In Lawmaking without Law: How Overreliance on Economics Fails Financial Regulation, we argue that lawmakers increasingly overrely on economists and economic scholarship when designing financial regulation. They generally ignore any valuable input from lawyers and legal scholarship. The consequence is that financial regulation often is poorly informed by experience and is based on theoretical models and assumptions that may not withstand real-world testing.
Several factors have contributed to this overreliance. As economics became more specialized and mathematical, for example, economists claimed greater and greater quantitative precision. At the same time, legal scholarship was becoming overly theoretical and abstract. As a result, the professional staffs of government agencies and intergovernmental bodies that are primarily responsible for financial regulation have become dominated by economists, who often influence the research and agendas. For example, although the leadership of the US Federal Reserve includes both lawyers and economists, the Fed employs over 400 PhD economists who provide most of the analyses and forecasts on which the Fed relies.
That dominance creates excessive dependence on mathematical modeling and idealized free-market economic outcomes. The purported mathematical rigor and numerical precision of these models can conceal their weaknesses, creating false optimism about their efficacy. Prior to the global financial crisis, for example, there was widespread acceptance of VaR, or value-at-risk, modelling for measuring investment-portfolio risk. Financial institutions favored investment products with low VaR risk profiles, like mortgage-related credit-defaults swaps and collateralized debt obligations, that calculations showed would generate reliable gains and only rarely have losses. Problematically, the model failed to predict that any losses that might eventually occur would be huge.
The overreliance on economists and economic scholarship also can ignore the importance of due process and forfeit the benefit of the legal community’s analysis and collective memory. For example, § 113 of the Dodd-Frank Act vests the Financial Stability Oversight Council (FSOC) with authority to designate non-bank financial institutions as ‘systemically important’. If so designated, these institutions become subject to rigorous prudential standards. Critics argue, however, that § 113 ignores due process, giving the FSOC almost plenary designation authority with little guidance or transparency.
Legal analysis and collective memory are also important because law is pragmatic. In contrast to economic analysis which focuses on modeling the future, lawyers look to precedent and draw analogies between new problems and previously successful solutions, which can provide valuable insights. For example, certain ‘margin regulations’ were promulgated to successfully curb the margin-lending excesses that contributed to the Great Depression. Those excesses closely paralleled the mortgage-lending excesses that contributed to the global financial crisis. Yet economists were completely unaware of—and the financial regulation spurred by the financial crisis was not informed by—those margin regulations. Although legal scholars argued that the post-crisis financial regulation should (among other things) include similar regulations, economists, and thus lawmakers, totally ignored their research.
To correct the overreliance on economics, the article suggests both procedural and substantive solutions. Procedural failures stem from the fact that the government agencies and intergovernmental bodies that are responsible for designing and implementing financial regulation are predominantly staffed by economists. These agencies and bodies should consider how more tailored legal staffing and collaborative work between economic and legal scholars could help to improve financial regulation.
Some economists appear to be unwilling, or to feel unqualified, to consider legal analysis. In some cases, the impediment is that law-review articles are daunting in length. Legal scholars should try to (and the article shows how they might) make their research more accessible. Economists also appear to feel unqualified by reason of training. To remedy that, perhaps some legal training could be included as part of the economics curriculum. Lawmakers also should encourage more interdisciplinary financial regulatory work involving economics, finance, and legal scholars.
More substantive failures, like the appearance of numerical precision and rigor that conceals the weaknesses of mathematical modelling, could be corrected by better informing lawmakers about the limits of such modelling. Even simple reminders may be sufficient to encourage more critical reflection, reflective of the memento mori, an ancient Roman tradition designed to increase a victorious general’s self-awareness of his human limitations. During the victory parade, a slave would repeatedly whisper ‘memento mori’ to the general—translated as ‘remember you will die’. Legal scholars also should strive to make their scholarship more grounded and accessible. The Fed, for example, often relies on finance scholars who actively engage with traders and other participants in financial markets and have a good feel for how banks, traders, and regulators function. Legal scholars might similarly consider engaging more actively with financial market participants.
Steven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law.
Theodore L. Leonhardt is an Associate at Skadden Arps law firm and a Duke Law graduate.