The global democracy movement has reached America’s shores. The national conversation has shifted. And each day, more and more of our citizens begin to ignore the billion dollar sideshow designed to distract us, divide us, and most importantly disguise the true causes of the Great Recession.
NOTE: Republic, Lost is the current selection of the Coffee Party Book Club, which is excited to host Prof. Lessig on Coffee Party Radio on Thursday Feb. 9, at 2 PM ET. Please read the chapter below, please seek out the book, and, whether you've finished it or not by Thursday, please join us for a conversation that will begin with diagnosis, and end with a plan of action.
From the book REPUBLIC, LOST. Copyright (c) 2011 by Lawrence Lessig.
Reprinted by permission of Twelve/Hachette Book Group, New York, NY. All rights reserved.
CH A P T E R 7
Why Isn’t Our Financial System Safe?
by Lawrence Lessig
merica is still feeling the effects of the worst economic collapse since the Great Depression. That collapse was triggered in 2008 by a crisis on Wall Street. All of the major banks in America were drawn to the brink of bankruptcy. It took the largest intervention in the history of the nation to avoid a crisis likely to be worse than the Great Depression. Tomes have been written about this crisis and its causes. Practically every single actor within our system of finance— from the borrowers to the lenders to the government overseeing it all— has been blamed by someone for the disaster. Some of that blame is politically motivated. Some of it is grounded in ignorance. But there is certainly enough to touch anyone of any consequence in this story, and more than enough to rock our confidence in these institutions intended to keep us financially safe. The cause that I find least convincing, however, is irrationality. Some argue that it’s just craziness that explains the crisis. That somehow, and inexplicably, everyone just became insanely greedy— irrationally borrowing more than they could repay, irrationally lending more than was prudent, irrationally ignoring the warnings of impending doom— and now that this fever has passed, we can look forward to another fifty years of financial stability. Like the measles or small pox, if you survive it, you don’t get it again.
This is a criminally incomplete understanding of the disaster that we’ve just suffered. And while it would take a whole book to make that case convincingly, in the few pages that follow, I sketch one part of the argument with enough detail to make it relevant to the argument of this book. For the core driver in this story was not craziness. It was rationality. The behavior we saw— from borrowers to lenders to Wall Street to government officials— was perfectly rational, for each of them considered separately. It was irrational only for the system as a whole. We need to understand the source of that irrationality— not an individual, but a systemic irrationality— to ask whether the policy judgments that produced it could even possibly have made sense. That source is tied directly to regulation. In my view, the single most important graph capturing the story of American finance was created by Harvard Business School professor David Moss (Figure 6).
Moss explains the picture like this:
Financial panics and crises are nothing new. For most of the nation’s history, they represented a regular and often debilitating feature of American life. Until the Great Depression, major crises struck about every 15 to 20 years— in 1792, 1797, 1819, 1837, 1857, 1873, 1893, 1907 and 1929– 33.
But then the crises stopped. In fact, the United States did not suffer another major banking crisis for just about 40 years— by far the longest such stretch in the nation’s history. Although there were many reasons for this, it is difficult to ignore the federal government’s active role in managing financial risk. This role began to take shape in 1933 with the passage of the Glass- Steagall Act. . . . The simple truth is that New Deal financial regulations worked. In fact, [they] worked remarkably well.
If you want to understand where the craziness began, we should begin where the “New Deal financial regulations” begin to end. This is the delta in the environment. Or it is at least the one self- conscious change that should be the first target of suspicion. The most efficient entry into this argument is a quote from Judge Richard Posner. Judge Posner sits on the U.S. Court of Appeals for the Seventh Circuit in Chicago. He is among the most prolific legal academics and the most prolific judges in the history of the nation. He is certainly among the most influential. His book Economic Analysis of Law (1973) founded the law and economics movement. Since then he has written fifty more books, hundreds of articles, and thousands of judicial opinions. He was appointed to the federal bench by Ronald Reagan thirty years ago. Whatever we can say, we can be certain, Posner is no socialist. Among Posner’s fifty- some books are two that deal specifically with the financial crisis. And at the core of Posner’s argument is an insistence that we understand the rationality behind this insanity. As he writes, criticizing a government report on the crisis:
The emphasis the report places on the folly of private- sector actors ignores the possibility that most of them were behaving rationally given the environment of dangerously low interest rates, complacency about asset- price inflation (the bubbles that the regulators and, with the occasional honorable exception, the economics profession ignored), and light and lax regulation.
This is the idea that I want to pursue here: that the gambling that Wall Street engaged in made sense to them given (1) “the environment of dangerously low interest rates,” (2) “complacency about asset- price inflation,” and (3) “light and lax regulation.” My focus will be on (3) “light and lax regulation” and (2) “complacency about asset- price inflation.” For our purposes, let us stipulate that (1) is also correct.
