Jack Balkin: jackbalkin at yahoo.com
Bruce Ackerman bruce.ackerman at yale.edu
Ian Ayres ian.ayres at yale.edu
Mary Dudziak mary.l.dudziak at emory.edu
Joey Fishkin joey.fishkin at gmail.com
Heather Gerken heather.gerken at yale.edu
Abbe Gluck abbe.gluck at yale.edu
Mark Graber mgraber at law.umaryland.edu
Stephen Griffin sgriffin at tulane.edu
Bernard Harcourt harcourt at uchicago.edu
Scott Horton shorto at law.columbia.edu
Andrew Koppelman akoppelman at law.northwestern.edu
Marty Lederman msl46 at law.georgetown.edu
Sanford Levinson slevinson at law.utexas.edu
David Luban david.luban at gmail.com
Gerard Magliocca gmaglioc at iupui.edu
Jason Mazzone mazzonej at illinois.edu
Linda McClain lmcclain at bu.edu
John Mikhail mikhail at law.georgetown.edu
Frank Pasquale pasquale.frank at gmail.com
Nate Persily npersily at gmail.com
Michael Stokes Paulsen michaelstokespaulsen at gmail.com
Deborah Pearlstein dpearlst at princeton.edu
Rick Pildes rick.pildes at nyu.edu
Richard Primus raprimus at umich.edu
K. Sabeel Rahmansabeel.rahman at brooklaw.edu
Alice Ristroph alice.ristroph at shu.edu
Neil Siegel siegel at law.duke.edu
Brian Tamanaha btamanaha at wulaw.wustl.edu
Mark Tushnet mtushnet at law.harvard.edu
Adam Winkler winkler at ucla.edu
In my last post, I praised Hernando de Soto's proposal to improve business recordkeeping, or "economic facts." Commenter A.J. Sutter responded that de Soto's "notion of 'economic facts' itself represents a fallacious reification. Those 'facts' are constructed by social actors." Sutter emphasizes the inevitably subjective, contingent aspects of accounting practices. He concludes that "rolling back some [accounting] innovations might be a good idea," but "the recovery of some sort of 'objectivity' is not likely to be the result."
Contrary to De Soto's simplistic claim that the very existence of registered property rights produces clarity and certainty about the delineation of powers and obligations (and hence that the only necessary reform of the financial markets is the creation of an adequate registration system for property in derivatives), most of property law is in fact about the enormous ambiguities that surround what powers and obligations flow from titled property ownership. . . .The real issue is whose certainty do you want to maximize, and about what. (164-65)
Both Sutter and Riles are right to criticize anyone who thinks the only, or even the major, "necessary reform of the financial markets is the creation of an adequate registration system for property in derivatives." It is naive to think that, if only we had more information, the crisis could have been avoided. To take but one of many possible examples: even if the analysts at the rating agencies had done far more due diligence on the quality of the loans behind the residential mortgage-backed securities that were sliced and bundled into collateralized debt obligations, they still could have come up with some rationale for a AAA rating. Many understood what was going on, but "danced while the music was playing." To the willfully blind, the naive, or the dense, virtually any arrangement can seem opaque. Nevertheless, it can't hurt to have some reporting of contract terms to authorities, especially if there is a delay. (Even defenders of the Fed's opaque operating arrangements concede that delayed releases would do little to no harm.) Secret contracts are proliferating in today's economy. When they cover a large enough swathe of activity, they become as repugnant as secret law. Even if the core problems in today's finance crisis are less about truth than about trust, better reporting can help address both issues.
Are Risks Quantifiable?
A great deal of financial regulation (and firm self-regulation) rests on the idea that the risks and liabilities of a firm are quantifiable. A vast and growing industry aspires to boil down firms' many obligations and expectations into comprehensive-yet-comprehensible accounts of financial well-being.
As Kenneth Bamberger has argued, technological systems used to quantify risks have many shortcomings. For example, "computer code . . . operates by means of on–off rules, while the analytics it employs seek 'to quantify the immeasurable with great precision.'” Bamberger makes at least two worthy suggestions for addressing the issue:
[C]urrent regulations [miss] the potential for transparency as to the exact methods of quantifying risk and the ways such measures automate decisionmaking [and] lack the ongoing capacity to provide timely and evolving risk information. . . . Transparency into the workings of regulated firms, however, provides only half the prescription. A new governance model further requires significant investment in the competence of administrative agencies themselves—both in terms of technical expertise and computing capacity. Regulators constrained by limited resources cannot currently keep up with the massive data-processing capacity of private corporations.
I think those points support de Soto's project. The SEC and CFTC also appear to be interested, given the broadly positive views expressed in their "Joint Study on the Feasibility of Mandating Algorithmic Descriptions for Derivatives." In that document, the staff concludes "that current technology is capable of representing derivatives using a common set of computer-readable descriptions[, which] are precise enough to use both for the calculation of net exposures and to serve as part or all of a binding legal contract."
There might be some sleight of hand going on here; perhaps the SEC/CFTC goal is less about representing the value of the exposures than it is about preferring or otherwise supporting more manageable deals. This is one idea behind the research program of "formalized financial expression," described in layman's terms by Jaron Lanier:
[H]ighly regular financial instruments . . . can be traded on an exchange . . . because they are comparable. But highly inventive contracts, such as leveraged default swaps or schemes based on high frequency trades, [should] be created in an entirely new way. They would be denied ambiguity. They would be formally described. Financial invention would take place within the simplified logical world that engineers rely on to create computing chip logic.
Reducing the power of expression of unconventional financial contracts might sound like a loss . . . for the people who invent them, but, actually, they will enjoy heightened powers. The reduction in flexibility doesn't preclude creative, unusual ideas at all. Think of the varied chips that have been designed [for computers].
Or, we might add, the dream of synthetic biologists to bring the efficiencies of interchangeable parts to the living world. Lanier insists that "the ability to register complex, creative ideas in a standard form would transform the nature of finance and its regulation," making it "possible to create a confidential . . . method for regulators to track unusual transactions." I don't think this model will solve all our problems, but I think it would be capable of detecting some of the more grotesque overreaches, like AIGFP's disastrous CDS business. Riles has also identified other rationales for reporting requirements; she cites research showing that they "are not simply ways of getting information---they are means of structuring an internal conversation within an institution that can lead to rethinking policies and perhaps internal change." Just trying to model transactions more transparently might help financial innovators better understand their fallibility.
The Lure of Naturalizing Markets
Admittedly, there are many critics of Lanier's proposal and others like it. For example, Michael Shermer, author of The Mind of the Market: How Biology and Psychology Shape Our Economic Lives, argues that the economy is as unmanageable as a natural system.
[E]conomies, like ecologies, are not intelligently designed from the top down; they spontaneously arise out of simpler systems from the bottom up. Life and economies, like language, writing, the law, civilizations, and cultures, arise spontaneously as self-organized emergent properties from within systems themselves and without the aid of a blueprint design by a clever engineer. Neither God nor Government are needed to explain such phenomena. In their stead, natural selection and the invisible hand explain precisely how individual organisms and people, pursuing their own self-interest in their struggle to survive and make a living, generate the emergent property of complex ecologies and economies. Both are Complex Adaptive Systems in which individual particles, parts, or agents interact, process information, learn, and adapt their behavior to changing conditions.
But this move toward naturalizing markets should be as suspect as its Social Darwinist forbears. Natural orders can be profoundly self-destructive. I am not saying that evolutionary theory has no role in economics; I've endorsed it myself in some scenarios. However, we need to be aware of the prevalence and pitfalls of natural images in economic thought. Geoffrey Hodgson has suggested that Hayek's use of evolutionary theory is "sketchy and sometimes ambiguous," and concludes that it "does not support the kind of political and policy conclusions that Hayek wishes to sustain." Similarly, Riles has identified the "ideological dimension of Hayek's argument" for "spontaneous order" in "the way he slips from observations that public legal reasoning has certain temporal weaknesses to a simple assumption that private reasoning must have equivalent temporal strengths" (158). Analogies between markets and ecological systems are the beginning of an argument about about the wisdom of regulation, not its end.
Invocations of the "invisible hand" are no less suspect. Adrian Vermeule has argued that there are "necessary conditions" for invisible hand "justifications to be cogent." Such a justification must combine "(1) an explanation that identifies an invisible-hand process with (2) a value theory that identifies some social benefit arising from the invisible-hand process and (3) a mechanism that explains how the invisible-hand process produces that benefit."* Shermer fails to articulate the social benefit from untrammeled financial markets, trying to imbue them with the same prestige that accompanies the longer history of market capitalism. But, as one commentator notes, financiers' "$4 trillion daily trade in cross border capital, their $600 trillion of derivatives, about twice the capital stock of the world, [and] their algorithmic trading that accounts for about half of the turnover in the US stock exchange" have "never existed before," and are as new a variant of “capitalism” as China's system is of "communism." It is naive to claim these enormous flows of funds are viable or even imaginable without sovereigns capable of guaranteeing order.
Little in finance is "irredeemably opaque," in Alan Greenspan's memorable phrasing. Rather, powerful actors are constantly maneuvering to consolidate influence over a law enforcement apparatus that could peak into traders' deals as intrusively as it examines those in suspect neighborhoods, professions, or political organizations. Of course, once the books are "open," there are ever more incentives to make them too complex to understand. I discussed some of those in the last post, including off balance sheet accounting. Modelling those obligations could be very difficult. As the ISDA said in comments on the "Algorithmic Descriptions" rulemaking, "it would be costly for regulators to independently define or impose a data representation standard, due to the breadth, complexity, and rapid rate of change in the OTC derivative marketplace."
But the question then becomes: how much more costly is the present system, where some new AIG might be blithely cashing in premium checks for obligations it can never meet? As Roscoe Pound has said, "In a commercial age wealth is largely made up of promises." Combine the recklessness or excessive optimism of swap "protection sellers'" promises with the rampant agency problems that survive the crisis, and you have a recipe for ongoing turmoil and lack of trust in financial markets. Until the swaps market is well and truly ring-fenced from the rest of the economy, disclosure laws should end certain types of deals because they can't be adequately represented, measured, or managed.
Truth or Trust
On the other hand, the "you can't manage what you can't measure" mantra has been abused in many contexts. "Data" can be endlessly massaged and manipulated, and any contractual arrangement depends on a stable background of responsible private and public sector actors. If we must be deeply agnostic about the accuracy of any representation of a firm's assets and liabilities, we need to rethink much more than reporting requirements. Finance does not merely require more scientistic accuracy (or "trust in numbers"); rather, regulators must promote institutions where accountability and trusting relationships can prevail.
What Sutter and Riles have both helped me realize is that trust is a far more pervasive and critical factor than truth. Not every "worst case scenario" can be defended against, or even predicted. What we can hope for is a market whose participants can act in ways somewhat less self-regarding than the "I'll be gone/you'll be gone" ethic that now rules major players in the finance sector.
Riles's proposed "new governance" solutions would require wide participation and "buy-in of market participants" (228). She is right to identify a broader cultural problem in today's markets. There was only a market for toxic assets because of unrealistic yield expectations of thousands of entities, and their clients. A few players engaged in Icarian risk taking, but only did so to satisfy unrealistic aspirations for risk to be engineered away. In the future, those on the buy side have to level with their clients: there is no free lunch, and no guaranteed way to make money. By accepting that sober wisdom, clients can free the managers of their investments to make the sell side less slippery. Riles articulates a "greater ambition" to "fundamentally change the culture of financial practice, to create a world in which actors of their own will, indeed before even being admonished, incentivized, pushed or prodded by regulators, make socially optimal choices, the very choices regulators would enshrine in regulation" (236). Riles sees in Japanese financial markets a model for regulators to turn regulated firms' employees "into collaborators, in the best sense of the term."
These are ambitious goals, but I fear they may not be grand enough. In the US, we first need to recognize that private markets can't aggregate the risk pools and credit necessary to do the work of a Social Security or Medicare program. The most basic and universal insurance is social, and if it is to work, it must be egalitarian, contestable, and politically determined.
Given overlapping ecological, health, and security crises, we need to relate the workings of the finance sector to the real needs of society. When finance mostly finances finance, we get a closed circuit economy, which does little more than drain purchasing power from lower and middle class households and reallocate it to insider elites. We must not only be able to trust that finance's processes are legitimate, but also its results. Massive bonuses for top managers, mass unemployment for workers, and crumbling infrastructure are three signs that finance as presently constituted in the US is not fulfilling many of its major social roles. Sadly, it is hard to find a financial regulator in the US who is willing to take on more than one of those three critical issues.