Upholding the Rule of Law, in Season and out of Season

One common assertion arising from the onset and resolution of the 2008 financial crisis is the belief that it proves the purported need and propriety of the government acting in a swift and discretionary manner and not have its hands tied by the constraints of the rule of law.  Yet a close examination of the most recent crisis as well as those of the past reveals the exact opposite truth: adherence to the rule of law is actually more important during periods of economic crisis, both to restore short-term economic prosperity during the crisis as well as for the long-term systemic impact.

There are four reasons why this is so.  First, adherence to the rule of law is necessary for economic prosperity in general, but even moreso during economic crisis.  Second, adherence to the rule of law is necessary to restrain the opportunism of politicians and special interests that use the opportunity presented by the crisis to piggyback their own narrow interests, often with no relationship to the real problems.  Third, once discretion is unleashed during the crisis history tells us that the dissipation of the crisis does not promote a return to the rule of law—in fact, there is a “ratchet effect” of government discretion as the post-crisis period brings about a consolidation of governmental discretion rather than new limits on it.  And finally, the mere potential for discretionary action promotes moral hazard, thereby creating the conditions for still further rounds of intervention.  Thus, while little is lost in the short run by tying the government’s hands from discretion, more importantly the only way to promote long-term economic growth and preserve freedom in the long run, and to avoid precisely the circumstances that then justify future arbitrary government intervention is to constrain government discretion in the short-run.  Consider each in turn.

First, adherence to the rule of law is a necessary condition for long-term economic growth.  Established rules of contract, property, bankruptcy, corporate law, and the like provide the institutional infrastructure for economic growth.  It is a trite and obvious statement that the modern global economy is an incredibly complex system.  But that should still not distract us from how miraculous it is that milk appears in our refrigerators every morning.  For the economy is a system in constant flux.  From missed planes in Toledo to hail storms in Oslo the underlying conditions of economic prosperity are in constant flux and of bewildering complexity.  As Hayek noted, the miracle of the modern economy is the ability of individuals to coordinate their affairs amidst this constant system of flux and uncertainty.  The backbone of that system is the rule of law, which enables parties to coordinate their affairs by enabling them to predict how others will act.  Thus it is little wonder that economists have identified the presence of the rule of law as one of the key determinants of economic prosperity in the developing world.

But this also means that adherence to the rule of law is even more important during periods of economic dislocation.  It is precisely because other variables of the economic system are in even greater flux than usual that adherence to the bedrock predictability of the rule of law takes on special institutional significance.  Yet many believe exactly the opposite—that the government’s discretion and arbitrary power should be greater, rather than lesser, during periods of economic dislocation.

I suspect that this justification rests on an intellectual error that confuses the appropriate responses to a national security crisis with that of an economic crisis.  In a national security crisis government discretion may be necessary in order to anticipate and respond to threats and to seize tactical opportunities.  But that is not what is needed following an economic crisis.  What is necessary is reestablish coordination among billions of people.  The problem is one of reestablishing decentralized coordination rather than centralized prevention of threats.  Political uncertainty about the integrity of contracts and regulatory policy undermines investor confidence and raises interest rates.  Thus, for every job supposedly saved through arbitrary intervention there may be many others that are never created as a result of the uncertainty created by government intervention in the economy.

Second, adherence to the rule of law is especially important during periods of crisis because that is when potential for political opportunism by politicians and interest groups is most dangerous.  In focusing on the potential for government intervention to do good things, Pollyannaish political analysts ignore the potential of politicians and interest groups to abuse the target-rich environment presented by the crisis to further their own self-interests.  President Obama’s then-chief of staff summed the mentality when he observed that you should “Never let a serious crisis go to waste,” a mantra which the President invoked in order to ram through a number of unrelated pieces of legislation and pet political projects.  Indeed, every act taken by the Obama administration in response to the financial crisis, from the initial $1 trillion stimulus, to the Dodd-Frank financial reform legislation and the auto bailouts, evidences this theme of piggybacking special interest and other provisions on the back of the purported crisis.

In the auto bailouts, for example, the administration used the narrow excuse that the reduced availability of debtor-in-possession financing as a result of the continued impact of the financial crisis on lending markets justified government support for post-petition financing.  But even if that is true, it hardly justifies the government’s heavy-handed and arbitrary intervention in the process, including the plundering of secured creditors in Chrysler, the massive wealth transfers to the United Auto Workers, the rigged bidding processes that foreclosed rival plans, and the political interference with General Motor’s business decisions and operations while under government ownership.  None of those activities in any way contributed to the rehabilitation of the auto companies and indeed they were largely adverse to that goal.

Third, the cessation of the crisis does not produce a retrenchment from the discretion that accompanied it.  Instead, as we have seen, the post-crisis period produces a codification and consolidation of the government’s discretion, making it a long-term element of the economy.  The massive, 2,400 page Dodd-Frank legislation, for example, entrenches much of the lawless and discretionary activity taken during the financial crisis.  For example, it gives the government virtually unreviewable authority to seize what the government deems to be failing financial institutions and to deem certain institutions but not others to be “systemically risky”—although it nowhere defines the criteria that marks such institutions as such.  The legislation imposes a number of rules that arbitrarily create winners and losers in the marketplace with little explanation or justification for doing so.

Moreover, once constitutional constraints and the rule of law are overridden the new regime creates clear winners and losers and the winner have little incentives to support a return to the rule of law.  It is often overlooked that the value of the rule of law is to benefit ordinary citizens.  Wealthy, powerful special interests can hire the lawyers and lobbyists that enable them to thrive in a system defined by loopholes and arbitrary government decision-making.  Ordinary citizens, however, are excluded from these back-room deals.  Thus, this post-crisis period reinforces the dynamics that emerge during the crisis.

Finally, discretion invariably produces problems of moral hazard and the inevitable production of the conditions for further future interventions.  Precisely because the government can exercise discretion when it believes necessary, this creates an incentive to force the government to exercise discretion by foreclosing alternatives.  For example, one reason the bankruptcy of Lehman Brothers was so catastrophic and disruptive was because Lehman Brothers rejected government efforts to broker a bargain to save it in the anticipation of holding out for a better bargain, or alternatively, a Bear Stearns-style bailout.  Similarly, when General Motors was spiraling toward insolvency, management refused to make plans for a bankruptcy filing, thereby effectively guaranteeing the self-fulfilling prophecy of a disorderly bankruptcy unless the government acquiesced to a bailout.

Moreover, now that President Obama has touted the auto bailouts as a successful exercise of governmental industrial policy, this will likely embolden still more moral hazard.  For example, several states face impending financial calamities as the result of overly-generous salary and benefit plans for state employees.  In light of the political success that Obama claims for the auto bailouts, there will be little incentive for states such as California facing massive budget shortfalls to repair their fiscal houses rather than to careen toward a fiscal cliff in the hope that the Obama administration will bail them out on the basis that the state is “too big to fail.”

The only way to preserve the rule of law in the long run is to also preserve the rule of law in the short run.  Short-run expedients in the midst of a financial crisis rarely assist in addressing the crisis and open the floodgates to future arbitrary governmental action.  One fears, however, that the opposite lesson has been absorbed by the public and the political class, with dire consequences for the nation.