Financial Collapse Was No ‘Failure of Capitalism’

Published December 1, 2009

Richard Posner, the noted judge of the Sixth Circuit Court of Appeals and professor of law and economics at the University of Chicago, says the recent U.S. financial collapse represents a “failure of capitalism.”

In a commentary in the August 9 Atlantic, Posner argued government policymakers were so blinded by a belief in perfectly functioning capital markets they ignored obvious signs of the pending collapse and waited until too late to do anything about it.

Posner has a point. There was a speculative bubble, and when it burst it sent the U.S. and world economy into a deep recession. Financial markets are not perfect, regulation of financial derivatives markets was lax, and the economy is vulnerable to financial crises. Policymakers could have acted sooner to address the financial imbalances and enact a regulatory framework providing the requisite transparency for the derivatives market to function effectively.

But it seems a stretch to call this “a failure of capitalism.”

Government interventions were largely responsible for the bubble and then caused it to burst precipitously. The policymakers, however, were by no stretch of the imagination rigid adherents to free-market capitalism. In fact, had some of them shown a greater respect for capitalism and capital markets, the crisis might have been averted. It almost certainly would have been much less severe.

Bernanke Warned of Threat

One of those whom Posner criticizes is Federal Reserve Board Chairman Ben Bernanke. To be sure, Bernanke played a part in the Lehman Brothers fiasco. But in 2005 he famously identified Asian currency policies as a serious threat to the stability of the U.S. and world economy. (See “The Global Savings Glut and the U.S. Current Account Deficit,” St. Louis Federal Reserve Bank, April 14, 2005.)

Bernanke noted the export-oriented policies of the Asian nations were fueling a boom in U.S. housing and financial markets at the expense of U.S. manufacturing industries. Supported by our own U.S. Treasury, Asian central banks were pouring money into Fannie Mae and other U.S. securities to keep their currencies below free-market levels and thus subsidize exports of their products into the United States.

While the below-market interest rates kept U.S. borrowing costs low, they also fueled the run-up in real estate and stock prices even as the artificially low Asian currencies weakened U.S. manufacturers.

Treasury Ignored Warnings

The United States would have to “repay [the] foreign creditors” someday, Bernanke warned, and we would “need large and healthy export industries” to do so. He said the “shrinkage” of the nation’s manufacturing sector, the predominant source of U.S. exports, was imposing “real costs of adjustment on firms and workers in those industries.” He cautioned many of them might not be here in the future when they would be needed to provide the means for repaying the foreign debt.

His arguments fell on deaf ears at the U.S. Treasury.

At the same time, under heavy pressure from Congress, our government pressured U.S. banks to engage in “reverse redlining,” to give hundreds of billions of dollars in loans to unqualified, low-income, subprime borrowers. The government also failed to implement rules to prevent excessive lending to other unqualified real estate borrowers. This was not a failure to intervene but instead a failed intervention.

Taken together, these policies fueled massive speculation and overinvestment in real estate and financial markets at the expense of U.S. manufacturers.

Bailouts Also Hurt

The real estate and financial bubbles were burst by yet another government policy, the on-again, off-again bailout of large financial institutions deemed “too big to fail.” When the government suddenly reversed course and refused to rescue Lehman Brothers on September 15, 2008, investors lost faith in the stability of financial markets. Real estate prices collapsed, and stock markets plunged by more than 25 percent in two weeks.

It is, of course, impossible to know exactly what would have happened had these government policies not created and then burst the financial market and real estate bubbles. The business cycle has not been repealed, and a recession would have occurred at some time in response to a real estate or some other financial bubble.

Would Have Been Milder

Capital markets are not perfect, the derivatives markets certainly need transparency regulations, and investor expectations can and do get out of line with intrinsic values from time to time. But such a recession likely would have been much milder.

One thing is for sure, however: The worst recession since the Great Depression was much more the result of government policy errors than of any inherent flaw in financial markets.

The government is no longer pushing banks to make loans to unqualified borrowers, and it is not supporting other governments’ efforts to keep their currencies artificially low. It is formulating rules that we hope will require much greater transparency in financial derivatives markets.

But it will take some time for the government to undo all the damage it has caused to financial markets and to restore investors’ confidence in them. This is not going to happen, however, if policymakers believe the financial collapse was a “failure of capitalism.”

Tom Walton ([email protected]) is a former special advisor to the United States Federal Trade Commission and director of economic policy for General Motors Corporation. He is currently adjunct professor of finance at the College of Business, Lawrence Technological University.