This is from a review of Richard Posner’s new book, A Failure of Capitalism. The reviewer is MIT’s Robert M. Solow, who won the 1987 Nobel Prize in economics.
It seems to me that effective limits on leverage, even if they have to be different for different classes of institutions, are basic to controlling the potential instability of the financial system. Even with more transparency, extreme leverage is what generates extreme uncertainty and systemic risk.
And it also encourages the dangerous compensation practices that Posner pillories. Leverage allows a clever player to manage enormous sums; it is then irresistible to focus on the short run and skim off mind-boggling paychecks and bonuses before the opportunity goes away…
The financial system does have a useful social function to perform, and that is to make the real economy operate more efficiently. Some human institution has to collect a nation's savings and put them at the disposal of those who have productive ways to use them. Risks arise in the everyday business of economic life, and some human institution has to transfer them to those who are most willing to bear them.
When it goes much beyond that, the financial system is likely to cause more trouble than it averts. I find it hard to believe, and I suspect that Judge Posner shares my disbelief, that our overgrown, largely unregulated financial sector was actually fully engaged in improving the allocation of real economic resources. It was using modern financial technology to create fresh risks, to borrow more money, and to gamble it away.