Economic uncertainty, the courts, and the rule of law.

• Author: Zywicki, Todd
• Position: Annual Federalist Society National Student Symposium

INTRODUCTION

Should judges protect private property rights and constitutional rights as vigilantly in times of crisis as in ordinary times? Conventional wisdom holds that crises justify suspending the rule of law and allow government discretion to address the crises. (1) The lesson of past economic crises as well as the most recent crisis, however, is that we should uphold the rule of law with special rigor in times of economic crisis because the temptations for politicians to misuse their powers during times of crisis are especially great. During crises, judges must be particularly vigilant in protecting private property and constitutional structure. (2)

Crisis often is invoked to rationalize both governmental discretion and waiver of the rule of law. (3) But as the financial crisis and its aftermath reveal, it is precisely during times of crisis that it is most important to tie the hands of government with the bonds of the rule of law. First, in times of economic crisis there is a special need for government behavior to be predictable and rule-bound to encourage investment and economic recovery in a period of uncertainty. Second, adherence to the rule of law in the face of crisis is important to restrain politicians from using the crisis to pursue their own self-interest or unleashing rent seeking by special interest groups--both of which dampen economic recovery and long-term economic growth. Third, the government's seizure of discretion creates a ratchet effect whereby the discretion and exceptions to the rule of law made during the crisis ossify and never return to pre-crisis levels. Fourth, the dynamics of short-term interventions tend to invite moral hazard that can be exploited by powerful special interest groups.

1. THE RULE OF LAW IN TIMES OF ECONOMIC UNCERTAINTY

   Should the rule of law be respected during times of economic crisis or should adherence to the rule of law be attenuated to allow greater executive discretion? First, what is meant by the term "the rule of law" and why does it matter? For current purposes it is not necessary to specifically define the rule of law; it is adequate to adopt a functional shorthand definition. At its heart, the value of the rule of law is Hayekian. (4) Simply, the world is in a state of constant flux. (5) Billions of economic transactions are conducted every minute throughout the world and it truly is a miracle that any productive economic activity happens, much less economic activity on such a great scale.

   Consider the milk in your refrigerator or cafeteria. Think of the chain of coordination required to get it there: Farmers must decide to use their land to graze dairy cows; determine how many cows to graze; and employ people and use machinery to milk the cows, pasteurize the milk, and deliver it into the stream of commerce. All the coordination in that relatively simple chain of production must then align with millions of consumers deciding whether to buy milk or Coke and ensuring that they can buy both milk and Cheerio's. (6) The extent to which these systems are coordinated is remarkable.

   Complex economic processes like the manufacture of cars or the introduction of initial public offerings pose even greater coordination difficulties. Add in the dynamic feature that all of these decisions are subject to a constant feedback loop as millions of individual purchasing decisions send signals about the relative demand for different products, and it is remarkable that this coordination occurs at all. Moreover, once achieved, economic coordination would seem to be in constant peril of disruption. Hayek's profound observation is that the price system is the mechanism by which this profound coordination occurs, leading to a functioning economy. (7)

   Hayek's corollary observation is that, in light of this uncertainty, the goal of social and political institutions is to minimize the number of variables that threaten coordination. (8) The legal regime and its governance of property and contract might be the largest and most important variable. Hayek's central insight about the value of the rule of law is that in a world defined by flux and dynamism, economic activity requires as much stability as possible from institutions like the legal regime that make economic coordination possible. (9)

   For instance, consider what it takes to make a loan. (10) Since credit markets blew up in fall 2008, lending activity has been very slow to recover. (11) It is not hard to understand why. To make a loan, a bank must be able to do two things. It must be able to price the risk of the loan accurately and reduce its risk exposure. (12) Government political response to the financial crisis (or perhaps more accurately rationalized as a response to the financial crisis) created a huge amount of instability that makes it difficult for people to price loans. As a result, lenders reduced their risk exposure by lending to fewer and fewer people, exacerbating the initial constriction of credit caused by the crisis. (13)

   The Credit CARD Act of 2009 (14) illustrates the counterproductive nature of legislative responses to the crisis. One of the important things that the Credit CARD Act does is to make raising interest rates more difficult when a borrower's risk profile changes. (15) If a card issuer cannot raise a customer's interest rate when she becomes more risky, the issuer will raise everybody's interest rates ahead of time, exactly what has happened in response to the Credit CARD Act. (16)

   If a bank cannot price risk accurately by adjusting interest rates, it will reduce its risk exposure, by either lending to fewer people by cutting off higher-risk borrowers or lending less to existing customers by reducing available credit lines. (17) Both market adjustments followed in the wake of the Credit CARD Act. For example, Jamie Dimon, the CEO of JP Morgan Chase, told the company's shareholders that fifteen percent of its customers would not be able to obtain credit cards anymore as a result of the CARD Act. (18) Similarly, after the financial crisis, banks slashed credit card credit lines by more than three hundred billion dollars. (19) Some of that, of course, is a consequence of the banking crisis. But some also is attributable to the Credit CARD Act's interference with the ability to price risk effectively. (20)

   The uncertainty caused by the Credit CARD Act is just a small piece of the regulatory uncertainty spawned in the wake of the financial crisis. If one piles the Credit CARD Act on top of healthcare reform, (21) the Dodd-Frank financial reform legislation, (22) the possibility of a far-reaching and onerous cap-and-trade bill, (23) and extensive and extraordinary growth in the regulatory state in general, (24) the enterprise of economic recovery is systematically dealt a death by a thousand regulatory cuts. In the face of a mountain of onerous legislation and regulation, is there any real way for a bank to determine what to charge for a loan that is going to be repaid in five or ten years? Lenders cannot possibly have an accurate sense of what the legal and regulatory regime is going to be like a decade from today.

2. CRISIS, RENT-SEEKING, AND POLITICAL OPPORTUNISM

   When judges fail to enforce contract and property rights, they create a target-rich environment for opportunistic politicians. These rights are guaranteed by law to constrain politicians and their special interest constituents. (25) When politicians are not constrained they take advantage of that freedom of opportunity to benefit themselves. The General Motors and Chrysler bailouts might be the most obvious and egregious examples of this dynamic from the financial crisis. One need not be reminded of the details of those bankruptcy proceedings to recall the outcome: With Chrysler, the government intervened to take money from the company's secured creditors--which included the pension funds for teachers and policemen--and give it to the retirement and health care funds of the politically powerful United Auto Workers, who had an unsecured claim in the case. (26) The government's actions ran roughshod over the longstanding rules of bankruptcy, not only by plundering senior creditors for the benefit of politically powerful junior creditors, but also by circumventing long-established bankruptcy processes governing the sale of a company as a going concern, the right of other parties to offer competing bids, and valuation procedures. (27)

   Even in its exit from bankruptcy, GM received a $45-billion windfall through a highly selective tax notice that provided preferential tax treatment to General Motors by allowing GM to carry forward net operating losses that are typically extinguished. (28) As Professor Mark J. Ramseyer and Eric Rasmusen noted, this preferential tax treatment concealed the true cost of the bailout (by reducing GM's tax liability via the obscure IRS "Notice" process) and artificially inflated the value of GM's stock. This valuation allowed UAW to sell its ownership stake at the inflated price and granted it a massive tax benefit not typically counted as part of the price of a bailout. (29)

   Financial interventions such as the GM and Chrysler bailouts create political risks, such as wealth seizure for investors, that were previously absent from the American political and economic system. (30) Studying the bond market response to the auto bailouts, Deniz Anginer and Joseph Warburton found that, although before those bailouts investors treated unionized and non-unionized firms identically, afterward investors began to treat them differently and embedded the possibility of a bailout into the price of the bonds of unionized firms. (31) Before the auto bailouts there was a general expectation that political risk was not an element of determining whether to invest in a company. Following the government's intervention, however, investors began to recognize that the American financial landscape had changed and that...