In A Legal Theory of Finance, Katharina Pistor introduces a provocative new theory about the relationship between law and finance and the role of law in producing and addressing financial instability.   Pistor shows that law plays a constitutive role in the financial system; yet, because of irreducible uncertainty and uneven liquidity, legal obligations, fully enforced, “would inevitably bring down the financial system.”  Hence, the law-finance paradox.  Collapse is avoided, and predictably so, by the relaxation or suspension of legal obligations, revealing law to be inherently elastic.  Significantly, however, law’s elasticity is not uniform.  “Law tends to be relatively elastic at the system’s apex [where the very survival of the system is at stake], but inelastic on its periphery.”  Thus, one’s position in the hierarchy plays a first order role in determining the likelihood that one will be compelled to perform one’s pre-existing legal obligations despite dramatically changed circumstances.  The implications for those within these hierarchies can be profound.  This post builds upon and raises questions about Pistor’s theory by examining whether a central position in the hierarchy necessarily translates into greater elasticity and exploring the ramifications of her suggestion that we recognize law’s elasticity and increase its flexibility at the periphery.

Law’s Elasticity

One of Pistor’s most important contributions, albeit only implicit in A Legal Theory of Finance, is that liquidity support can function as a substitute for treating law as elastic.  Because limited liquidity is one of the two factors giving rise to inherent instability and inhibiting the ability of market participants to make good on existing legal obligations, the provision of liquidity during times of distress can increase market participants’ capacity to satisfy their obligations.  The support the Federal Reserve provided to AIG in September 2008 illustrates.  A downgrade in AIG’s credit rating following the failure of Lehman Brothers triggered a contract-based legal obligation for it to post significant amounts of collateral on various derivatives to which it was a party.  While AIG had assets far in excess of the collateral required, those assets were not in liquid form and could not be sold sufficiently quickly to meet the collateral demands.  AIG survived by arranging for a collateralized loan from the Federal Reserve, which in addition to being fully secured gave the U.S. government the right to acquire a nearly eighty percent equity stake of AIG.  That liquidity infusion enabled AIG to satisfy its legal obligations (at least temporarily), rendering moot the question of whether the government could or should intervene to soften the application of the law, e.g., by altering the terms of AIG’s commitments or achieving the same result through the bankruptcy proceedings that would otherwise ensue.

The government’s decision to intervene as it did, and the high probability that it otherwise would have found a way to weaken or suspend application of the law to AIG, is consistent with Pistor’s theory that intervention is most likely when failure to intervene “would inevitably bring down the financial system.”  AIG’s centrality to the financial system, in the U.S. and abroad, was well recognized, as was the risk that failure to intervene could trigger a crippling paralysis, bringing the entire system to its knees.  The capacity of the U.S. government to intervene in the way that it did is similarly consistent with Pistor’s claim that power lies with “those who have the resources to extend support to others without being legally obliged to do so” and “sovereigns with control over their own currency and debt,” like the United States, thus “have the most power.”  The account of AIG is thus consistent with many of Pistor’s core assumptions and insights, yet it also illustrates some limitations and extensions of her theory that merit attention.

For one thing, the AIG scenario cleanly demonstrates that access to a lender of last resort can reduce the need to soften enforcement of legal obligations.  The importance of this interchangeability are increased by the wide range of individualized and broad-based credit facilities that the Federal Reserve created in its role as lender of last resort during the recent financial crisis.  A related implication is that the more aggressive and creative central banks are willing to be in the provision of liquidity, the easier it may be to maintain the façade that legal obligations are fixed rather than inherently contingent and elastic, as Pistor contends.

Additionally, the foreseeable redistribution resulting from the liquidity support provided to AIG and to AIG’s counterparties illustrates how treating legal obligations as fixed can, like elasticity, benefit those at the center of the hierarchy and promote systemic stability.  Among the reasons that the government failed to impose haircuts on AIG’s counterparties is that many of those firms played similarly critical roles in the financial system and were facing challenges of their own.  The imposition of haircuts may improve market discipline, and hence financial stability, ex ante; but, once a crisis is underway, imposing losses on financial firms functions as a mechanism of contagion, increasing the probability of systemic distress.   This suggests that the same factors that may cause law to at times be more elastic at the core can also result in law being treated as inelastic at the core.  Law’s inelasticity in such circumstances justifies, and is enabled by, other forms of government intervention, most often in the form of liquidity support.

This analysis reveals an alternative to Pistor’s claim that the law tends to be more elastic at the core and less so at the periphery.   It may instead be the case that the law’s elasticity varies in accord with the allocation of the losses that will inevitably result.  Legal obligations are given their full force when doing so protects parties—nations and firms—at the core and they are similarly relaxed or suspended when such treatment protects those at the core.  The infliction of losses upon those at the periphery, by contrast, carries relatively little weight in such determinations.  The same is true with respect to decisions about when and how to provide liquidity support.  The predictable effect is that efforts to maintain the stability of the financial system, whether by rendering legal obligations elastic or injecting liquidity, have significant distributional consequences.  Losses are disproportionately allocated to those at the periphery.  While framed in different terms, this result seems consistent with much of Pistor’s analysis.  It similarly may help to explain her normative claim that law’s elasticity should be acknowledged and, at the periphery, increased.  That claim is the final issue I want to address.

Embracing Elasticity

According to Pistor, “[o]ne of the major lessons [her theory] holds is that we need more safety valves … not only at the apex where law tends to be relatively more elastic, but also on the periphery of the system.”  It is not entirely clear whether the motivation underlying the call for additional safety valves is to promote systemic stability, redress the distributional consequences of the current hierarchical regime, or both.  I believe this claim may be justified on distributional grounds but is harder to defend in terms of systemic stability.

Pistor’s analysis highlights the ways that law’s inelasticity increases systemic fragility, but it does not necessarily follow that greater flexibility at the periphery will result in less systemic risk.  To the extent that the aim is to create a more stable financial system, the ex post benefits of a regime that is adaptive to changed circumstances must be balanced against the ex ante cost of increased moral hazard and the correspondent behavior changes which may increase systemic risk.  More generally, the charade of law’s inelasticity plays a foundational role in modern finance in part because of its influence on the behavior of participants within that system.  Explicitly acknowledging and embracing law’s elasticity might well encourage gamesmanship and other costly behavior outside of crisis periods.

The tension between the type of regime that would create the optimal ex ante incentives and the important role of flexibility in preserving the system from destruction ex post is a core challenge in financial regulation generally.  Pistor’s theory contributes to debates about this core tension by allowing us to see the important role that one’s place on the hierarchy plays in the analysis.  In addition to the “power” explanation that Pistor provides for the greater protections granted to the core, another explanation is welfare maximization—allowing a constituent element to collapse could bring down the entire system.  The same generally cannot be said about elements at the periphery.  When viewed in conjunction with the incentive problems that could arise, this suggests that Pistor’s call for greater safety valves specifically to help the periphery cannot be easily justified on systemic stability grounds.

An alternative, and more viable, basis for her claim lies in concerns about distribution and fairness.  Economists and others have long tried to separate policy matters that affect the size of the pie from those that affect its distribution.  This is reflected in the commonly invoked assumption that we should do all that we can to maximize the size of the pie and use separate mechanisms, primarily tax, to resolve allocation.  I tend to be sympathetic to such approaches, but Pistor’s analysis reveals why they are likely to be incomplete.  Putting to the side the likely insurmountable political economy dynamics, Pistor’s theory suggests not a singular hierarchy, but multiple overlapping and embedded hierarchies.  Different nations sit in different places in the hierarchy, yet there are also hierarchies within domestic systems and, separately, among financial firms in ways that do not map neatly within the sovereign hierarchical regime.  Just as there is no single body positioned to serve as a universal lender of last resort, there is no existing mechanism for redistributing wealth among constituents to these overlapping hierarchies after authorities have intervened in ways that benefit some at the expense of others.  Hence, I would add to the questions that Pistor proposes in her conclusion the relative role of systemic stability and distribution in determining when and how to treat law as elastic and whether there are politically viable ways to do all we can to preserve the system without triggering unpalatable distributional consequences.  Given the power of backlash against the Fed and the challenges facing the ECB, these questions are not ones that those concerned about financial regulation can continue to ignore.