How to Understand the Disaster

By Robert M. Solow
The New York Review of Books
Volume 56, Number 8, May 14, 2009

Edited by Andy Ross

A Failure of Capitalism: The Crisis of '08 and the Descent into Depression
By Richard A. Posner
Harvard University Press, 346 pages

Richard Posner is a judge of the US Court of Appeals for the Seventh Circuit. To call him a polymath would be a gross understatement. Judge Posner evidently writes the way other men breathe. He has an extraordinarily sharp mind. But his grasp of economic ideas is precarious.

Suppose I have $100,000 of my own, and I see an opportunity to earn a 10 percent return. If it pans out, I make $10,000. If it earns nothing, I have my original stake. If it loses money, that comes out of my initial capital. But I have a shot at something bigger. I can borrow $900,000 at, say, 5 percent interest, and invest the whole million. If it earns the expected 10 percent, I have $1,100,000. I can pay off my debt, plus interest of $45,000, and have $155,000 left. I have earned 55 percent on my money. Only in America!

In the past, 10-to-1 leverage would have been about par for a bank. More recently, many large financial institutions reached for 30-to-1 leverage. So suppose I borrow $2.9 million to go with my very own $100,000 — leverage of 29 to 1. I can buy $3 million of whatever asset I fancy. If it earns 10 percent, I repay the $2.9 million plus $145,000 in interest and go home with $255,000, having earned 155 percent on my own capital. But now, if the investment earns zero, I have an asset worth $3 million and liabilities of $3.045 million. I am, to coin a phrase, bankrupt.

This sob story is just the beginning. Many highly leveraged financial institutions — banks, hedge funds, and insurance companies among them — have dug themselves into similar, interconnected holes. They have borrowed from other financial institutions to make complicated bets on risky assets, and they have lent to other leveraged financial institutions so that those institutions could make complicated, risky asset bets. These are the "toxic assets" that weigh down the balance sheets of banks.

All those banks and others are now unwilling to lend to one another because they fear that the potential borrower is already broke and will be unable to repay. And so the credit markets freeze up and ordinary businesses that need credit for ordinary business purposes find that they cannot get it on any reasonable terms. The breakdown of the financial system exacerbates the recession. The recession then worsens the state of the financial system.

It is leverage that turns large banks and financial institutions into ninepins that cannot fall without knocking down others that cannot fall without knocking down still others. That seems to be the key to the potential instability of an unregulated financial system. This understanding must then also be the key to designing regulations that can reduce the frequency of financial crises. Regulation should require that the uses and amounts of leverage be made public and that limits be set.

We are in a long and serious recession. What is important is the interaction of the "real" recession and the financial crisis. According to data compiled by the Federal Reserve, household wealth in the US peaked at $64.4 trillion in mid-2007, and had plummeted to $51.5 trillion at the end of 2008. Something like $13 trillion of perceived wealth vanished in not much more than a year.

It might be thought that somehow fixing the financial mess would automatically fix the real economy. That is not so. In the first place, all that vanished wealth cannot be restored. American families are not worth $64.4 trillion. Secondly, the restoration of credit flows is not just a matter of clarifying and strengthening the balance sheets of banks and other lenders. It takes two to make a loan: a solvent and willing lender and a credible borrower. In a deep recession, there are not enough credible borrowers.

The Obama administration has been trying to inject enough clarity and capital into the balance sheets of banks so that they can resume providing credit for businesses and consumers. The job of regulatory reform has had to wait. There is no way yet to know what form the new system will take.

Robert M. Solow, Institute Professor Emeritus of Economics at MIT, won the 1987 Nobel Prize in economics.
 

AR  I can only agree with the analysis.