Legal theory lessons from the financial crisis.

• Author: Driesen, David M.

INTRODUCTION I. TRADITIONAL LAW AND ECONOMICS AND THE FINANCIAL CRISIS A. Law and Microeconomics B. Deregulation and the Financial Crisis C. The Posner Defense II. COMPLEXITY AND THE IMPOSSIBILITY OF PREDICTING A MEANINGFUL EQUILIBRIUM III. INSTITUTIONAL FACTORS MAKING EFFICIENCY AN ELUSIVE GOAL FOR GOVERNMENTS IV. TOWARD LAW AND MACROECONOMICS A. Focusing on the Shape of Change Over Time B. Avoiding Systemic Risk While Keeping Open a Reasonably Robust Set of Economic Opportunities C. Economic Dynamic Analysis D. Economic Dynamics' Limits and Some Potential Objections V. CONCLUSION INTRODUCTION

What lessons should we draw from the financial crisis? Many scholars have addressed this question in narrow terms, focusing on specific reforms to the financial system. (1) The literature has remained remarkably quiet on the broader question of what lessons the crisis teaches about the theory of law and economics. This Article addresses this question in the realm of laws regulating complex systems. This realm includes, at a minimum, the fields of financial regulation, environmental law, intellectual property, and antitrust law. These areas (and many others) involve substantial problems of discontinuities, surprise, nonlinearities, and complexity, which create huge challenges for cost-benefit analysis (CBA) based on statistical probability functions. Furthermore, in these dynamic areas, the most important problems often stem from the least predictable phenomena, at least quantitatively.

This Article argues that for these sorts of dynamic problems the current theory of law and economics has proven inadequate. That theory treats law as if it were a mere transaction, much like the purchase of a good. Accordingly, it emphasizes attainment of equilibrium between costs and benefits, captured by the microeconomic concept of allocative efficiency. (2) This Article argues that at least for these dynamic systems, this ideal proves both unattainable and not terribly important.

It rests these conclusions primarily on two grounds. First, in a dynamic system with significant discontinuities and true uncertainties, complexity defeats optimality as a goal for legal decisions because optimality becomes impossible to calculate and relatively unimportant. (3) Furthermore, the financial crisis teaches us that the CBA substitutes neoclassical law and economics employs to cope with intractable problems of complexity and uncertainty--assumptions of rationality and perfect information--work very badly as guides to major policy decisions.

The second ground for doubting allocative efficiency's utility as a guide to law in this context is more institutional in nature. Law is not a transaction. Law by its nature provides a framework that influences, but usually does not control, resource allocation. Accordingly, most law is neither efficient nor inefficient. It simply provides the framework under which market actors seek to achieve efficient outcomes. Hence, it is often not possible to determine whether a law is efficient. Because law provides a framework, it should be thought of as more closely analogous to macroeconomic policy (which likewise influences but does not control resource allocation) than to the transactions that microeconomics typically focuses on.

These insights have profound implications for legal theory. They mean that law and economics' problems run deeper than the debate about whether to use neoclassical assumptions or assumptions from behavioral and institutional economics to "predict" which legal rules will prove efficient. Instead, these two problems--the dynamic nature of many regulated systems and the institutional place of law--undermine the use of efficient transactions as a legal model at least in the many areas of law that regulate complex irregular phenomena.

One can imagine a unifying role for legal theory combining law and economics to address complex systems that avoids these problems, but this new role would substantially change law and economics' focus, goals, and methods to make it more macroeconomic and less transaction-oriented, at least when it addresses the law of complex systems. Policymakers and scholars should focus on the shape of change over time, treating legal reform as an effort to countervail negative long-term trends, adopt a goal of avoiding systemic risks while keeping open a robust set of economic opportunities, and employ economic dynamic analysis, a method for bringing institutional economic insights to bear on legal problems. To be sure, no theory of law and economics captures all important legal goals. But, I argue that this approach, which I call an economic dynamic approach, does a much better job of focusing on important problems and addressing complex dynamic systems than the microeconomic approach to law and economics.

Although legal scholars have said little about the financial crisis' implications for legal theory, economists such as Paul Krugman and Joseph Stiglitz saw the financial crisis as a major challenge to the neoclassical microeconomic model, which underlies Chicago School law and economics. (4) Although obviously concerned about government economic policy, these Nobel Prize winning economists did not address what changes this challenge to the neoclassical model might portend for legal theory. Their work, however, strongly suggests a macro, rather than micro, economic focus, an emphasis quite congruent with the approach I advocate here. (5)

Richard Posner, who has addressed the crisis' implications for legal theory, acknowledges the central role of macroeconomics in thinking about responses to the economic crisis, but does not treat macroeconomics as useful for the theory of law and economics more generally. (6) He goes on to highlight the need for law and economics to address uncertainty, not just in the sense of risk (cases of known probabilities), but also in cases of true Knightian uncertainty (where probabilities are unknown). (7) And his writing acknowledges that this need to address uncertainty reaches beyond the domain of financial regulation. (8) Yet, his writing on the financial crisis sees uncertainty as a technical problem in understanding "efficient responses" to the business cycle, thus keeping the focus on the microeconomic goal of efficiency and preserving neoclassical assumptions about human behavior. (9) This Article argues that Posner's acknowledgment that uncertainty defeats CBA leads to the conclusion that allocative efficiency does not work as a central goal for regulation of complex dynamic systems.

This Article's first part provides relevant background by discussing traditional law and economics and how neoclassical law and economics contributed to the financial crisis. The second part explains why the complex nature of many systems that law must regulate makes efforts to achieve efficient outcomes futile and relatively unimportant. The third part focuses upon the institutional role of law, showing that law usually provides a long-term framework that typically influences, but does not control, resource allocation, thereby undermining the transaction-focused microeconomic theory of law. The fourth part argues for the economic dynamic approach that I briefly summarized above.

Because I have written a book on economic dynamics, this fourth part offers only a brief sketch of that alternative. (10) Furthermore, the validity of the lessons I draw from the financial crisis about the triviality and uselessness of an "optimality" goal for law addressing complex systems does not depend on the full acceptance of the economic dynamic alternative I sketch out in the fourth part.

1. TRADITIONAL LAW AND ECONOMICS AND THE FINANCIAL CRISIS

   This part begins by discussing the basics of neoclassical law and economics and how its assumptions tend to support deregulation. It then shows that these ideas helped support the deregulation that set the stage for the financial crisis. It closes with a discussion of Richard Posner's defense of the neoclassical model in the aftermath of the crisis.

   1. Law and Microeconomics

      When scholars write about law and economics they mean law and microeconomics. (11) Law and economics neglects the entire field of macroeconomics. (12) Microeconomics addresses the behavior of particular market actors or of discrete groups of market actors. (13) By contrast, macroeconomics concerns itself with the economy as a whole, including such key concerns as economic growth, depressions, and job creation. (14) The individual transaction serves as the archetypical unit of analysis in microeconomics. (15) The microeconomic model tends to focus on achievement of equilibrium, rather than the questions of growth and decline at the heart of macroeconomics. (16)

      Law and economics' creators established allocative efficiency as legal analysis' principal goal. (17) This idea flows from the transactional model that underlies microeconomics. (18) Use of the allocative efficiency concept to guide law implies that we should test legal reform's efficiency by asking whether a proposed reform generates benefits commensurate with its cost. An efficiency goal therefore leads to invocation of CBA as a methodology for evaluating the desirability of legal changes.

      In some fields, such as government regulation protecting the environment, health, or safety, CBA has played a major role in evaluating legal decisions. Since Ronald Reagan's presidency, a series of executive orders have called for application of CBA to significant proposed regulations. (19) The prestige that CBA has gained through the elevation of the efficiency concept as a guide to legal decision-making has empowered a part of the White House, the Office of Information and Regulatory Affairs (OIRA) in the Office of Management and Budget, to review regulations, ostensibly to help ensure that a regulation's costs do not exceed its benefits. (20) OIRA, however, does not limit itself to application of an...