James P. Sweeney is a Managing Director on the Global Strategy Team in Fixed Income Research at Credit Suisse in New York.
Increasingly, economists and regulators are seen on trading floors and investors are seen in libraries. The challenge of understanding the Global Financial Crisis’s causes and implications has forced everyone who thinks about the economy to broaden their perspective.
Bridging the investment, academic, and regulatory worlds is not easy. Investors chuckle when an academic claims credit for “discovering” that LIBOR-OIS spreads or repo haircuts played a critical role in the crisis. And the professors and regulators cringe when investors or analysts talk about the dangers of liquidity transformation without a backstop, as if that’s new.
The best results of this crossing of the aisles come when market participants grasp deep academic concepts while educating others about the specifics of modern markets.
Katharina Pistor’s Legal Theory of Finance (LTF) shows the benefits of a broadened perspective. LTF argues that law and finance are intermingled. It starts with the barest realities of most actual investments – Knightian Uncertainty and liquidity risks.
Any good investment manager is keenly aware of the limits of forecasting when rules can change, and the consequences of sudden liquidity stress. That is why investors focus on the concrete circumstances of their trades, such as the legal environment, the institutions whose norms make the trade possible, and the specific current and potential providers of liquidity into the market.
This approach is particularly apparent now, after five years of acute market turmoil. For instance, investors’ knowledge of the ECB’s relationships with national governments and national central banks is far greater after the recent sovereign debt crisis. The focus is on how those relationships might change in the future.
Of course, the public sectors’ relationship with markets, like the markets themselves, is ever-changing. This implies something obvious to recent readers of the financial news: all contracts are not set in stone. This raises further questions. For example, are inflation-linked securities always a good inflation hedge, given that governments can change the rules they follow ex post?
Most academic economists long ago eschewed an institutionalist focus in order to pursue purer theoretic insights. Sanctified principles like the Coase Theorem, the Miller-Modigliani Theorem, and Goodhart’s Law seemed to justify this by showing that things like initial endowments, capital structures, and even specific policy rules might not matter much to economic outcomes under certain conditions.
Of course, those “certain conditions” are exactly the ones investors spend so much time questioning. Representing the synthesis between practical investors and the academic world, Pistor’s view starts from questioning the assumptions of abundant liquidity, no transactions costs, and fixed rules and regulations. The result is a bouleversement of anti-institutionalism: “Financial markets do not exist outside rules but are constituted by them,” according to Pistor.
The LTF argues that financial markets are rule-bound systems, essentially hybrid between public and private, beset by the law-finance paradox (contracts cannot bind at all times; but finance needs contracts to work), and revelatory of power, which is defined by the differentiation of law (i.e. who gets the bailout).
My own work on shadow banking has focused on how today’s markets create liquidity in private securities, sometimes giving rise to a sort of “shadow money” that is consequential not just as a short run symptom of a credit bubble, but also as evidence of an evolving financial system that is meeting the liquidity needs of an increasingly complex, technology-heavy, and global economy.
Regulatory efforts at stemming private shadow money creation are well advanced in the United States and globally. However, because law and finance are intertwined, the consequences of rule changes are difficult to foretell. Policymakers would be better served if they had a well-developed Legal Theory of Finance as a starting point of a regulatory overhaul. Better understanding the relationship between law and markets is a key part of discovering how markets interact with the economy in good and bad ways. Shadow money is just one example of that intersection.
Recently, I co-authored a paper with Perry Mehrling, Zoltan Pozsar, and Daniel Nielson on shadow banking. The LTF idea meshes extremely well with our view of practical finance. And more generally, the inductive approach in both papers is reminiscent of an earlier strand of American Institutionalist Economics that Professor Mehrling has described in an earlier book.
He wrote “What held American institutionalism together, and what prevented it from degenerating into mere opportunistic eclecticism, was its commitment to the American project of blending democracy and a decentralized market system.”
The LTF, and the effort to understand how our financial system really works, is a new effort toward that old, and all-important goal.