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Lawless Capitalism
The Subprime Crisis and the Case for an Economic Rule of Law
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About This Book
Inthis innovative and exhaustive study, Steven A. Ramirez posits that thesubprime mortgage crisis, as well as the global macroeconomic catastrophe itspawned, is traceable to a gross failure of law.
Therule of law must appropriately channel and constrain the exercise of economicand political power. Used effectively, it ensures that economic opportunityisn’t limited to a small group of elites that enjoy growth at the expense ofmany, particularly those in vulnerable economic situations. In Lawless Capitalism, Ramirez calls forthe rule of law to displace cronycapitalism. Only through the rule of law, he argues, can capitalism bereconstructed.
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1
A Revolution in Economics (but Not in Law)
As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market.
Adam Smith (1776)
Adam Smith long ago recognized that the extent of the marketplace drove ever-increasing specialization. Larger and deeper markets support a more developed division of labor, which enhances economic growth.1 He further recognized the importance of financial regulation, to contain panics and system risk.2 Smith evinced skepticism that governing elites would impose âjust and equitableâ laws upon themselves and expressed empathy for the plight of ordinary workers.3 Indeed, he doubted that any society could prosper if it permitted too much poverty: âNo society can surely be flourishing and happy of which the greater part of the numbers are poor and miserable.â4 These ideas encapsulate the legal deficiencies leading to the subprime fiasco. In other words, traditional economic ideas and principles, principles more recently abandoned in favor of politically convenient elite interests, light the way for reconstructing capitalism.
Today these ideas form the basis of modern growth theory and modern trade theory. Growth theory holds that new ideas give rise to increasing returns to scale rather than diminishing marginal returns spurring rapid macroeconomic growth. The initial fixed cost of creating ideas or knowledge can support mass production at ever lower average unit costs.5 Trade theory now holds that opening greater markets expands increasing returns to scale and accounts for an increased volume of trade, beyond trade driven by traditional notions of comparative advantage.6 In other words, under both New Trade Theory and Endogenous Growth Theory, ideas drive average costs lower, leading to higher productivity and consequently greater economic growth. Ideas benefit from nonrivalry, meaning that an unlimited number of people can use an idea at no additional cost. Increasing returns from nonrivalrous ideas constitute a boon to economic growth, and larger markets multiply these benefits. Maximum economic growth therefore requires maximizing the generation of valuable ideas and permitting their application within broader and deeper markets.
This innovation-led growth requires appropriate institutions under law to fully empower human resources.7 âInstitutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction.â8 Thus, economic scholars increasingly focus on law and institutions as key to macroeconomic growth.9 According to these economists, institutions and law will not always arise to secure growth because of a divergence between the interests of rulers versus the interest of all citizens in growth.10 Law must operate to secure property rights for everyone (including investor protection), constrain elite political power, and broadly empower citizens to participate in economically productive activities. Law must preclude elites from exercising excessive power to rig markets and create uneven playing fields. History shows that these legal institutionsâproperty rights, human rights, and an economic rule of lawâpowerfully form the root causes of growth.11 Failure to secure such laws and institutions explains the persistence of poverty in many societies.12
Law and institutions create appropriate incentives to encourage appropriate economic behavior. The genesis of the recent financial crisis lies in a bipartisan consensus to dismantle important elements of the New Deal and to deregulate business and the financial sector. These regulations delivered stability and prosperity in the U.S. for more than seven decades following the Great Depression. During this period, major financial disruptions and crashes vanished.13 âOnce deregulation had taken hold it was only a matter of time before these horrors of the past would return.â14 Financial systems must appropriately allocate capital to the most promising investments. Economic activity can be hobbled if financial stability is not secured. Massive misal-locations of capital (into Internet stocks, subprime mortgages, or even tulip bulbs) will occur in the absence of sound financial regulation. Regulatory infrastructure must address these challenges through means that raise the return to capital or lower the cost of capital, just as a superhighway may permit trucks to last longer and deliver more goods in shorter time. Elites will not naturally seek optimal market infrastructure if they can profitably rig unregulated financial markets in their favor.
Law must secure rationalized human capital formation, market development, and regulatory infrastructure in order to maximize macroeconomic performance. Stunted human capital formation, market development, and legal infrastructure form the root causes of the financial crisis of 2007â9. Global growth rested excessively upon American consumption because governing elites put little effort into market development elsewhere. American consumption rested upon an infirm foundation of debt, as corporate elites relentlessly moved jobs from the U.S. to low-wage locales, eroding middle-class buying power. Ultimately capital flows from developing nations to the U.S. funded highly exploitative debtâpredatory and subprime loans to the most disempowered elements of society. Excessive American debt exploded and crashed the global economy. Law facilitated this exploitative pattern of global finance. Corporate elites profited mightily from these flows because corporate governance permitted compensation arrangements that created incentives for senior managers to take reckless risks. Elites distorted law to achieve irrational indulgences from traditional notions of accountability for fraud and due care. Although the system collapsed, financially, in the fall of 2008, the basic structure persists and seems destined to produce further economic pain.
Law could disrupt this reality. Unfortunately, Law and Economics (as taught in American law schools) retains a moribund focus on market efficiency, narrowly interpreted to mean laissez-faire principles, with no emphasis on macroeconomic growth. Indeed, the work of economists regarding the endogenous factors associated with growth does not even warrant a mention in two primary Law and Economics texts. Essentially, law schools taught generations of legal policymakers that growth does not matter to law and that law does not matter to growth, despite the learning from economics. This empowered elites to hide behind laissez-faire dogma to justify the elimination of legal and regulatory constraints. Thus, an economic revolution went by unnoticed by law. The Law and Economics canon rested upon shaky economics and even shakier history. This would lead to devastating consequences in the context of the subprime debacle. Law must comprehend the full breadth of economic learningâincluding macroeconomics.15
Traditionally, economics said little about growth. Traditional economic models deemed the dynamics of growth exogenousâgrowth fell from the sky in the form of technological change. In 1957, the Nobel laureate Robert Solow calculated that economic models of growth focusing only on capital and labor accumulation could not account for the great weight of growth. The Solow residualâthe amount of growth unaccounted forârepresented technological change that drove growth above and beyond capital and labor expansion.16 Soon thereafter, economists focused on the enhanced capabilities of human capital to drive economic growth and innovation. As the Nobel laureate Robert Lucas stated, âThe main source of growth is the accumulation of human capitalâof knowledgeâand the main source of differences in living standards among nations is differences in human capital.â17 The nation that empowers its people to achieve maximum productivity will outproduce those nations that do not.
Maximum economic growth requires meta-ideasâmeta-ideas that serve as platforms for the generation of more ideas.18 Legal frameworks support institutions that secure the propagation of ideas. Economists now study the relationship between law, institutions, and growth. â[P]eopleâs innovative activities are conditioned by the laws, institutions, customs, and regulations that affect their incentive and their ability to appropriate rents from newly created knowledge.â19 This chapter explores the link between macroeconomic growth and law from the perspective of economic science (and other social science evidence).
This chapter first reviews the importance of growth to social well-being and the central role of free market capitalism in fostering growth. Then, the chapter reviews evidence regarding sources of macroeconomic growth. A theory of legal infrastructure follows. Thereafter, the chapter reviews evidence regarding the economic threats posed by inequality. Next, the chapter highlights the key shortcomings of the current mainstream Law and Economics approachâlaissez-faire ideologyâand articulates a theory of perfect competition that focuses on maximizing human potential. The conclusion of the chapter summarizes the legal infrastructure flaws creating the subprime debacle. Economics will serve to illustrate the key elements of this chapter, even though economists concur unanimously on very little, and they often condition their models and studies on many (often profligate) assumptions.
The Virtues of Growth and Capitalism
Macroeconomic growth should not monopolize the attention of policymakers. First, growth must be sustainable in the sense that any environmental costs should give rise to resources that can repair the environment so that each generation inherits roughly the same environmental resources. Growth founded upon environmental degradation simply shifts costs to future generations. Such growth is illusory at best and can impose staggering long-term macroeconomic costs in the form of diminished human capabilities at worst. Growth nevertheless appears more sustainable than many imagine. The right kind of policies can enhance economic growth and environmental sustainability simultaneously.20 More than 200 years ago, Thomas Malthus predicted that population growth would outstrip earthâs resources.21 History shows that Malthus simply underestimated human ingenuity.22 Human ingenuity is perhaps the exclusive means of dealing with environmental challenges.
Second, not all economic activity benefits society. Most notably, in the U.S. massive resources support the criminal justice system, yet the U.S. incarcerates more of its citizens than any nation on earth. This certainly signals a social malignancy inconsistent with social well-being. Excessive prison expenditures may enhance short-term growth, but only at the cost of any reasonable measure of aggregate social happinessâa society that imprisons many of its citizens suffers from either an abnormally high concentration of dangerously violent people (unlikely) or an out-of-whack criminal justice system.23 Mass incarceration (along with accompanying stigmatization) fails to maximize human productivity, notwithstanding the short-term impact on macroeconomic output that prison-related expenditures may generate.24
Third, other measures of social well-being beyond per capita GDP may prove more insightful. For example, the United Nations annually assesses national development through its Human Development Index. The index includes life expectancy, educational attainment, inequality, and GDP per capita as four dimensions of development. As of 2011, twenty-two nations scored higher than the U.S.25 In general, however, economic growth is an important consideration and one measure of the well-being and quality of life within a given society. Sustainable macroeconomic growth gives society the resources necessary to address longevity, education, and other elements of well-being.
Countries with higher GDP enjoy longer life expectancy, better health, more leisure, and higher educational attainment. Modern capitalist societies deliver astonishing social outcomes without historic precedent. In Great Britain, over the past 200 years average height has increased by 3.6 inches. In the U.S., the average work week plunged since 1870 and the prospect of retirement soared, even as previously unaffordable amenities became widespread. Meanwhile, real GDP per capita increased sevenfold. âA Japanese baby born in 1880 had a life expectancy of 35 years; today life expectancy in Japan is 82 years.â26 The spread of capitalism served to lift 200 million Chinese citizens out of poverty over 20 years, from 1981 to 2002. The number of people worldwide living on less than one dollar per day declined by half during the same period.27 This is the promise of modern capitalism.
The political consequences of growth also matter. Economic stagnation harms community values and encourages intolerance. For example, Nazi Germany arose from the extended economic chaos facing Germany in the 1920s and early 1930s. Japan and Italy also took an extremist path. World War II illustrates that wars frequently follow economic disruptions. Nations experiencing economic turmoil may well be drawn to extremist government, even if the U.S. followed a more moderate path out of the Great Depression. Prosperity encourages support for the less privileged elements within a society.28
Maximizing economic growth represents an urgent need today, as nearly 1 billion people still survive on less than one dollar per day and 2.6 billion live on less than two dollars per day. In poor nations, 10,000 children per day die from contaminated water. The 573 million world citizens who live in less-developed nations face a life expectancy of 46 years, while the 1.3 billion living in rich nations can expect to live 78 years. Educational attainment in the poorest nations averages less than two years; in the richest nations it reaches as high as 13 years. Getting economics and law right enhances longevity as well as the quality of life within a nation.
The record of market-based economies regarding growth suggests that capitalism remains humanityâs best economic hope for organizing economic activity. Every major episode of explosive growth occurred in market-based economies (whether in China, eastern Asia, or Japan). Worldwide growth amounted to essentially zero for centuries prior to the advent of modern capitalism.29 Capitalist systems benefit from a strong historic record in terms of producing wealth relative to centrally planned economies. Thus, West Germany outperformed East Germany economically, just as South Korea outperformed North Korea.30 In the absence of any real alternative, and in view of its decentralized decision-making ...
Table of contents
- Cover Page
- Title Page
- Copyright Page
- Dedication
- Contents
- Acknowledgments
- Preface: A Historic Collapse of Capitalism
- Introduction
- 1. A Revolution in Economics (but Not in Law)
- 2. The Corrupted Corporation
- 3. Animal Spirits and Financial Regulation
- 4. Rigged Globalization
- 5. The Costs of Economic Oppression
- 6. The Crisis in Crisis Management
- 7. The Potential for an Economic Rule of Law
- Epilogue: Optimized Legal Infrastructure and the End of Scarcity
- Notes
- Index
- About the Author