The following post comes to us from David M. Driesen, University Professor at the Syracuse University College of Law. It is based on his article, “Legal Theory Lessons from the Financial Crisis,” which is forthcoming in the Journal of Corporation Law and is available here.

Many analysts have addressed the financial crisis’ implications in narrow terms, asking what financial reforms we should put in place in its wake. This post addresses a broader question: Does the financial crisis teach us lessons about legal theory more generally? This post argues that the financial crisis demands that we fundamentally rethink law and economics along more macroeconomic lines.

An important starting point involves understanding the role neoclassical law and economics played in creating the financial crisis. Neoclassical law and economics justified and supported the deregulation that made the financial crisis possible. It did this by shifting the normative values underlying financial regulation, leaving behind the goal of protecting investors from systemic risk and instead embracing the goal of maximizing economic efficiency. Using the assumption that market actors were rational and possessed perfect (or at least very good) information, law and economics scholars concluded that markets act efficiently on their own and that therefore there was little need for pesky regulation. This law and microeconomic approach supported the regulatory rollback that led to the financial crisis.

The financial crisis teaches us that allocative efficiency, the main goal of law and microeconomics, does not function as an important and realistic goal for laws addressing complex systems. Complexity and the institutional role of law make calculation of optimal rules impossible and relatively trivial for complex systems like those addressed through financial regulation, intellectual property, antitrust law, environmental law, and national security law.

Complex systems are dynamic in ways that make it impossible to calculate the costs and benefits of legal reforms for rules addressing such systems. No matter what the regulatory framework, the complexity subjects the regulated systems (and therefore any rule’s costs and benefits) to Knightian uncertainty (where probabilities cannot be predicted), nonlinearities, and therefore surprises. Apparently recognizing that complexity defeats identification of optimal rules through cost-benefit analysis, law and economics scholars have used assumptions of rationality and perfect information as a substitute for quantitative analysis of costs and benefits in finance and antitrust. These assumptions, of course, glorify markets and wish away some of their most important attributes (e.g., irrational exuberance during bubbles and fear when asset prices decline). The financial crisis teaches us that this cost-benefit-analysis-substitute dangerously supports deregulatory ideology. Furthermore, the dynamic nature of complex systems renders any equilibrium between costs and benefits short-lived and therefore of relatively little value. Complexity simply defeats efforts to calculate optimality.

The institutional function of law also defeats the use of efficiency as a goal for law addressing complex systems. Law does not function as a resource-allocating transaction. Instead, it provides a framework, under which private actors make a number of unpredictable transactions, thereby making prediction of efficient outcomes extremely unlikely. To be sure, law does influence resource allocation, but it does not control it when the law regulates complex systems with some role for private choice, like a financial system. Law provides a framework under which private actors can pursue efficiency, but is not itself either efficient or inefficient in a predictable way.

Accordingly, we need a macroeconomic approach to law. I have developed this approach and supported it in a recent book, The Economic Dynamics of Law. This economic dynamic approach would treat law as an effort to countervail negative trends over time with a goal of avoiding systemic risks while keeping a reasonably robust set of economic opportunities open. The Economic Dynamics of Law develops a methodological approach to accomplishing these goals rooted in institutional economics and the best practices of law and economics scholars.