Richard Posner, leader of the Chicago School of Economics and Fourth Circuit Court of Appeals judge, uses his new book, “A Failure of Capitalism,” to try to rescue the Chicago School’s foundational assumption that the economy behaves as if all economic agents and actors are rational, far-sighted calculators. In some sense, Posner must try. For without this underlying assumption, the clock strikes midnight, the stately brougham of Chicago economic theory turns into a pumpkin, and the analytical horses that have pulled it so far over the past half- century turn back into little white mice.

Thus he writes: "At no stage need irrationality" on the part of markets or their participants "be posited to explain” the collapse of financial markets last year and the current deep recession.

Posner’s effort looks to me like an earlier effort to “save the appearances” in the face of discomfiting contradiction. The Jesuit astronomers of 17th-century Rome wanted above all to maintain the assumption that the sun revolved around the earth—for if it did not then the Bible’s declaration that Joshua called on God to make the sun stand still in the sky was a lie, and a Bible that lies even once cannot be the inerrant foundation of faith.

Thus the Jesuits created much more complicated models than the elegant heresy of Copernicus, in which the earth revolved around the sun. They succeeded in their attempt to save the appearances. Posner’s attempt does not: It is definitely a retrograde motion, for we see many things in the financial crisis and the recession that are not what we would see in an economy populated by smoothly rational utilitarian calculators.

* It was not rational for Bear-Stearns CEO James Cayne, with his own $1 billion fortune on the line, to allow his firm to become hostage to the excessive risks taken by his subordinates in the mortgage markets.

* It was not rational for Citigroup CEO Charles Prince to keep dancing to the music, without thinking which seat Citi would claim when the round of musical chairs came abruptly to a halt.

* It was not rational for shareholders of newly incorporated investment banks to offer traders large annual bonuses for performance assessed by a year-to-year mark-to-market yardstick—rather than rewarding them with long-run restricted stock that would hold its value only if the traders' portfolio strategies proved durable.

* It was not rational for the shareholders and executives of General Motors and Chrysler to ignore the need for a Plan B in the event Americans fell out of love with SUVs.

The litany of financial lunacy is longer than even the Eastern Orthodox litany of the saints. Yet Posner’s insistence that the crisis cannot spring from compound irrationality drives him to a claim that the real cause is a failure of government—specifically a too-lax, too-nurturing, insufficiently strict Mommy State that raised the children all wrong.

"The mistakes were systemic,” he writes, “the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools." What we needed, Posner implies, was a Daddy State in the early 2000s that would have kept interest rates high, kept the recovery from the 2001 recession much weaker, and kept unemployment much higher. The Daddy State should have restricted financial innovation because a "depression is too remote an event to influence business behavior. The profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy."

Posner's claim that the Princes of Wall Street were rationally ignoring small probabilities is simply not true. The venture capitalists of Silicon Valley in the 1990s raised money for their funds overwhelmingly through equity rather than debt tranches. They did so because they wanted themselves and their clients to retain some considerable fraction of their fortunes in an event that they regarded as small probability—but actually happened—that the overwhelming bulk of the value from the internet revolution flowed to customers rather than to businesses.

Jamie Dimon and his team at JPMorgan Chase tried to move their firm out of the subprime mortgage market and into position to profit from the correction by the end of 2006. So did Lloyd Blankfein and his team at Goldman Sachs. (They suffered anyway because neither imagined the possibility that a hedged long position in mortgages was not really hedged at all if the counterparty on the short leg was AIG.)

Yet while Posner insists on saving the appearance of individual rationality, he is willing to jettison the Chicago School's conclusion that markets are everywhere and always perfect. As Robert Solow observed: "If I had written that, it would not be news. From Richard Posner, it is." Abandoning the conclusion of market perfection opens the door to the idea that government needs to properly check, balance, and regulate markets in order to help them function as well as possible. But clinging to the assumption of individual rationality forces Posner’s view of what regulation is appropriate into a very awkward straightjacket.

If the dons of the Chicago School were locked in an ivory tower, it would not matter that Posner tries to save the appearances, and so attributes the crisis not to failure on the part of “capitalists” but rather of regulators. Posner, however, is one of America’s leading public intellectuals. His views spread. His influence is very wide. For example, Jonathan Rauch in The New York Times Book Review joins in and extends Posner’s error. For Rauch, “to see the crisis through populist spectacles, as President Obama does when he attributes it to 'irresponsibility,' is to misunderstand the whole problem by blaming capitalists." Rauch echoes and congratulates Posner, asserting that Posner’s “merciless scrutiny” leaves "not one populist cliché” remaining intact.

But Posner’s Chicago clichés not only remain intact but burst into full flower. Attributing responsibility to the errant Princes of Wall Street, and the directors and shareholders who were supposed to be overseeing them, would be "populism." And "populism" is bad. There should be no sanctions—not even a reduction in influence—for financiers. As for reregulation of the financial market, we should be satisfied with “pretty small beer,” because the failure was not a failure of individual capitalists but of capitalism itself.

As remedy, we should prohibit the Federal Reserve from seeking full employment through low interest rates. One actor whom Posner does clearly blame is Alan Greenspan, whose reduction of interest rates to 1 percent in 2002–2003 was, in Posner's eyes, a root of the evil. Full employment already loses out to price stability when the latter is threatened by inflation. In Posner's view, full employment must also give way if achieving it requires low interest rates.

Let us conduct a thought experiment. Suppose that Judge Posner had been willing to embrace Copernican theory. In that case, what would his policy recommendations have been? Start with the observation that financial markets have six useful purposes:

* to aggregate the money of people who ought to be savers into pools large enough to finance large-scale enterprises.

* to channel the money of people who ought to be savers to institutions and people who ought to be borrowers.

* to spread risks so that no one individual finds herself ruined by the failure of any one investment or the bankruptcy of any one company or the slow growth of any one region.

* to keep managements efficient by upsetting and replacing teams and organizations that have outlived their usefulness.

* to encourage savings by creating liquidity—the marvelous fact that one can own a piece of an extremely illiquid and durable piece of social capital (an oil refinery, say) and yet get your money out quickly and cheaply should you suddenly have an unexpected need for it.

* to take the money of rich people who like to gamble and, by providing some excitement for them as they watch their gains and losses, use it to buy capital equipment that raises the wages of the rest of us (at the price of paying a 20 percent cut to the Princes of Wall Street). This is a superior use for the rich—and for the rest of us—than, say, taking their wealth to the craps tables of Vegas.

Wall Street innovations and practices are useful only insofar as they promote these six useful purposes. Call them aggregation, accumulation, diversification, efficientization, liquiditization, and casinoization.

By these standards, the current compensation scheme on Wall Street—large annual bonuses based on annual marked-to-market results—is absurd. It helps achieve none of these six goals, and it greatly increases the chance of a crash by providing everyone with an incentive to help their friends by marking up value, marking down risk, and ignoring the impact of their actions on the long-term survival of the enterprise. Silicon Valley compensation schemes seem much better: no large payouts until assets have reached maturity and portfolio strategies have proved their value in all phases of the business cycle.

From this perspective, the rapid growth of derivative markets has also proved to be absurd. Derivatives were supposed to assist in risk spreading and diversification. Amateurs and outsiders could take on a position easily, and the professionals who sold it to them could then dynamically hedge it away, and so tap the risk-bearing capacity of the public to a greater degree. It did not work, and it made the books of Wall Street firms opaque even to the most sophisticated of executives. Kenneth Arrow would tell us that stocks, bonds, commodities, puts, and calls alone already carry us as close to a spanning set of securities as we are going to get. The potential diversification benefits of more complicated securities appear to be outweighed by the information they destroy.

The thirty-to-one effective leverage ratios achieved in the 2000s by major banks were absurd. When public money is involved—and when high-leverage portfolio strategies become common, public money is always involved—any system that relies on the intelligence of equity holders to restrain traders’ risks within bounds at a thirty-to-one leverage ratio is absurd. Every financial institution should be a bank holding company regulated by the Federal Reserve. And every bank holding company should keep a healthy proportion of its liabilities—10 percent? 20 p?—on deposit at the local Federal Reserve.

In the future, we need to change the culture of Wall Street by changing how top-earning financial professionals are paid, changing the assets they trade to make the markets less opaque, and changing the risks they run by taking capital requirements very seriously once again. If we accomplish all three, there’s a chance that the next Minsky Moment that comes along will be a minor disturbance rather than a globe-shaking catastrophe for 100 million people.

The key irrationality was a private-sector failure on the part of the shareholders and top managements of the banks to make sure that their traders had an appropriate stake in the long-run survival of the bank and not just in constructing a portfolio that would be marked-to-market at a high valuation on Dec. 31. And the government needs, for all our sakes, to compensate for this private-sector irrationality. That’s the conclusion that Posner’s book should have reached. But it never gets there: Because to get there, he would have had to begin his book by acknowledging that it matters that the earth revolves around the sun.