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.
Thus he writes: "At no stage need irrationality" on the part of markets or their participants "be posited to explain? the collapse of financial markets last year and the current deep recession.
We see many things in the financial crisis and the recession that are not what we would see in an economy populated by smoothly rational utilitarian calculators:
* 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.
* It was not rational for Citigroup CEO Charles Prince to keep dancing to the music, without thinking which seat Citi would claim when the round of musical chairs came abruptly to a halt.
* It was not rational for shareholders of newly incorporated investment banks to offer traders large annual bonuses for performance assessed by a year-to-year mark-to-market yardstick?rather than rewarding them with long-run restricted stock that would hold its value only if the traders' portfolio strategies proved durable.
* It was not rational for the shareholders and executives of General Motors and Chrysler to ignore the need for a Plan B in the event Americans fell out of love with SUVs.
Yet while Posner insists on saving the appearance of individual rationality, he is willing to jettison the Chicago School's conclusion that markets are everywhere and always perfect. As Robert Solow observed: "If I had written that, it would not be news. From Richard Posner, it is."
Abandoning the conclusion of market perfection opens the door to the idea that government needs to properly check, balance, and regulate markets in order to help them function as well as possible. But clinging to the assumption of individual rationality forces Posner?s view of what regulation is appropriate into a very awkward straightjacket.
"The mistakes were systemic,? he writes, ?the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools." What we 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.
The Daddy State should have restricted financial innovation because a "depression is too remote an event to influence business behavior. "The profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy."
Posner's claim that the Princes of Wall Street were rationally ignoring small probabilities is simply not true. The venture capitalists of Silicon Valley in the 1990s raised money for their funds overwhelmingly through equity rather than debt tranches.
They did so because they wanted themselves and their clients to retain some considerable fraction of their fortunes in an event that they regarded as small probability?but actually happened?that the overwhelming bulk of the value from the internet revolution flowed to customers rather than to businesses.
