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A blog on financial markets and their regulation
The Journal of Comparative Economics (subscription required) has a special issue on Law in Finance (The CLS Blue Sky Blog has a series of posts summarizing and commenting about this work – see here, here and here). The lead paper in the special issue by Katharina Pistor presents what she calls the Legal Theory of Finance (LTF); the other papers are case studies of different aspects of this research programme.
Most finance researchers are aware of the Law and Finance literature (La Porta, Shleifer, Vishny and a host of others), but Pistor argues that “Law & Finance is … a theory for good times in finance, not one for bad times.” She argues that though finance contracts may appear to be clear and rigid, they are in reality in the nature of incomplete contracts because of imperfect knowledge and inherent uncertainty. When tail events materialize, it is desirable to rewrite the contracts ex post. This can be done in two ways: first by the taxpayer bailing out the losers, or by an elastic interpretation of the law.
One of the shrill claims of the LTF is that legal enforcement is much more elastic at the centre while being quite rigid at the periphery. Bail out is also more likely at the centre. I do not see anything novel in this observation which should be obvious to anybody who has not forgotten the first word of the phrase “political economy”. It should also be obvious to anybody who has read Shakespeare’s great play about finance (The Merchant of Venice), and noted how differently the law was applied to Jews and Gentiles. It has also been all too visible throughout the global financial crisis and now in the eurozone crisis.
Another persistent claim is that all finance requires the backstop of the sovereign state which is the sole issuer of paper money. This is in some sense true of most countries for the last hundred years or so though I must point out that the few financial markets that one finds in Somalia or Zimbabwe function only because they are not dependent on the state. The LTF claim on the primacy of the state was certainly not true historically. Until the financial revolution in the Holland and later England, merchants were historically more credit worthy than sovereigns. Bankers bailed out the state and not the other way around.
Most of the case studies in the special issue do not seem to be empirically grounded in the way that we have come to expect in modern finance. I was not expecting any fancy econometrics, but I did expect to see the kind of rich detail that I have seen in the sociology of finance literature. The only exception was the paper by Akos Rona-Tas and Alya Guseva on “Information and consumer credit in Central and Eastern Europe”. I learned a lot from this paper and will probably blog about it some day, but it seemed to be only tangentially about the LTF.