The Economic Dynamics of Law
Proposed Synopsis and Outline
By
David M. Driesen
University Professor
Syracuse University College of Law
E.I. White Hall
Syracuse University
Syracuse, NY 13244-1030
ddriesen@law.syr.edu
(315) 443-4218
The Proposed Work
Static neoclassical economic theory has, until recently, dominated law and
economics, which in turn has profoundly influenced the legal academy and public
policy. This theory treats the neoclassical economic concept of allocative efficiency
as both a reasonably accurate description of markets and the proper normative
theory for government. This theory views the market as enhancing consumers’
welfare through transactions reflecting market actors’ rational calculations of
known costs and benefits. Its favorable view of markets makes its adherents
skeptical of government intervention. When government must intervene to correct
“market failure”, however, it should, according to this theory, generally try to
emulate the efficiency attributed to markets, regulating only through measures that
balance known costs and benefits, and it should employ the market itself to perform
as many governmental tasks as possible through market-based mechanisms and
privatization.
The financial crisis, to put it mildly, has created some doubts about this
worldview’s efficacy. Supposedly rational market actors using sophisticated
mathematical models brought us risky subprime mortgage lending, complex
derivatives making that risk systemic, and the resulting economic collapse. In the
wake of this collapse, the country elected a President who ran against the less
government is always better model. Widespread support for more regulation of
financial markets, a greater government role in health-care, and serious government
efforts, albeit using a market-based mechanism, to address global climate change
have emerged in the wake of the market collapse. While the neoclassical worldview
began to fray around the edges within the legal academy before the recent debacle,
with scholarship increasingly reflecting psychological and institutional economic
challenges to the neoclassical framework, the financial crises has dealt it a more
fundamental blow.
1
This book proposes a theory to replace the neoclassical theory of law and
economics in a variety of domains, the economic dynamic theory of law. This theory
posits that the primary role of government often involves containing systemic risk
in the face of substantial uncertainties, while keeping the society open to fresh
opportunities for valuable innovation, rather than optimizing discrete steps through
calculations of measurable costs and benefits. In order to play that role properly,
government should be much more concerned about the shape of change over time,
than about the short-term efficiency, in the economic sense, of its decisions and the
markets it shapes. It’s possible to efficiently drive a car off a cliff, and arguably that
is what we have done with respect to both financial markets and climate change.
This theory, proposes an analytical method premised on institutional economics
aimed not at measuring the microeconomic efficiency, but focusing on the general
shape of macroeconomic change and the incentives government measures create for
different types of change. The book shows how the considerations this theory
focuses on have already begun to shape legal scholarship and how this focus on the
economic dynamics influencing systemic risk could guide policy prescriptions in a
variety of areas.
An Annotated Outline
This annotated outline represents my current thinking about the book.
Because I plan to illustrate the economic dynamic theory’s generality through
examination of a wide variety of legal subjects, I anticipate a major research effort
before writing this. This research effort may lead to substantial changes, especially
in chapters 4-10.
Introduction
The introduction will explain the book’s aim, to provide a useful alternative
to the increasingly questionable neoclassical law and economics approach. It will
outline the book’s structure. The first three chapters will contrast the basics of the
neoclassical model with the economic dynamic model, using the experience of the
financial collapse to make the discussion concrete and salient.
The remaining chapters will apply the economic dynamic approach to a
variety of areas of law. These chapters will show how the economic dynamic theory
leads to a useful reframing of inquiry and enjoys implicit support from leading
scholarship in a variety of fields. While these chapters will not resolve all of the key
policy issues in these fields, they will demonstrate the theory’s policy relevance
through concrete examples of policies that the economic dynamic approach might
favor.
Chapter 1. The Neoclassical Model of Law and Economics
2
This chapter explains the basics of the neoclassical model of law and
economics and provides background about its influence. It will discuss concepts of
allocative efficiency, cost-benefit analysis, privatization, and market mechanisms.
The chapter will emphasize the assumptions employed to make the model go,
especially the assumption of perfect information, what has long been known to be
false and has proven significant in the economic debacle. The perfect information
assumption tends to make cost-benefit analysis static, as it helps justify focusing the
analysis on that which we can quantify, instead of upon unknowns, such as the
potential for a housing market downturn or a feedback loop that magnifies global
climate disruption. The introduction will emphasize the microeconomic nature of
the neoclassical framework, as opposed to a broader macroeconomic framework
that emphasizes growth and change over time.
The chapter will explain that much of the legal academy embraced the model
and how it heavily influenced policy at least since the time of Ronald Reagan and
Market Thatcher. For the most part, this description of policy influence will be
fairly general, as later chapters will discuss the models’ influence in particular areas
in greater detail.
Chapter 2. The Financial Debacle
This chapter will provide a summary of the financial debacle, emphasizing
the role of the neoclassical law and economics worldview. This world view led to a
number of deregulatory decisions that set the stage for the debacle, including the
repeal of the Glass-Steagal Act, which may have prohibited the types of derivatives
that fueled the crises and the decisions not to subject derivatives to regulation. This
chapter will explain the economic collapses’ mechanics and how the collapse
undermined, at least in the political sphere, commitment to the law and neoclassical
economics worldview. It also will explain how financial models that failed to
account for the possibility of a change in the shape of change over time, namely a fall
in the value of housing prices, contributed to the failure to account for risk. This
chapter will also introduce the concept of systemic risk.
Chapter 3. The Economic Dynamics of Law: Essential Elements
This chapter presents the core of the book’s thesis, providing a general
description of economic dynamic theory. The economic dynamic theory proposes
that government focus on systemic risk and change over time, rather than the
summing of known costs and benefits. This implies that unknown future events
require at least as much attention as known costs and benefits. Government policy
should focus on the question of what measures are needed to limit systemic risk
while providing a climate hospitable to needed changes. While this theory certainly
includes careful consideration of the advantages and disadvantages of proposed
policies, it deemphasizes the role of calculation of costs and benefits in dollar terms.
It explains that policies influence the future, not the past. As a result, we do not
know precisely what results they will have. Wise policy-making therefore requires
3
the analysis of dynamics likely to influence the direction of future change, rather
than calculation of known costs and benefits.
Economic dynamic theory requires analysis of how government action
shapes economic incentives, just as traditional law and economics does, but it
assumes that those who respond to the incentives do so within a framework of
bounded rationality, meaning that they focus on information made salient by their
frame of reference, habits, and routines, and neglect much other information. This
contrasts with the traditional assumption of perfect information. This institutional
economic approach requires an analysis of the habits and routines of those a law
might influence to analyze how they might respond or not respond to potentially
relevant incentives.
Furthermore, the theory incorporates Douglas North’s concept of adaptive
efficiency, meaning that governments unable to calculate all costs and benefits
should endeavor to keep future options open to provide for future growth and
change. The chapter thus provides an account of economic dynamic analysis, which
provides a richer more accurate way of attempting to predict the influence of
economic incentives on private actions under conditions of change then the rather
unstructured observations that perform this function in most law and economics
scholarship.
This theory also builds on public choice theory and requires analysis of the
question of whom a proposed measure empowers. The incentives law and policy
create not only shape outcomes (at least to the extent that actors respond to its
incentives), they tend to empower some groups and disempower others.
Empowered groups, as public choice theory teaches, can influence law’s future
direction. Hence, a dynamic analysis requires analysis of law’s influence on the
distribution of power.
Chapter 4. Securities Regulation: Systemic Risk’s Challenge to the Market Failure
Paradigm
This chapter will examine government regulation of securities. It contrasts
two models of containing risk. One views the role of government as correcting
market failure by supplying information that enables market actors to protect
themselves from risks. The other type of reform, exemplified by the Glass- Steagal
Act, envisions more systematic containment of risk through government limits on
the structure of markets.
This chapter will show that a shift from a question of how to correct market
failure to a focus on systemic risk illuminates policy dilemmas in the securities area.
In general, the disclosure model fits static neoclassical law and economics, rather
well. If all actors respond rationally to information, then adequate disclosure should
allow markets to function properly. The economic dynamic model’s embrace of the
bounded rationality assumption raises questions about whether investors will
4
necessarily assimilate all of the information disclosed, thereby calling into question
the efficacy of the disclosure reform model. The economic dynamic model also
requires analysis of the likely response of institutional actors to disclosure
requirements over time, including the possibility of lobbying to limit disclosure and
conflicts of interest creating disinformation. The economic dynamic model’s focus
on systemic risk implies that we must take structural reform more seriously than
the policy world has so far. I will show that securities law scholars have raised
issues about the disclosure model’s adequacy with respect to systemic risk, and
show how the economic dynamic model both reflects their insights and may raise
valuable questions for further work.
Chapter 5. Anti-Trust and Bailouts: Too Big to Fail?
Neoclassical law and economics justifies anti-trust as an antidote to
monopoly power, which is economically inefficient. This chapter explains how
neoclassical law and economics’ skepticism about government regulation has
supported a narrowing of anti-trust law’s scope and vigor.
The economic dynamic theory suggests another rationale for breaking up
large companies. Bigness may imply more systemic risk. If that risk becomes too
large, it may make sense to simply break up large companies. This chapter will
address this hypothesis through the lens of economic dynamic theory.
An economy consisting of many small companies may prove more dynamic
than an economy consisting mostly of large companies. If this is true, then this
would have implications for bailouts in times of economic distress. The tendency of
governments facing the failure of very large firms is to keep them afloat. But it may
be better to use the funds that might keep them afloat to subsidize smaller rivals
and fund transitions of workers to the new company. It’s not at all clear, for
example, from an economic dynamic perspective that bailing out Chrysler and GM
makes more economic sense than subsidizing small manufacturers of vehicles with
more advanced technology. This part of the chapter will discuss the literature on
smaller and larger firms’ relative merits and show that the economic dynamic
theory invites consideration of a smaller is better hypothesis.
Chapter 6. National Security Law: Strategic Thinking Versus Cost-Benefit Analysis
In recent years, some proponents of law and economics have advocated the
use of cost-benefit analysis to choose and prioritize among security measures. This
approach is doomed to fail, as most of the important variables defy quantification.
Privatization has made significant inroads on national security. We have
outsourced much of our intelligence analysis and some vital military functions in
Iraq, with disastrous results.
5
While no economic theory solves all national security problems, the
economic dynamic theory has something to contribute even here. The focus on
systemic risk and change over time implies a need to pay more attention to
reputational factors that influence people to side with us or against us in the long
run. This is consistent with Barak Obama’s emphasis on upholding the rule of law in
order to preserve our reputation. This chapter will include information from a brief
filed by military leaders in a Supreme Court case about our decision to indefinitely
detain and torture inmates has fueled recruitment of terrorists, i.e. set up a negative
economic dynamic increasing systemic risk.
The economic dynamic theory focuses us on lengthening our time horizons
and thinking through problems strategically. The failure to think through the longterm problems with securing Iraq once Saddam Hussein was toppled shows a failure
to think through the economic dynamics of change. Recently, however, writers on
national security have begun to focus more on the economic dynamics of change as
they imagine how soft power approaches may produce a successful outcome in
Afghanistan. This same sort of strategic economic dynamic thinking can also
contribute to thinking through the merits of privatization. It suggests that we must
think about the sets of incentives a tradition of privatization sets up over the long
term versus those set up by the build-up of government expertise over time.
Chapter 7. Climate Change: Calculation, Systemic Risk, and Market Mechanisms.
This chapter uses the climate change problem as an example of neoclassical
economic failure and shows how an economic dynamic theory helps reveal a better
approach. The U.S. policy until recently roughly conformed to the suggestion of
William Nordhaus’ cost-benefit analysis, which showed that the costs of vigorous
action to protect the climate outweighed the likely benefits to the U.S. This analysis
overvalued benefits by neglecting non-quantifiable climate change effects and
through the choice of assumptions that favored doing nothing. Recently, however,
some leading economists have begun to realize that the most important features of
climate change science are not the quantitative predictions of the climate change
models, but rather than potential for catastrophic feedbacks that defy quantification.
They have therefore, begun expressing doubt about the neoclassical approach to
this issue.
I will show that an economic dynamic approach has begun to take hold that
significantly changes how we approach this issue. This approach takes the systemic
risk very seriously. It also recognizes that the costs and benefits of taking action are
themselves dynamic and unpredictable. The focus on systemic risk and economic
dynamics raises questions about how we construct caps on carbon and the role of
market mechanisms, such as emissions trading.
Chapter 8: Property Law: Responses to Incentives
6
The law and economics of property focuses on a fascinating, if arcane,
theoretical issue, the choice between property rules, which protect property rights
by enjoining infringement, and liability rules, which allow interference with
property rights upon payment of damages for the infringement. Participants in this
debate seek to predict which choice would be most efficient. A lot of this debate has
focused on figuring out which rule lessens transaction costs that may impede
private efforts to bargain for an efficient solution after a court chooses a result
without sufficient information to reliably choose an optimal solution itself. While
this debate is of great theoretical interest, there is good evidence that few if any
litigants bargain around the judicial result in the manner predicted by the theory.
This chapter shows that economic dynamic theory can help explain this result.
As law has become more global, property rights scholarship has increasingly
focused on more fundamental issues that arise in countries without highly
formalized property rights regimes. These debates focus on predicting the effects
that choices among regimes will have on change over time, as they focus on
property rights as an economic development tool. Economic dynamic theory
suggests that this sort of focus on macroeconomic considerations promises much
more payoff than a focus on economic efficiency. This chapter will evaluate
economic dynamic theory’s capacity to contribute to the analysis of property rights
as a development tool.
Chapter 9. Intellectual Property Law: Innovation, Diffusion, and Learning
The traditional law and economics story of intellectual property has come
under heavy assault by most prominent intellectual property scholars. This
account, often associated with Demsetz, posits that innovators under-invest in
innovation; they therefore require strong and broad property rights in all manner of
creative work in order to make the costs of innovation worth the benefits.
Modern intellectual property scholarship, however, provides an implicit
economic dynamic critique of this static pro-property rights picture. Over time,
innovation not only happens, it generates spillover effects that benefit society. The
innovations diffuse and provide information that produces further innovation. The
proper approach to property rights then must balance the desire to create adequate
incentives for innovation against the need to allow innovations to spread and
develop. This approach to change over time leads many leading intellectual
property scholars to complain about too much intellectual property and to
recommend limits on the commoditization of intellectual work.
I plan to show that this apparently ad hoc critique in fact carries out an
economic dynamic analysis. I plan to build upon and extend an analysis I already
published in Ecology Law Quarterly showing that Lawrence Lessig’s work on open
internet architecture and Brett Frishman’s work on the infrastructure commons
conform to an economic dynamic approach as part of this demonstration. I also will
7
build on some of the knowledge I obtained in writing an article on Transaction Costs
with intellectual property scholar Shubha Ghosh (U. of Wisconsin).
Chapter 10. Why Contract Law?
Neoclassical economic theory seems to aptly characterize contract law’s
essence. Contracts enable two parties to reach a mutually beneficial agreement,
thereby facilitating economically efficient transactions.
This chapter will examine an alternative hypothesis, that contract is all about
enforcing some inefficient bargains in order to provide enough security to make
people cooperate over fairly long periods of time. On this account, contract law
manages change over time, rather than achieves static efficiency.
The traditional account adequately explains why parties make contracts, i.e.
because they anticipate benefits exceeding the costs of carrying out their bargain.
Yet, the neoclassical account does not explain the law of contracts, which except in
narrow circumstances coerces involuntary performance or payment of damages
later on, when one party no longer agrees to perform. The breaching party
presumably has determined that performance does not provide benefits equal to
costs to him. If there were continued mutual agreement indicating an efficient
contract, there would be no need to enforce. The law of contracts exists because
often something changes after the parties sign a contract making continued
performance inefficient. Hence, contract law is about enforcing inefficient
agreements in order to manage change over time, in other words the economic
dynamics involved in carrying out a bargain.
In addition to developing this dynamic picture of contract law, this chapter
will examine recent contract law scholarship that implicitly uses analysis that seems
consistent with the economic dynamic theory. Recent law and economics
scholarship, for example, focuses on questions of fairness in modifying contracts
and has moved away from focusing solely on economic efficiency.
Conclusion: Economic Dynamics’ Scope and Limits
After a brief recapitulation of the theory, this chapter will draw conclusions
about the theory’s scope and limits from the subject matter specific chapters. The
theory most clearly applies to law and policy domains where policy-makers seek to
influence the future, such as in much of public law. But the contract chapter
suggests that the theory has some applicability beyond that domain, as contract law
and property law, like common law generally, are generally viewed as retrospective.
All theories have their limits, and this chapter will discuss some of this theory’s
limits. This chapter will also pose some questions for future research.
8