The Chicago School IsEclipsed

J. Bradford DeLongU.C. Berkeley and NBER

June 9, 2009

http://delong.typepad.com delong@econ.berkeley.edu

Richard Posner, leader of the Chicago School of Economics andFourth Circuit Court of Appeals judge, uses his new book, “A Failureof Capitalism,” to try to rescue the Chicago Schoolʼs foundationalassumption that the economy behaves as if all economic agentsand actors are rational, far-sighted calculators. In some sense,Posner must try. For without this underlying assumption, the clockstrikes midnight, the stately brougham of Chicago economic theoryturns into a pumpkin, and the analytical horses that have pulled it sofar over the past half- century turn back into little white mice.

Thus he writes: "At no stage need irrationality" on the part ofmarkets or their participants "be posited to explain” the collapse offinancial markets last year and the current deep recession.

Posnerʼs effort looks to me like an earlier effort to “save theappearances” in the face of discomfiting contradiction. The Jesuitastronomers of 17th-century Rome wanted above all to maintain theassumption that the sun revolved around the earth—for if it did notthen the Bibleʼs declaration that Joshua called on God to make thesun stand still in the sky was a lie, and a Bible that lies even oncecannot be the inerrant foundation of faith.

Thus the Jesuits created much more complicated models than the

elegant heresy of Copernicus, in which the earth revolved aroundthe sun. They succeeded in their attempt to save the appearances.Posnerʼs attempt does not: It is definitely a retrograde motion, forwe see many things in the financial crisis and the recession that arenot what we would see in an economy populated by smoothlyrational utilitarian calculators.

It was not rational for Bear-Stearns CEO James Cayne, withhis own $1 billion fortune on the line, to allow his firm tobecome hostage to the excessive risks taken by hissubordinates in the mortgage markets.

It was not rational for Citigroup CEO Charles Prince to keepdancing to the music, without thinking which seat Citi wouldclaim when the round of musical chairs came abruptly to ahalt.

It was not rational for shareholders of newly incorporatedinvestment banks to offer traders large annual bonuses forperformance assessed by a year-to-year mark-to-marketyardstick—rather than rewarding them with long-runrestricted stock that would hold its value only if the traders'portfolio strategies proved durable.

It was not rational for the shareholders and executives ofGeneral Motors and Chrysler to ignore the need for a Plan Bin the event Americans fell out of love with SUVs.

The litany of financial lunacy is longer than even the EasternOrthodox litany of the saints. Yet Posnerʼs insistence that the crisiscannot spring from compound irrationality drives him to a claim thatthe real cause is a failure of government—specifically a too-lax, too-nurturing, insufficiently strict Mommy State that raised the childrenall wrong.

"The mistakes were systemic,” he writes, “the product of the natureof the banking business in an environment shaped by low interestrates and deregulation rather than the antics of crooks and fools."What we needed, Posner implies, was a Daddy State in the early2000s that would have kept interest rates high, kept the recoveryfrom the 2001 recession much weaker, and kept unemploymentmuch higher. The Daddy State should have restricted financial

innovation because a "depression is too remote an event toinfluence business behavior. The profit-maximizing businessmanrationally ignores small probabilities that his conduct in conjunctionwith that of his competitors may bring down the entire economy."

Posner's claim that the Princes of Wall Street were rationallyignoring small probabilities is simply not true. The venture capitalistsof Silicon Valley in the 1990s raised money for their fundsoverwhelmingly through equity rather than debt tranches. They didso because they wanted themselves and their clients to retain someconsiderable fraction of their fortunes in an event that they regardedas small probability—but actually happened—that the overwhelmingbulk of the value from the internet revolution flowed to customersrather than to businesses.

Jamie Dimon and his team at JPMorgan Chase tried to move theirfirm out of the subprime mortgage market and into position to profitfrom the correction by the end of 2006. So did Lloyd Blankfein andhis team at Goldman Sachs. (They suffered anyway becauseneither imagined the possibility that a hedged long position inmortgages was not really hedged at all if the counterparty on theshort leg was AIG.)

Yet while Posner insists on saving the appearance of individualrationality, he is willing to jettison the Chicago School's conclusionthat markets are everywhere and always perfect. As Robert Solowobserved: "If I had written that, it would not be news. From RichardPosner, it is." Abandoning the conclusion of market perfection opensthe door to the idea that government needs to properly check,balance, and regulate markets in order to help them function as wellas possible. But clinging to the assumption of individual rationalityforces Posnerʼs view of what regulation is appropriate into a veryawkward straightjacket.

If the dons of the Chicago School were locked in an ivory tower, itwould not matter that Posner tries to save the appearances, and soattributes the crisis not to failure on the part of “capitalists” but ratherof regulators. Posner, however, is one of Americaʼs leading publicintellectuals. His views spread. His influence is very wide. Forexample, Jonathan Rauch in The New York Times Book Reviewjoins in and extends Posnerʼs error. For Rauch, “to see the crisisthrough populist spectacles, as President Obama does when he

attributes it to 'irresponsibility,' is to misunderstand the wholeproblem by blaming capitalists." Rauch echoes and congratulatesPosner, asserting that Posnerʼs “merciless scrutiny” leaves "not onepopulist cliché” remaining intact.

But Posnerʼs Chicago clichés not only remain intact but burst intofull flower. Attributing responsibility to the errant Princes of WallStreet, and the directors and shareholders who were supposed tobe overseeing them, would be "populism." And "populism" is bad.There should be no sanctions—not even a reduction in influence—for financiers. As for reregulation of the financial market, we shouldbe satisfied with “pretty small beer,” because the failure was not afailure of individual capitalists but of capitalism itself.

As remedy, we should prohibit the Federal Reserve from seekingfull employment through low interest rates. One actor whom Posnerdoes clearly blame is Alan Greenspan, whose reduction of interestrates to 1 percent in 2002–2003 was, in Posner's eyes, a root of theevil. Full employment already loses out to price stability when thelatter is threatened by inflation. In Posner's view, full employmentmust also give way if achieving it requires low interest rates.

Let us conduct a thought experiment. Suppose that Judge Posnerhad been willing to embrace Copernican theory. In that case, whatwould his policy recommendations have been? Start with theobservation that financial markets have six useful purposes:

to aggregate the money of people who ought to be saversinto pools large enough to finance large-scale enterprises.

to channel the money of people who ought to be savers toinstitutions and people who ought to be borrowers.

to spread risks so that no one individual finds herself ruinedby the failure of any one investment or the bankruptcy of anyone company or the slow growth of any one region.

to keep managements efficient by upsetting and replacingteams and organizations that have outlived their usefulness.

to encourage savings by creating liquidity—the marvelousfact that one can own a piece of an extremely illiquid and

durable piece of social capital (an oil refinery, say) and yetget your money out quickly and cheaply should yousuddenly have an unexpected need for it.

to take the money of rich people who like to gamble and, byproviding some excitement for them as they watch theirgains and losses, use it to buy capital equipment that raisesthe wages of the rest of us (at the price of paying a 20percent cut to the Princes of Wall Street). This is a superioruse for the rich—and for the rest of us—than, say, takingtheir wealth to the craps tables of Vegas.

Wall Street innovations and practices are useful only insofar as theypromote these six useful purposes. Call them aggregation,accumulation, diversification, efficientization, liquiditization, andcasinoization.

By these standards, the current compensation scheme on WallStreet—large annual bonuses based on annual marked-to-marketresults—is absurd. It helps achieve none of these six goals, and itgreatly increases the chance of a crash by providing everyone withan incentive to help their friends by marking up value, marking downrisk, and ignoring the impact of their actions on the long-termsurvival of the enterprise. Silicon Valley compensation schemesseem much better: no large payouts until assets have reachedmaturity and portfolio strategies have proved their value in allphases of the business cycle.

From this perspective, the rapid growth of derivative markets hasalso proved to be absurd. Derivatives were supposed to assist inrisk spreading and diversification. Amateurs and outsiders couldtake on a position easily, and the professionals who sold it to themcould then dynamically hedge it away, and so tap the risk-bearingcapacity of the public to a greater degree. It did not work, and itmade the books of Wall Street firms opaque even to the mostsophisticated of executives. Kenneth Arrow would tell us thatstocks, bonds, commodities, puts, and calls alone already carry usas close to a spanning set of securities as we are going to get. Thepotential diversification benefits of more complicated securitiesappear to be outweighed by the information they destroy.

The thirty-to-one effective leverage ratios achieved in the 2000s by

major banks were absurd. When public money is involved—andwhen high-leverage portfolio strategies become common, publicmoney is always involved—any system that relies on theintelligence of equity holders to restrain tradersʼ risks within boundsat a thirty-to-one leverage ratio is absurd. Every financial institutionshould be a bank holding company regulated by the FederalReserve. And every bank holding company should keep a healthyproportion of its liabilities—10 percent? 20 p?—on deposit at thelocal Federal Reserve.

In the future, we need to change the culture of Wall Street bychanging how top-earning financial professionals are paid, changingthe assets they trade to make the markets less opaque, andchanging the risks they run by taking capital requirements veryseriously once again. If we accomplish all three, thereʼs a chancethat the next Minsky Moment that comes along will be a minordisturbance rather than a globe-shaking catastrophe for 100 millionpeople.

The key irrationality was a private-sector failure on the part of theshareholders and top managements of the banks to make sure thattheir traders had an appropriate stake in the long-run survival of thebank and not just in constructing a portfolio that would be marked-to-market at a high valuation on Dec. 31. And the governmentneeds, for all our sakes, to compensate for this private-sectorirrationality. Thatʼs the conclusion that Posnerʼs book should havereached. But it never gets there: Because to get there, he wouldhave had to begin his book by acknowledging that it matters thatthe earth revolves around the sun.