Reagan-era judge for deregulation changes his tune

LesWaggoner BN 1 2012/08/26 20:59:26

In wide-ranging discussion, Judge Richard Posner weighs in on Wall Street, the Constitution


“Viewpoint” host Eliot Spitzer sits down with federal Judge Richard Posner of Chicago’s Seventh U.S. Circuit Court of Appeals to discuss his views on the 2008 financial crisis and the controversy surrounding how to interpret the Constitution — is it a living document or should we only care about what its framers originally intended?

Of the financial collapse, Posner, who was dubbed “the most influential federal judge outside the Supreme Court” by The New York Times, says: “I was an advocate of the deregulation movement, and I made — along with other, a lot of smarter people — made a fundamental mistake, which is that deregulation works fine in industries which do not pervade the economy in their consequences. The financial industry undergirds the entire economy, and if it is made riskier by deregulation and collapses … the entire economy freezes because it runs on credit.”

And of the Constitution, he argues against “originalism”: “[The Constitution's framers] made it almost impossible to amend the Constitution — not impossible, but almost impossible. And as a result of limited foresight of the framers and the difficulty of amendment, it has to be interpreted loosely, otherwise it becomes a straitjacket.”

Financial collapse and the Internet are behind our polarized politics, says Judge Richard Posner


Federal Judge Richard Posner, of Chicago’s Seventh U.S. Circuit Court of Appeals, explains to “Viewpoint” host Eliot Spitzer why he thinks the country has become increasingly politically polarized and why a “rigorous fringe” seems dominant.

“I think it’s due primarily to the crash of 2008 and the ensuing decline in economic confidence. Because in the ’30s we saw a lot of radical movements. Communists had a lot of support, and there were the extreme right-wingers,” Posner notes. “Another factor … which is operating, which is not limited to the economic situation at all, is that the growth of the electronic media has fostered extremism of all sorts because the problem is that people who used to have really extreme views on anything, they didn’t realize — they didn’t think these views were widely shared.”

Is Banking Unusually Corrupt, and If So, Why? Posner

One has the impression—no more than that, but it is difficult even to imagine what “evidence” is obtainable that could confirm or refute the impression—that imprudent, unethical, unlawful, and downright criminal behavior is more common in large financial institutions (“banks,” as defined in the next paragraph) than in other, and otherwise comparable, business firms. Much of this behavior occurred during the housing and related credit bubbles of the 2000s and was discovered in the wake of the financial collapse of September 2008, yet much seems to have taken place afterward as well, continuing up to the present with the Libor scandal.

If the impression is correct, what might account for it? I think the answer lies in the nature of banking, understood broadly as financial intermediation: if A has money he’d like to save and B needs money, then rather than A lending directly to B A might lend to C to lend to B, because C—a bank—is a specialist in assessing creditworthiness. To finance its operations C will need to borrow from A at a lower interest rate than the rate it charges B for a loan. It can minimize the interest rate it pays A by borrowing short term (the shortest-term borrowing being a demand deposit). This both reduces the risk of default to A and offers A continued liquidity; should it need the money it’s lent to the bank, it can get it back on demand. And the bank can maximize the interest rate it charges B by making the loan long term, thus transferring liquidity to B and assuming a higher risk of default. C can increase its expected return across the board by lending to borrowers whom the market rates as risky (this pushes up the market interest rate to such borrowers) but whom C thinks less risky than the rest of the market thinks them.

The bank’s business model is thus a risky one. Its capital is short term and thus can disappear with little or no notice (a bank run), while its assets (its loans) are long term and may be illiquid and thus hard to sell should the bank need to replace some of its capital. Government deposit insurance can reduce the risk of runs and by thus making depositors’ capital more secure reduce the interest rate the bank has to pay them. Bank regulatory agencies can further reduce the risk of banks’ defaulting by requiring banks to hold cash or cash-equivalent reserves, such as Treasury bonds.

But risk and return are positively correlated; by reducing risk, government intervention in the banking industry reduces expected return. This is true even at the depositor level: the interest rate that a depositor receives is reduced because the risk of his losing his money is reduced. And at the bank level, deposit insurance is a cost to the bank. The bank may therefore decide to augment its capital base by uninsured borrowing. It may also decide to offset the cost of its reserves (cash on which it receives no return), and amplify the spread between its cost of borrowed capital and its return on investment, by making riskier investments with its borrowed funds than mortgage loans, municipal and corporate bonds, Treasury notes, and other conventional bank investments: it may decide to speculate.

The tradeoff between increased risk and increased expected return is attractive for two reasons. First, a risk is less likely to materialize in the short term than in the long term: a 1 percent annual risk of default becomes formidable only when projected over a 10-year or 20-year or longer period. A banker who has a high probability of making very large profits for the next 10 years may feel well compensated for taking a small risk of bankruptcy during that period.

Second, not only a bank’s financial capital but also its human capital is short term; very little financial human capital seems to be firm-specific, judging by the rate at which bankers move from firm to firm. Any firm that has short-term capital is under great pressure to compete ferociously, as it is in constant danger of losing its capital to fiercer, less scrupulous competitors, who can offer its investors and its key employees higher returns.

Such a business model attracts people who have a taste for risk and attach a very high utility to money. The complexity of modern finance, the greed and gullibility of individual financial consumers, and the difficulty that so many ordinary people have in understanding credit facilitate financial fraud, and financial sharp practices that fall short of fraud, enabling financial fraudsters to skirt criminal sanctions.

These circumstances make an unregulated banking industry a Darwinian jungle, with bankers as predators and their customers (and each other) as prey, and so may explain why bankers are prone to cut corners—to take excessive risk from a social as distinct from their private standpoint (they like and are compensated for taking risk, remember)—and why banking is a regulated industry (and we have learned from the 2008 crash and the ensuing economic depression the macroeconomic significance of a sound global banking industry). It remains to explain why banking regulation seems largely ineffectual.

Its ineffectuality is on display in the Libor scandal. Libor (an abbreviation for “London interbank offered rate”) is ostensibly a reliable estimate of the interest rate that leading world banks charge each other for three-month or one-year loans. This rate is important both as an indication of a maximally safe private interest rate and so (like the more familiar “prime rate”) a basis for calculating interest rates to different risk classes of borrowers (“Libor plus 1 percent,” like “prime plus 1 percent”), and as a clue to the health of the banking industry: the lower Libor is, the stronger it signals that banks have confidence in each other’s solvency.

Libor is not a transaction price; it’s an estimate by the banks participating in the estimation process of what they would charge each other for a three-month or one-year loan. Libor is reestimated daily and on many days many of the participating banks are not lending or borrowing for three months or a year from each other. With the financial crash of 2008 and ensuing reduction in loan activity, banks had fewer and fewer occasions to borrow from each other, so the daily Libor rate became increasingly hypothetical. And since Libor is an index of bank solvency, it was in the interest of the participating banks to “estimate” Libor rates lower than actual transaction rates; and apparently that’s what they did.

The regulators were aware of this monkey business, but apparently did nothing, continuing a pattern of bank-regulatory laxity of many years’ standing. How is this to be explained? There seem to be four explanations. One is the revolving door: some regulators look forward to a post-governmental career in the regulated industry and fear lest the industry punish them for regulatory zeal by refusing to give them a good job. Another is the political heft of immense banks with their enormous financial resources. Another is the opacity of modern finance. But the most interesting is the complacency about capitalism typified by the attitude of Alan Greenspan, the long-serving chairman of the Federal Reserve Board, and by other conservative economists. Greenspan seems to have believed that competition was an adequate substitute for regulation in the banking industry. Competition often is an adequate substitute for regulation; that was the insight behind the deregulation movement that began in the late 1970s. But it is not an adequate substitute for banking regulation, because of the macroeconomic risks that a collapse of the banking industry can precipitate.

Banking is not the only industry that is prone to bankruptcy unless regulated. Another is airlines. Because of their heavy fixed costs, the wild variability of their principal variable cost (fuel), and fluctuations in consumer demand, airlines are constantly on the brim of bankruptcy and often over it. But because the airline industry is small and an airline can function quite effectively in bankruptcy, the industry’s riskiness has no macroeconomic significance. Shareholders lose their investment but the airline keeps flying, though now owned by its creditors, and eventually passes out of bankruptcy. There is no good reason therefore for regulation designed to prevent major airlines from going broke. But when banks get into trouble, their capital starts to vanish, and they can’t function. Credit freezes—and the economy, because it runs on credit, also seizes up. Oddly, few economists seem to have understood modern banking, or its role in the economy.

The banks resist effective regulation, so far effectively, because their managers are better off with the Darwinian business model, which enables the reaping of short-term profits great enough to compensate—not the country, but the bank’s managers and investors—for an increased risk of bankruptcy.

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  • Ken 2012/08/26 22:06:30
    Where do they find all these liberal, Constitution hating Justices? Their job is to interpret the Constitution not try to remake it.
  • LesWagg... Ken 2012/08/26 22:23:52
    LesWaggoner BN 1
    Getting back to the thinking of the Founding Fathers...
    Letter from Thomas Jefferson to James Madison - 6 Sept. 1789

    "Every constitution then, and every law, naturally expires at the end of 19 years. If it be enforced longer, it is an act of force, and not of right.--It may be said that the succeeding generation exercising in fact the power of repeal, this leaves them as free as if the constitution or law has been expressly limited to 19 years only." ~ Thomas Jefferson.
  • Ken LesWagg... 2012/08/26 22:35:20
    That's why more than one person was involved in developing the Constitution.
  • LesWagg... Ken 2012/08/27 06:12:24
    LesWaggoner BN 1
    If you read the entire article I think you'll see that he is right.
  • Ken LesWagg... 2012/08/28 00:38:15
    I read the entire article, I just don't believe in his thought process. Because the morals of one decade or life span changes, there is no need to change our Constitution without following the principles of our Constitution. Ratification of changes is necessary and required.
  • LesWagg... Ken 2012/08/28 04:59:47
    LesWaggoner BN 1
    Think of the changes in everything since the Constitution was written. The best example I can think of is the second amendment. The Founding Fathers could not foresee automatic weapons.
  • Ken LesWagg... 2012/08/28 15:40:18
    Yes they could, that is why they wrote the 2nd Amendment so people could have one to protect themselves. What are you going to do, fight automatic weapons with a handgun?
  • LesWagg... Ken 2012/08/28 19:07:17
    LesWaggoner BN 1
    You really think that a civilization that was using cap and ball weapons as their "modern technology" knew about automatic weapons????
  • Ken LesWagg... 2012/08/29 00:49:57
    Those were the automatic weapons of the age.
  • LesWagg... Ken 2012/08/29 22:34:51
    LesWaggoner BN 1
    In that case maybe only cap and ball firearms should be allowed.
  • Ken LesWagg... 2012/08/29 23:42:28
    If everyone else only had that; yes.
  • LesWagg... Ken 2012/09/02 00:19:37
    LesWaggoner BN 1
    My point is that if we eliminated automatic and semi-automatic weapons incidents like the Century 16 in Aurora Colorado would be far fewer.
    The key to any legislation like that would to make the penalty so stiff that it isn't worthwhile to be caught with those type of weapons. Something like ten years in prison for each violation.

    Your comeback is going to be that the criminal/crazy element would still find a way to get illegal weapons but I think it would be far less problematic.
  • Ken LesWagg... 2012/09/02 02:24:28
    Didn't Denmark try that with poor results and it's not working very well in the UK or Australia either. My concerns though are, how are we going to protects ourselves on the Southern border against drug criminals with these weapons already? Or, how can we protect ourselves from an out of control Government with these weapons?
  • LesWagg... Ken 2012/09/02 02:45:30
    LesWaggoner BN 1
    On this topic I find your arguments to be illogical and based on fears of what might happen no matter how improbable.
  • Ken LesWagg... 2012/09/02 03:04:28
    In today's world, it is very likely to happen. Mexico, Libya, Syria, Egypt, Iraq, Pakistan, Afghanistan and Yemen are good examples.

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