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The Adhoc-racy and the Rule of Law in the 2008 Financial Crisis

Paulson, Bernanke, And FDIC Chairman Make Statement On Financial Markets

When surveying the vast wreckage of the 2008 financial crisis, many classical liberals worry that the most profound damage done was to the rule of law in America.  Though it is difficult to pin down the concept with great precision, the core of the rule of law is simple: we have a government of laws, not men.  Our officials must follow rules that have been publicly and clearly set forth in advance rather than acting on their own caprice, and they are not welcome to simply make up rules as they go along and declare their conduct lawful in retrospect.  Without adherence to this precept, government’s actions can have no basis for legitimacy.

If we closely scrutinize what the Treasury Department, Federal Reserve, and other agencies of the federal government did in response to the recent financial crisis, there is no avoiding that they made a mockery of the rule of law.  Indeed, as Lawrence H. White puts it, “The approach of Federal Reserve and Treasury officials during this crisis, unfortunately, has been to consider every possible remedy but applying the rule of law.”

I shared something close to this view as I watched the crisis unfold, and my sense that the rule of law had become a victim to the crisis responses led me to undertake a deeper exploration of the issue, one that would grapple with the conceptual particulars of the rule of law as well as historical precedents set by other crisis responses.  The result of that work is my new book, To the Edge: Legality, Legitimacy, and the 2008 Financial Crisis (Brookings Institution Press).

My research largely changed my mind.  The rule of law, properly understood, has a more limited scope than many of its champions seek for it.  Legality is not the sole basis for government legitimacy; indeed, I argue that legality is neither necessary nor sufficient for an action to achieve legitimacy.  Instead, citizens may accept government actions as legitimate for other reasons: because they believe an action was truly necessary to fend off some imminent harm; because they trust their leaders; or because they believe adequate non-legal mechanisms to hold officials accountable make the risks of legally questionable actions acceptable.

Within the classical liberal tradition, there is actually considerable recognition of the limits of the law, especially as it relates to crises.  Alexander Hamilton, in Federalist No. 72, takes care to separate out a sphere of “administration of government” for the executive to decide on its own terms, and this includes core functions of foreign negotiations, organizing the army and navy, and conducting war.  F.A. Hayek’s frequent paeans to legal generality notwithstanding, he explicitly conceded in the Constitution of Liberty that it is neither desirable nor practicable in every situation (see especially Chapter 10).  Lon Fuller called attention to the limits of his “morality” of law, and warned that such areas as taxation, control of the military, and “tasks of economic allocation” are fundamentally unsuited to the forms of law, which if applied would “result in inefficiency, hypocrisy, moral confusion, and frustration” (The Morality of Law, 168-174).  Both thinkers warned of the damage to the rule of law that would result if people mistakenly believed it to extend to all of the government’s actions, thereby creating an impression of arbitrariness and hypocrisy where none was warranted.

War is obviously the paradigmatic case here.  Even if we might condone wartime executives’ departures from the law (Lincoln, Wilson, and FDR all furnish tasty examples), financial crises may not deserve to be put in the same category.  Unlike in a war, and especially a total war, a financial crisis should not create any existential anxiety; rules that may bend when many lives are at stake should hold firm when only fortunes are in the balance.

Perhaps—but rules do not apply themselves, and the history of financial crises in America gives ample reason to doubt whether public officials will be willing to impose significant financial losses for the sake of obedience to rules, even clear ones.  In bank runs throughout the nation’s history, legislatures and courts alike have shown a willingness to temporarily suspend depositors’ legal rights as a means of saving institutions that would otherwise fail.  In his excellent Misunderstanding Financial Crises, Gary Gorton offers a choice quotation from William Graham Sumner that captures the fundamental dilemma of deciding the fate of banks trying to save themselves: “in which a restriction to be effective must be intensely severe, and if it is intensely severe, proves impracticable when it is needed.”

So stalwart legalists should temper their expectations about just how firm the rule of law will be in crises, both military and financial.  Their purity of legal mind (if that is how they choose to see it) is shared neither by officeholders nor by most of their fellow citizens—who will by and large judge actions on other grounds, and will praise to the heavens (or at least have the courtesy to promptly forget about) such deviations from the law as they believe ultimately serve the public good.  A kind of prerogative necessarily inheres in the government’s power and the people’s willingness to accept its beneficent uses, whatever the theoretically-minded like to believe about the rule of law.

To give just one example of this dynamic in action, take what was probably the most legally ridiculous action of 2008: the Treasury Department’s September 2008 rescue of money market funds using the Exchange Stabilization Fund (ESF).  The ESF was, in 1934, set up to empower shadowy American currency warriors to do battle with shadowy British currency warriors, making its very existence somewhat awkward for the rule of law.  (And yes, somewhere on the Internet, there is someone who thinks it is at the center of nefarious global conspiracies.)  But it is not wholly without legal limitations, and at the very least it is clearly meant to deal with matters of international finance and foreign exchange.

The ESF had never been used for anything remotely like a guarantee of a class of domestic assets, and the best Treasury could say to justify this use was that, if the American economy went through the floor, that would surely affect the value of the dollar.  By the time Treasury’s top lawyer at the time reflected on this justification in 2011, he could barely keep a straight face (start around 11:00 of this video).  But it worked, marvelously, stopping the crisis from worsening at a crucial moment.  Very few citizens regret that fancy legal footwork, if they remember it—in spite of its huge importance, it doesn’t make the cut in HBO’s version of history.  Even among legal formalists in the academy, you will be hard pressed to find any energetic criticism.

But if we lower our expectations for the rule of law and accept that successful improvisations like the use of the ESF are likely to be accepted as legitimate, that hardly means that everything that the Bush and Obama administrations did to respond to the financial crisis gets a pass.  In my book, I dub the dominant mode of crisis response “adhocracy,” for the persistent failure to define clear, unifying principles of crisis response.  This was understandable in March 2008, when the Federal Reserve’s scrambling to prevent a collapse of Bear Stearns led Paul Volcker to uncomfortably state that the Fed had “take[n] actions that extend to the very edge of its lawful and implied powers.”

This becomes harder to accept as necessary six months later when Fannie Mae, Freddie Mac, Lehman Brothers, AIG, and the money markets forced another round of ad hoc solutions—or non-solutions, in the case of Lehman.  And harder still in the Obama years as the FDIC performed various acrobatics, the Treasury invoked the exigency of the crisis to justify express bankruptcies for Chrysler and GM featuring side-deals favoring the UAW, and Fannie and Freddie experienced legally dubious reorganizations in conservancy.  These late maneuvers departed from the law in ways that hurt mostly publicly unsympathetic interests, so they did not generate any widespread backlash, but there are many reasons to lament the extension of the adhocracy for so long.  We can afford to have higher hopes for the rule of law in normal times than in crises, and so the large pockets for unpredictable government discretion that persist even after recent financial reforms are a cause for concern.

When thinking about what the rule of law will mean in practical terms going forward, those who find it a worthy ideal should think carefully about what it is they want.  From both the Left and the Right, there are serious thinkers who believe that the concept is more trouble than it is worth and believe it should be abandoned as anachronistic.  I generally think these critiques are hyperbolic: even if the law is an imperfect and limited tool for rendering government actions predictable, it is nonetheless one of the most effective we have.

The focus should be on when and how law is most useful—for more on which in the context of financial crises, consult To the Edge.  As in so many policy areas today, we must select from what kinds of choices our beleaguered legislature has a comparative advantage in making. The proper role for legislature-made law remains significant, frequent snide jokes about Washington aside.  Our government’s ability to produce legitimacy remains inextricably tied to the rule of law.  That admittedly fuzzy concept needs to be interrogated and improved, not carelessly discarded.

Reader Discussion

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on April 21, 2015 at 12:32:23 pm

[The executive must] act according to discretion for the public good, without the prescription of the law and sometimes even against it.

John Locke, Second Treatise of Government

[A] strict observance of the written laws is doubtless one of the high duties of a good citizen, but it is not the highest. The laws of necessity, or self-preservation, of saving our country when in danger, are of a higher obligation.

Thomas Jefferson

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nobody.really
on April 21, 2015 at 12:55:55 pm

"[L]egality is neither necessary nor sufficient for an action to achieve legitimacy. Instead, citizens may accept government actions as legitimate for other reasons: because they believe an action was truly necessary to fend off some imminent harm; because they trust their leaders; or because they believe adequate non-legal mechanisms to hold officials accountable make the risks of legally questionable actions acceptable."

The reason Reagan gets away with this, of course, is that his hypocrisy mirrors the hypocrisy of the voters, who also want to be hard-nosed and sentimental at the same time. In that sense, unfortunately, the president's duplicity is more the fulfillment of democracy than its betrayal. We like being lied to.

TRB from Washington, New Republic, 12/8/86

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nobody.really
on April 21, 2015 at 13:09:28 pm

An interesting piece!

Doubtless, there are times when necessity must take precedence over statute (and yes, even constituent law).

I suppose I would be somewhat more comfortable with a general (unspoken) rule or understanding that such is the case were it not for the rather real problem of *moral hazard* that presents itself and for which most actors prefer to ignore. This is more clearly evident in instances of financial crises where the mischief of certain actors, both governmental (Fannie, Freddie) and private (S&P, AIG, Countrywide, etc.) have precipitated the crisis. Yet, these same actors are also charged with crafting the solution to the crisis - at taxpayer expense.
The same conditions obtained during the Clinton administration with Rubin, (another Wall Street government *revolvee*) playing a crucial role.
And from this we learned exactly what? - Well, that we could pull the same financial shenanigans AND once again be made whole by the taxpayer.

As our fellow commenter R. Richard might say: What are the motivations and just how precisely have these crisis resolutions modified those motivations. I submit that they do not, nor are they intended to do so. Rather they reinforce the belief that one can simply defy the laws of sound economic practice (and ethics, perhaps?) with impunity.

While Mr. Wallach argues that periodic abrogation of statute may be wholesome provided "The focus should be on when and how law is most useful", one must recognize that even this *focus* on "when and how" is apt to also be set aside as some new crisis emerges.
Yes, it may have a certain form of legitimacy based upon need (or fear of dire consequence), public clamor, etc. yet until such time as the peril of moral hazard is addressed it is no more legitimate than a poor man robbing a bank based upon need. At least Willie Sutton was honest enough to proclaim that he rob banks because they were there.

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gabe
on April 21, 2015 at 16:14:07 pm

"The rule of law, properly understood, has a more limited scope than many of its champions seek for it. Legality is not the sole basis for government legitimacy; indeed, I argue that legality is neither necessary nor sufficient for an action to achieve legitimacy. Instead, citizens may accept government actions as legitimate for other reasons: because they believe an action was truly necessary to fend off some imminent harm; because they trust their leaders; or because they believe adequate non-legal mechanisms to hold officials accountable make the risks of legally questionable actions acceptable."

Yes, indeed, Mr Wallach!

One of the things we threw off when we through off the British crown in 1776 was their principle-based constitution. In throwing out the British constitution we also threw out a lot of the recognition of the Fundamental Laws that underlay it. We replaced it with what appears at first to be a rule-based constitution.

But reading closer, especially the first ten amendments, we see that we also have a set of Fundamental Laws underlying our Constitution. The written Constitution does not usually spell them out explicitly. Even the first ten amendments, which we call incorrectly The Bill of Rights, do little to elucidate our Fundamental Laws. The preamble of the bill containing the first ten amendments refers to them as declaratory and restrictive clauses. Perhaps a better name for them would be The Declaration of Restrictions on Government. They serve to reinforce the Constitution by making explicit the otherwise implicit limitations on the American form of republican government. They do so by stating the limitations relative to a set of pre-existing rights, which are the natural extension of Fundamental Laws. Those Fundamental Laws can and often do supercede the items in written charters such as the Constitution. I think that is the gist of the article and probably the book.

I am coming to believe strongly that we need the equivalent of Blackstone's Commentaries to make those American Fundamental Laws more explicit. Then we would have a general standard against which we could more easily measure government actions such as those discussed here. That's why I am all for a proper petition for redress of grievances, complete with a robust bill of rights (as in 1774), to help establish a better explication our Fundamental Laws.

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Scott Amorian
on April 22, 2015 at 13:01:29 pm

No need, nobody, to look back that far, and to the Old Republic - really?

"You never let a serious crisis go to waste. And what I mean by that it's an opportunity to do things you think you could not do before." Rahm Emanuel

From the Property and Environment Research Center website, an article written a year ago. Far more relevant to the point of Mr. Wallach's article, but a reflection of the utter abuse of the current administration's circumvention of the rule of law - crisis or not, unplanned and fabricated.

" 'You never want a serious crisis to go to waste." Those words, according to the latest article from Bruce Yandle in The Freeman, capture the essence of what could be considered Rahm's Rule, after CHICAGO MAYOR and FORMER [Obama] WHITE HOUSE Chief of Staff Rahm Emanuel. As Bruce explains, when it comes to crisis management, opportunistic politicians such an Emanuel [and Obama] never miss a chance to convert crises into political pork for special interests:

[Hitting the bull's eye,]

"Rahm’s Rule is a useful accessory to a body of theory that seeks to explain the political economy of regulation. The rule tells us that major crises can provide cover for distributing benefits to targeted special interest groups. The greater the magnitude of a given crisis and the shorter the interval for forming legislation to deal with it, the larger the spread of pork that can be packed into the final legislation. Rahm’s Rule is a guarantee that efforts to resolve a deadline-based crisis will go on to the very last minute.' "

FYI: About PERC - Property and Environment Research Center - the nation’s first and largest institute dedicated to improving environmental quality through property rights and markets. Founded 35 years ago in Bozeman, Montana; a think tank where scholars documented how government regulation and bureaucracy often led to environmental degradation. PERC sought to explore how property rights and markets could play a more direct role in improving environmental quality. From this work originated the idea of free market environmentalism (FME).

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EJW

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