Reconsidering the Crisis

This past May, the Law School brought together a small number of senior academics, jurists, private practitioners, and regulators to discuss an issue of critical importance, "Are Markets Efficient? Legal Implications of Economic Theories of Market Behavior." The summit was the third in a series of invitation-only meetings that began in 2007 to consider pressing issues of law and economics.

The first, which was held in November 2007 in Chicago, considered the question "Have U.S. Laws and Regulations Kept Up with Market Forces?" That first University of Chicago Law School Summit seemingly foreshadowed the financial meltdown that occurred less than a year later. The events of the fall of 2008 provided the topic for the second Summit, entitled "The NewWorld of Securities, Financial Markets, and Regulation," which was held in February 2009 in New York. Sessions at the second Summit were labeled simply "What Happened?" "What Worked and What Didn't?" and "Where Should We Go from Here?"

The 2010 gathering began on Thursday, May 6, at the Chicago Club with a keynote talk by Judge Richard A. Posner. A pioneer in the study of law and economics, the judge presented a stimulating talk, "What We Have Learned from the Crisis, Its Causes and Prevention."

"The populist theory for the crash is that it was caused by greedy, reckless, stupid bankers and homebuyers," Posner began. "But I don't think we can understand the crisis without understanding the monetary policy created by Alan Greenspan."

"Excessive deregulation and a lack of enforcement of the existing regulations are a cause," he continued. "But so are mistakes by Congress."

The judge began by explaining how Greenspan's lowering and holding interest rates overstimulated the economy, which led to excessive credit and a resulting rise in housing prices. All these together led to a housing and credit bubble that ultimately burst. Credit froze, which means the economy froze, and the government was forced to step in.

"The regulation for banking has to be stricter than it is for other industries," Posner explained. "And this is where I have changed my opinion."

The judge went on to explain that for years he supported deregulating the banking industry, without adequately realizing that the consequences of its failure are enormously more far-reaching than for any other industry. While the airline industry, for example, can become deregulated, risky, and eventually broke, its bankruptcy, unlike that of the banking industry, cannot bring down the entire economy. "The riskiness of banking has microeconomic significance," Posner went on. "Everything in business is geared to the availability of credit, and if the banking industry falls apart, credit goes away, and the economy can grind to a halt. Deregulation went too far in the financial sector," Posner emphasized, "because financial bankruptcies created externalities that other industries do not."

The issue of "dumb" consumers was also discussed. While the press and others present the rash of home foreclosures as the result of incompetent purchasers, there are other ways of looking at purchasers' behavior. Because many of these foreclosures took place on mortgages with very small, or even no, down payments, the actual financial losses to these owners were often minimal.

"If a buyer didn't put up a down payment, or put up only a small one, how much has he lost?" Posner asked. "He may even have spent less than he would have on rent."

But with the market's collapse, many are demanding more government intervention and new regulations, which Posner does not support. What is needed, he explained, is for the existing regulations to be properly enforced. The judge pointed out that in addition to requiring the Federal Reserve Bank to obtain a better understanding of the bank failures, the Securities and Exchange Commission (SEC) needs to regulate the shadow banks more effectively. The SEC has never been interested in solvency issues-look at their failure to regulate Lehman Brothers.

But while proper enforcement would improve the future safety of our economy, there are still enormous problems with the multinational entities that now populate the banking industry, because assets in foreign countries cannot be regulated by the United States.

"The economists think that the recession is over when the gross domestic product goes up," Posner noted. "Well, in 1933 the GDP was growing, and unemployment was at 25 percent, so that is not really the right way to look at this. You have to look at the unemployment rate and at the level of political unrest, along with all the other indicators. If you consider the European crisis as well, you will realize that we are still in recession." Judge Posner was kind enough to sign copies of his latest book for all attendees.

On Friday, May 7, the Summit participants continued their discussions at the Gleacher Center, in two sessions, titled "Efficient Market Hypotheses versus Behavioral Economics-Which is the Best Guide?" and "What Are the Implications for Law, Finance, Accounting, and Regulatory Reform?"

Sidley Austin partner and chairman Tom Cole, '75; Cravath, Swaine & Moore partner Philip Gelston; Delaware Supreme Court Justice Jack Jacobs; and David Zarfes, Associate Dean for Corporate and Legal Affairs and Schwartz Lecturer at the Law School, developed the summits in order to underline the commitment of the Law School to the field of law and economics. This year's Summit was a thought-provoking gathering that will likely generate continued discussion among the group of participants and beyond.