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Did Capitalism Fail?

NEW YORK – Until six days before Lehman Brothers collapsed five years ago, the ratings agency Standard & Poor’s maintained the firm’s investment-grade rating of “A.” Moody’s waited even longer, downgrading Lehman one business day before it collapsed. How could reputable ratings agencies – and investment banks – misjudge things so badly?

Regulators, bankers, and ratings agencies bear much of the blame for the crisis. But the near-meltdown was not so much a failure of capitalism as it was a failure of contemporary economic models’ understanding of the role and functioning of financial markets – and, more broadly, instability – in capitalist economies.

These models provided the supposedly scientific underpinning for policy decisions and financial innovations that made the worst crisis since the Great Depression much more likely, if not inevitable. After Lehman’s collapse, former Federal Reserve Chairman Alan Greenspan testified before the US Congress that he had “found a flaw” in the ideology that self-interest would protect society from the financial system’s excesses. But the damage had already been done.

That belief can be traced to prevailing economic theory concerning the causes of asset-price instability – a theory that accounts for risk and asset-price fluctuations as if the future followed mechanically from the past. Contemporary economists’ mechanical models imply that self-interested market participants would not bid housing and other asset prices to clearly excessive levels in the run-up to the crisis. Consequently, such excessive fluctuations have been viewed as a symptom of market participants’ irrationality.