The Great Degeneration: How Institutions Decay and Economies Die (6 page)

In his book
Antifragile
, the statistician and options trader turned philosopher Nassim Taleb asks a wonderful question: what is the opposite of fragile? The answer is not ‘robust’ or ‘strong’, because those words simply mean less fragile. The true opposite of fragile is ‘anti-fragile’. A system that becomes stronger when subjected to perturbation is anti-fragile.
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The point is that regulation should be designed to heighten anti-fragility. But the regulation we are contemplating today does the opposite: because of its very complexity – and often contradictory objectives – it is pro-fragile.

Lessons from Lombard Street

Over-complicated regulation can indeed be the disease of which it purports to be the cure. Just as the planners of the old Soviet system could never hope to direct a modern economy in all its complexity, for reasons long ago explained by Friedrich Hayek and Janos Kornai,
²⁵
so the regulators of the post-crisis world are doomed to fail in their efforts to make the global financial system crisis-free. They can never know enough to manage such a complex system. They will only ever learn from the last crisis how to make the next one.

Is there an alternative? I believe there is. But we need to go back to the time of Darwin to find it. In
Lombard Street
, published in 1873, Walter Bagehot described with great skill the way in which the City of London had evolved in his time. Bagehot understood that, for all its Darwinian vigour, the British financial system was complex and fragile. ‘In exact proportion to the power of this system’, he observed, ‘is its delicacy – I should hardly say too much if I said its danger . . . even at the last instant of prosperity, the whole structure is delicate. The peculiar essence of our financial system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.’
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No one has ever given a better description of how a bank run happens than Bagehot; those unfamiliar with
Lombard Street
had to find out for themselves in 2007, at the time of the runs on Northern Rock and Countrywide, and again in 2012, when it was the turn of the Spanish Bankia to lose the confidence of its depositors. One of the great beauties of
Lombard Street
is the way it surveys all the key institutions of the London money market – the ascendant joint-stock banks, the waning private banks, the bill brokers, the new savings banks – and exposes the weakness in the position of each. In theory, Bagehot would have preferred a system in which each institution had to look to itself by maintaining a reserve against contingencies. But in practice the London market had evolved in such a way that there was only one ultimate reserve for the entire City and that was the Bank of England’s: ‘the sole considerable unoccupied mass of cash in the country’.
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As in our time, in other words, the central bank (and, behind it, the government that called it into being) constituted the last line of resistance in time of panic.

By reviewing half a century of financial crises, Bagehot brilliantly showed how the Bank of England’s role as custodian of the nation’s cash reserve was quite different from its role as defined by statute or, indeed, as understood by the men running it. In the 1825 panic the Bank had done the right thing, but much too late in the day, and without knowing quite why it was the right thing. In each of the three panics that followed the passage of the Bank Charter Act of 1844 – a piece of legislation which was largely concerned with the Bank’s note-issuing function – the Act had been suspended. There was, as in our time, uncertainty about which securities it would accept as collateral in a crisis. The Bank’s governance structure was opaque. Its governor and directors were themselves not bankers. (In those days they chose merchants; nowadays we prefer academics – which not everyone would regard as an improvement.) They barely coped when a SIFI called Overend Gurney blew up in 1866.

Bagehot’s remedies were clear-cut, though I believe they are very often misinterpreted. The famous recommendation was that in a crisis the central bank should lend freely at a penalty rate: ‘Very large loans at very high rates are the best remedy . . .’
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Nowadays we follow only the first half of his advice, in the belief that our system is so leveraged that high rates would kill it. Bagehot’s rationale was to ‘prevent the greatest number of applications by persons who do not require it’.
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Watching all banks, strong and weak alike, gorge themselves on today’s seemingly limitless supply of loans at near-zero rates, I see what he meant.

We also neglect the rest of what Bagehot said, and in particular the emphasis he laid on discretion as opposed to set rules. In the first place, he stressed the importance of having Bank directors with considerable market experience. ‘Steady merchants’, he wrote, ‘always know the questionable standing of dangerous persons; they are quick to note the smallest signs of corrupt transactions.’ Executive power should be conferred on a new, full-time deputy governor acting as a kind of permanent under-secretary. And the advisory Court should be selected so as ‘to introduce . . . a wise
apprehensiveness
’.
³⁰

Secondly, Bagehot repeatedly stressed, as he put it, ‘the cardinal importance of [the Bank of England’s] always retaining a great banking reserve’. But he was emphatic that the size of the reserve should not be specified by some automatic rule, the way the banknote circulation was under the 1844 Bank Charter Act: ‘No certain or fixed proportion of its liabilities can in the present times be laid down as that which the Bank ought to keep in reserve.’ The ideal central bank would target nothing more precise than an ‘apprehension minimum’, which ‘no abstract argument, and no mathematical computation will teach to us’:

And we cannot expect that they should [he went on]. Credit is an opinion generated by circumstances and varying with those circumstances. The state of credit . . . can only be known by trial and inquiry. And in the same way, nothing can tell us what amount of ‘reserve’ will create a diffused confidence; on such a subject there is no way of arriving at a just conclusion except by incessantly watching the public mind, and seeing at each juncture how it is affected.
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Nor should there be predictability in the Bank’s discount rate, the rate at which it lent against good-quality commercial paper. The rule ‘that the Bank of England should look to the market rate and make its own rate conform to that . . . was . . . always erroneous’, according to Bagehot. The ‘first duty’ of the Bank was to use the discount rate to ‘protect the ultimate cash of the country’.
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This too of course implied a discretionary power, since the desirable size of the reserve was not specified by any rule.

There are some today, like Larry Kotlikoff and John Kay, who see the only salvation in a root-and-branch structural reform of our financial system: ‘narrow banking’ of some sort, if not the replacement of banks altogether.
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I can see the intellectual appeal of such arguments. In theory, perhaps it would be much better if big banks were chopped up, leverage ratios were drastically reduced and the interconnections between deposit-takers and risk-takers were reduced.
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But, like Bagehot, I take the world as I find it, and I do not expect to see in my lifetime a wholesale abandonment of the current model of ‘too big to fail’ institutions backstopped by the central bank and, if necessary, by the public purse. Our task, like Bagehot’s, is ‘to make the best of our banking system, and to work it in the best way that it is capable of. We can only use palliatives, and the point is to get the best palliative we can.’
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How to Encourage Bankers

‘The problem is delicate,’ as Bagehot candidly concluded his great work, and ‘the solution is varying and difficult.’
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It remains so today. But I believe a return to Bagehot’s first principles would not be a bad starting point. First, strengthen the central bank as the ultimate authority in both the monetary and supervisory systems. Second, ensure that those in charge at the central bank are ‘apprehensive’ as well as experienced, so that they will act when they see excessive credit growth and asset-price inflation. Third, give them considerable latitude in their use of the principal central banking tools of reserve requirements, interest rate changes and open-market securities purchases and sales. Fourth, teach them some financial history, as Bagehot taught his readers.

Finally – a point Bagehot did not need to make because in his time it was a matter of course – we must ensure that those who fall foul of the regulatory authority pay dearly for their transgressions. Those who believe this crisis was caused by deregulation have misunderstood the problem in more than one way. Not only was misconceived regulation a large part of the cause. There was also the feeling of impunity that came not from deregulation but from non-punishment.

There will always be greedy people in and around banks. After all, they are where the money is – or is supposed to be. But greedy people will commit fraud or negligence only if they feel that their misdemeanour is unlikely to be noticed or severely punished. The failure to apply regulation – to apply the law – is one of the most troubling aspects of the years since 2007. In the United States, the list of those who have been sent to jail for their part in the housing bubble, and all that followed from it, is risibly short. In the United Kingdom, the harshest punishment meted out to a banker was the ‘cancellation and annulment’ of the former Royal Bank of Scotland CEO Fred Goodwin’s knighthood.

Bagehot never got the powerful and permanent deputy governor that he proposed; instead the governor himself became both less powerful and less permanent. Since being deprived of his regulatory role, which was handed to the Financial Services Authority by Gordon Brown, the governor has been in the unenviable position of running a monetary policy research department (combined recently with an emergency money-printing works). The Federal Reserve System, too, has no real teeth. The agencies supposed to prosecute fraud have performed miserably. The result is that very few malefactors have been brought to justice in a meaningful way.

I will cite just one of many possible examples. In October 2010 Angelo Mozilo reached a settlement with the Securities and Exchange Commission in which he agreed to pay $67.5 million in penalties and ‘disgorgements’ to settle civil fraud and insider-trading charges relating to his time as CEO of Countrywide, the failed mortgage lender. At least part of this fine was paid not by Mozilo himself but by Bank of America, which acquired Countrywide in the depths of the financial crisis, and by insurers. Between 2000 and 2008 Mozilo received nearly $522 million in total compensation, including sales of Countrywide stock: nearly ten times more than the fine.
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If there was nothing criminal in his conduct, it is surely only because the criminal law is defective in this area.

Voltaire famously said that the British periodically executed an admiral
pour encourager les autres
. All the detailed regulation in the world will do less to avert a future financial crisis than the clear and present danger in the minds of today’s bankers that, if they transgress in the eyes of the authority on whom their business ultimately depends, then they could go to prison. Instead of exhausting ourselves drawing up hopelessly complex codes of ‘macro-prudential’ or ‘counter-cyclical’ regulation, let us go back to Bagehot’s world, where individual prudence – rather than mere compliance – was the advisable course, precisely because the authorities were powerful and the crucial rules unwritten.

I began this chapter by contradicting the proponents of stricter regulation, only to end it by advocating the exemplary incarceration of bad bankers. I hope it is now clear why these positions are not contradictory but complementary. A complex financial world will be made less fragile only by simplicity of regulation and strength of enforcement.

To repeat: among the most deadly enemies of the rule of law is bad law. The next chapter will consider at a more general level the ways in which the rule of law itself, broadly defined, has degenerated in Western societies – and especially in the United States – in our time. In the realm of regulation, as I have said, we ought to be going back to Bagehot. But has the legal system in the English-speaking world inadvertently gone back to Dickens? Has the rule of law degenerated into the rule of lawyers?

The Lure of Law

The fundamental question the Chinese government must face is lawlessness. China does not lack laws, but the rule of law . . . This issue of lawlessness may be the greatest challenge facing the new leaders who will be installed this autumn [of 2012] . . . Indeed, China’s political stability may depend on its ability to develop the rule of law in a system where it barely exists.
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These are the words of Chen Guangcheng, the blind lawyer who was allowed to leave China to study in the United States after successfully escaping from his Communist Party persecutors in April 2012. Less well known in the West, but more influential in China, is the legal scholar He Weifang. In an essay entitled ‘China’s First Steps towards Constitutionalism’, published in 2003, He rather more tactfully observed: ‘The Western legal landscape does make an interesting and illuminating contrast to China’s legal situation, revealing many discrepancies and inconsistencies between the two . . . Although China’s modern system was borrowed from the West . . . things often proceed in different ways between China and the West.’
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The theme of this chapter is the landscape of law. I want to ask what, if anything, developing countries like China can learn from the West about the rule of law. And I want to cast some doubt on the widespread assumption that our Western legal systems are in such good health that all the Chinese need to do is replicate our best practice – whatever that may be.

The English Way of Law

What exactly do we mean by the rule of law? In his book of that name,
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the late Lord Chief Justice, Tom Bingham, specified seven criteria by which we should assess a legal system:

1. the law must be accessible and so far as possible intelligible, clear and predictable;
   
2. questions of legal right and liability should ordinarily be resolved by application of the law and not by the exercise of discretion;
   
3. the laws of the land should apply equally to all, save to the extent that objective differences [such as mental incapacity] justify differentiation;
   
4. ministers and public officers at all levels must exercise the powers conferred on them in good faith, fairly, for the purpose for which the powers were conferred, without exceeding the limits of such powers;
   
5. the law must afford adequate protection of fundamental human rights;
   
6. means must be provided for resolving, without prohibitive cost or inordinate delay,
   bona fide
   civil disputes which the parties themselves are unable to resolve; and
   
7. adjudicative procedures provided by the state should be fair.
   

Under heading 5, Bingham lists no fewer than fourteen different rights that the rule of law should be expected to protect: the right to life, protection from torture, protection from slavery and forced labour, the right to liberty and security, the right to a fair trial, protection from punishment without law, the right to respect for private/family life, freedom of thought/conscience/religion, freedom of expression, freedom of assembly/association, the right to marry, freedom from discrimination, protection of property and the right to education. (He might have gone further, since some countries today explicitly acknowledge rights to housing, healthcare, education and a clean environment. Why not a right to drinkable wine, too?)

In England, the rule of law in Bingham’s sense of the term is the product of historical evolution. In 1215 Magna Carta established the principle that all Englishmen were equal before the law and that the Crown could not raise taxation without the consent of the Great Council, later Parliament. It was in the medieval period, too, that the writ of habeas corpus (against unlawful detention) came into use, that around 500 towns acquired charters of effective self-government and – after 1295 – that these boroughs were also represented in Parliament. From the time of Henry III until the time of James II there was a protracted tug of war between the monarch and Parliament, in which the Crown’s tendency to sell off the royal demesne to finance wars steadily weakened its position. The culmination came, as we saw in Chapter 1, with the Glorious Revolution, which asserted the sovereignty of the king-in-Parliament. Also in the seventeenth century, torture was done away with; though it was not until a century later, with Somerset’s Case in 1772, that slavery in England was definitively declared illegal. Throughout this period, the common law courts effectively resisted encroachments on their jurisdiction by institutions under royal control. Still, it was not until the 1701 Act of Settlement that the independence of the judiciary was assured with the advent of life appointments.

My undergraduate reading at Oxford persuaded me that the real point of English history was to establish, for the first time, three sacred principles. First, an Englishman’s home is his castle. In the case of
Entick
v.
Carrington
, Lord Camden ruled against the government for raiding the home of the radical journalist John Entick. ‘The great end for which men entered into society was to secure their property,’ declared Camden, quoting John Locke. ‘By the laws of England, every invasion of private property, be it ever so minute, is a trespass.’ Secondly, do what you like as long as you do no harm. ‘The privileges of thinking, saying, and doing what we please, and of growing as rich as we can, without any other restrictions, than that by all this we hurt not the public, nor one another, are the glorious privileges of liberty’: that was the formulation of ‘Cato’ (the nom de plume of John Trenchard and Thomas Gordon), writing in the early 1720s. Third, mind your own bloody business. ‘The taste for making others submit to a way of life which one thinks more useful for them than they do themselves’, John Stuart Mill explained to the French liberal Alexis de Tocqueville, ‘is not a common taste in England.’
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And these pillars of the English rule of law, as A. V. Dicey had pointed out in 1885, were the products of a slow, incremental process of judicial decision-making in the common law courts, based in large measure on precedents. There were no ‘grand declarations of principle’, just the interplay of judicial memory and statutory innovations by Parliament.

I now realize that this was a rather naive reading of English legal history. As the greatest modern theorist of law in the English-speaking world, the late Ronald Dworkin, explained in
Law’s Empire
, there really are principles underpinning the common law, even when those principles are not codified as they are in the US Constitution. ‘We insist’, writes Dworkin, ‘that the state act on a single, coherent set of principles even when its citizens are divided about what the right principles of justice and fairness really are . . . Judges . . . decide hard cases by trying to find, in some coherent set of principles about people’s rights and duties, the best constructive interpretation of the political structure and legal doctrine of their community.’
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Behind the operation of the law lie two things: the integrity of judges and ‘legislation . . . flowing from the community’s present commitment to a background scheme of political morality’.
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Questions concerning legality (or ‘principle’) are for judges to decide; questions of policy are matters for executive and legislature. In this legal world, the judge engages in an authentically Herculean struggle to arrive at a best fit between the rule that he eventually defines and applies in order to resolve the case before him and the general corpus of rules, legal policies and reasonable expectations. So even England’s constitution-free common law is based (again in Dworkin’s words) ‘not only [on] the specific rules enacted in accordance with the community’s accepted practices but also [on] the principles that provide the best moral justification for those enacted rules . . . [including] the rules that follow from those justifying principles, even though those further rules were never enacted’.
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Like democracy, the rule of law in this sense may be good in its own right. But it may also be good because of its material consequences. Few truths are today more universally acknowledged than that the rule of law – particularly insofar as it restrains the ‘grabbing hand’ of the rapacious state – is conducive to economic growth. According to Douglass North, ‘the inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment . . .’
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Enforcement of contracts by a third party is necessary to overcome the reluctance of private sector agents to participate in non-simultaneous economic transactions, especially over long distances in both time and space. Contract enforcement can be provided by private sector agencies such as exchanges, credit companies and arbitrators. But usually, in North’s words, ‘third-party enforcement [means] . . . the development of the state as a coercive force able to monitor property rights and enforce contracts effectively.’
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The problem is getting the state not to abuse its power – hence the need to constrain it. As Stanford’s Avner Greif has argued, if public contract-enforcing institutions reveal information about the location and amount of private wealth, the state (or its functionaries) may be tempted to steal some or all of it.
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Where states are not constrained by law, therefore, private contract-enforcing institutions are safer, like the network operated by eleventh-century Maghribi traders in the Mediterranean, which was based on their common Jewish religion and kinship ties, or the eighteenth-century Scottish diaspora, which had an almost global reach, or the South Asian traders of East Africa. We see such networks operating in many parts of the world today: think of the Chinese business communities operating outside China. Their defect, as with medieval guilds, is their tendency to raise entry barriers and establish monopolies, discouraging competition and reducing economic efficiency. That is why private contract enforcement tends to yield to public as economies become more sophisticated. But that process is dependent on constraining the state to use its power of coercion in such a way as to respect private property rights. In economics, that is the essential function of the rule of law. It is the property rights more than the human rights that are fundamental.

Law and Economics – and History

Few contributions to the literature on law and economics have had a greater impact than the argument of Andrei Shleifer and his co-authors that the common law system that evolved in the English-speaking world was superior in performing the twin roles of contract enforcement and coercion constraint to all other systems. Neither the French civil law system, originating in the Roman legal tradition, nor the German and Scandinavian legal systems, were as good, to say nothing of non-Western systems of law. What was it that made and makes common law economically better? In their seminal 1997 article, La Porta, Lopez-de-Silanes, Shleifer and Vishny argued that common law systems offer greater protection for investors and creditors. The result is that people with money are more willing to invest in, or lend to, other people’s businesses. And higher levels of financial intermediation tend to correlate to higher rates of growth.
¹¹

In a succession of empirical studies, these and other scholars sought to demonstrate that common law countries:

1. have stronger investor protections and provide companies with better access to equity finance than civil law countries, as manifested in larger stock markets, more numerous firms and more initial public offerings;
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2. have better protection of outside investors relative to ‘insiders’, whereas French civil law countries have poorer protection;
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3. make it easier for new firms to enter the market, as manifested in the number of procedures, number of days and costs of setting up a new business;
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   *
   
4. have more efficient (because less formalistic) courts, as measured by the time it takes to evict a non-paying tenant and to collect a debt after a cheque has bounced;
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5. regulate their labour markets less and therefore have higher labour-force participation and lower unemployment rates than civil law countries;
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6. have more extensive mandatory disclosure requirements, which again encourages investors;
   ¹⁷
   and
   
7. have more efficient procedures in cases of insolvency, such as a hypothetical hotel bankruptcy.
   ¹⁸
   

Summarizing their theory of the determining role of legal origins, the authors write:

Legal investor protection is a strong predictor of financial development . . . [as well as] government ownership of banks, the burden of entry regulations, regulation of labour markets, incidence of military conscription, and government ownership of the media . . . In all these spheres, civil law is associated with a heavier hand of government ownership and regulation than common law . . . [These are in turn] associated with adverse impacts on markets such as greater corruption, larger unofficial economy, and higher unemployment . . . Common law is associated with lower formalism of judicial procedures . . . and greater judicial independence . . . Common law stands for the strategy of social control that seeks to support private market outcomes, whereas civil law seeks to replace such outcomes with state-desired allocations . . . Civil law is ‘policy implementing’, while common law is ‘dispute resolving’.
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This brings us back to where we began, with the notion that there is greater ‘flexibility of judicial decision-making under common law’, because ‘common law courts [can] use broad standards rather than specific rules’.
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Like so many arguments in social science, this theory of legal origins implies a certain version of history. Why did French law end up being worse than English? Because the medieval French Crown was more assertive of its prerogatives than the English. Because France was less peaceable internally and more vulnerable externally than England. Because the French Revolution, which distrusted judges, sought to convert them into automata, implementing the law as defined and codified by the legislature. The result was an even less independent judiciary and courts precluded from reviewing administrative acts. The Gallic conception of freedom was more absolute in theory and less effectual in practice. In any case, as Alexis de Tocqueville shrewdly observed when comparing the United States and France in the 1830s and 1840s, the French preferred equality to liberty. This preference resulted in a strong central state and weak civil society. When the French exported their model to their colonies in Asia and Africa, the results were even worse.