Cycles and Romance in Financial Law

Thank you to Dan for questioning my argument that the political economy of financial institution regulation is different. I agree whole heartedly that there are other areas of law -- like environmental law -- in which a concentrated industry can externalize cost onto a diffuse public.

But there are still crucial differences between the political economy of environmental law and the political economy of financial institution regulation:

First, the negative externalities in financial institutions are more closely coupled with the very services that the public demands. We want financial institutions to take risks, extend credit, and provide capital. Too much of these good things, however, can put the government safety net into play. In environmental law by contrast, there is a tradeoff between positives (jobs) and negatives (pollution). No one wants dioxin. It is possible that technological advances or Coasean bargains can mean we can have more jobs without more pollution. But if financial markets are even somewhat efficient, it is hard to have more reward without more risk taking.

Second, financial markets are subject to cycles. It is when the political cycle becomes too closely coupled with the financial cycle that we need to be most concerned. Booming financial markets can contribute to disaster myopia among regulators and herd behavior by financial institutions and investors. I looked at the interactions between market cycles and regulatory cycles a few years ago  and am exploring them much more in my book. Perhaps similar cycles and feedback loops exist in other regulatory areas (if readers have thoughts on this, please e-mail me), but financial markets makes the feedback stronger.

Third, let’s talk romance. In environmental law, there is at least a semblance of interest group pluralism because environmental groups are deeply and ideologically committed to defending wildlife, protecting natural spaces, and fighting pollution. Financial regulation doesn’t have that same civil society. Claire Kelly has written very creatively about the possible role of civil society in financial regulation. But where is the motivation for people to participate? Where is the ideology? Where is the romance?

I am not being facetious. Earlier in the summer, we had dinner with environmentalist friends who described how they met and fell in love in the “movement.” Where is the “movement” in our field? (Granted my future wife thought it was cute when I was reading Against the Gods before we were dating, but still…)

Moreover, I think “insurance” regulation differs somewhat from “banking.” When I pressed you a few years ago, you said that (bond insurance and credit derivatives aside) insurance didn’t raise the same systemic risks that banking did. So I think there is less incentive for firms to externalize the cost of their failure on taxpayers (AIG is different, because it involved insuring financial products). That of course doesn’t diminish the possibility that “Joe the Plummer” will get screwed when he purchases his life insurance.

Comments

[Kim Krawiec]

"Where is the romance?"
love that one.
You and Brett have been on a roll with titles today.

[Cristie Ford]

Erik, I think there's all kinds of romance around these issues, and I'm not just talking about our little group's esoteric tastes. Thing is, the romance is in the Tea Party.

Your second post did an extraordinary job of identifying all the ways in which the path forward for financial institutions regulation is fraught with peril. But some of them would be significantly changed, defanged even, in a different political environment. I know that might sound flaky. On the other hand, the political calculations were not always as they are now. Anyone who's been in an institution that has undergone a cultural shift recognizes the reality of it, even if proactively trying to make it happen is a maddening and slippery project.

Sometimes I wonder whether the language of financial regulation allows us to make appropriately nuanced normative claims about what's at stake: an essential tension between the market, the state, and society. Has the clarity of economic scholarship and the constant reference back to efficiency blinded us to other, more resonant ways of framing these issues?

[Erik Gerding]

Thanks for this comment, Cristie. I do worry that our (and particularly) focus on economic efficiency can prevent us from discussing the broader and vital political and social values that are at stake in financial regulation and the regulatory process more generally. Economics is not value free.

There is nothing close consensus, however, in the United States today on the balance among market, state, and society. A lack of consensus should not stop a conversation. At the same time, no one can find that the events leading up the financial crisis was a sensible balance. Privatizing gains and socializing risk doesn't accord with any principled political view.

I understand the rage and romance that drives the Tea Party, but Tea Party opposition to financial reform strikes me as misguided and an indication of a political dialogue that has run off the rails. First, it is just not credible that the government will not bail out financial firms. Second, the bailouts weren't the only problem. Had we allowed more financial firms to founder, we can debate what the exact consequences would have been, but they would have been severe. Financial institution risk imposes severe negative externalities -- to to put it more bluntly -- hurts workers, businesses, homeowners, who may never have taken out a subprime mortgage or invested in Wall Street.

I think the populist wave after the financial crisis has been severely misdirected and squandered. My question is how does one channel populist rage so that it is productive. Personally, I get extremely nervous about populism and whether its energies in the wake of financial crises can be harnessed. The history of financial crises is full of exmaples of scapegoats and ugly legal reactions. (To reach far back in history: the English stock market bubble that burst in 1696 prompted Parliament and the mayor of London to impose restrictions that limited the number of Jewish stock brokers).

We didn't really discuss it much in the forum -- despite Kim's prodding -- but popular energy is an incredibly powerful force that scholarship can too easily sidestep because of discomfort, the messiness it can add to analysis or whatever.