee, “created a boom in lobbying activities” (p. 63). Authors of the Act also created the Financial Stability Oversight Council (FSOC), composed of the ten bank regulatory agency leaders, headed by the treasury secretary. Members of the FSOC designated insurance giant MetLife a “systemically important financial institution,” or a SIFI in the acronym-loaded language that informs bank regulation (p. 151). Opponents and especially MetLife executives, contends law professor Jeffrey N. Gordon, brought “the heavy artillery” and won a lawsuit (p. 151). MetLife was no longer a SIFI. And in turn, Coffee reports, the Trump administration gave a “lobotomy” to the FSOC (p. 324). Frank, undaunted, urged an effort to unify bank regulatory agencies, an idea that had circulated for decades among bankers, legislators, regulators, and U.S. presidents and never won a large number of converts. To be certain, however, Dodd-Frank's key strictures, such as higher capital requirements for the largest banks, remained in effect.
In 2008, Judge Posner identified a failure of capitalism. The more fundamental problem, as these authors demonstrate, has been a failure among political and financial leaders to shape a coherent financial architecture capable of framing bankers’ markets from top to bottom. Given the size and diversity of the nation's financial landscape, that task, at least this year, resides outside their political reach.
