Global Positioning

In the midst of the worst international economic meltdown in generations, Law School scholars of varying backgrounds and perspectives are grappling with how to effectively assess and address what has become a global crisis.

By Peter Coy

Summer 2009

Like civil engineers after a bridge collapse, legal scholars are joining the inquest into the wipeout of the global financial system. The drive to build a better, more durable governance structure may be just as strong now as it was in the aftermath of the Great Depression and World War II. That was when British economist John Maynard Keynes helped create the International Monetary Fund and the World Bank, and a Tennessee lawyer named Cordell Hull—President Franklin Roosevelt’s secretary of state—spearheaded formation of the United Nations.

At Columbia Law School, fixing finance, both in the United States and worldwide, has vaulted to the top of the agendas of several faculty members, among them Katharina Pistor, Jeffrey N. Gordon, Merritt B. Fox, and John C. Coffee Jr. While sharing a common goal, the professors have different perspectives on whether the global financial system requires extreme reforms or something less—in other words, a whole new bridge or just some extra girders and better rivets.

No question, there’s plenty to think about. “We are clearly in the midst of a legal tsunami,” Thomas Hall, a partner at Chadbourne & Parke in New York, told Reuters last October. Even many strong believers in free markets say that more regulation, or at least more effective regulation, may be required. U.S. Court of Appeals Judge Richard Posner, in a visit to Columbia Law School last November, told students, “You can have rationality, and you can have competition, and you can still have disasters.”

One of the Law School’s most active scholars in the field is Katharina Pistor, the Michael I. Sovern Professor of Law. The German-born professor thinks countries
with poorly developed domestic financial systems should control inflows of capital
and strictly regulate the activities of international financial institutions that operate
within their borders. Pistor, who joined the Columbia Law School faculty in 2001, has made a project out of rethinking international finance with a focus on protecting vulnerable developing economies. She received her law degree in Germany and has worked in Russia, Eastern Europe, and Asia. Pistor counts as a formative experience her time researching corporate governance in Russia during the “shock therapy” of rapid privatization in the early 1990s—a botched process that led to the rise of the oligarchs. “By magic hands, the market was supposed to work,” she says. “Traveling through Russia and talking to company managers and directors, I thought that was an unlikely proposition.”

Pistor attributes the current global crisis to a credit boom that was created by banks and abetted by politicians, who enjoyed the politically popular (though impermanent) prosperity that was engendered by abundant lending. Bank managers made imprudent loans because they feared losing business to aggressive rivals. Pistor likes to quote former Citigroup CEO Charles Prince, who in 2007 told the Financial Times, “As long as the music is playing, you’ve got to get up and dance.”

If nothing changes, says Pistor, it’s highly likely that the music will eventually restart, and the bankers will be swept up in the frenzy all over again. In an article published by the Center for Economic Policy Research’s website earlier this year, she wrote, “A major task for the new governance of finance is to break this cycle.”

Pistor argues that the breakdown of trust in the international financial system has left a vacuum that is being filled by private, bilateral arrangements between suppliers and consumers of capital. On the supply side are sovereign wealth funds, such as those of China, Singapore, and Kuwait. On the demand side are big Western banks, which distribute the cash by lending to consumers and businesses. She predicts these relationships will evolve over time into tight networks lending support to members and shaping the governance of global markets.

But Pistor says these ad hoc arrangements exclude nations that are too small or undeveloped to attract the interest of sovereign wealth funds or Western banks in the post-crisis world. She doesn’t favor going back to the old, one-size-fits-all international regulatory system exemplified by the IMF’s international financial architecture, which she says “leaves little room to countries for protecting themselves.” Instead, in a March 3 piece for VoxEU, she advocated “multiple, decentralized, yet interlinked, governance networks.” All nations, regardless of which network they joined, would pay into a global insurance fund that, like the International Monetary Fund, would bail out countries that got in over their heads. Her idea is that fragile countries that clamp down on volatile capital flows would expose themselves to less risk, and thus would be permitted to pay lower premiums into the insurance fund.

Pistor knows her ideas may strike some people as extreme, but she says this is a time for bold thinking. She approvingly quotes Federal Reserve Chairman Ben Bernanke, who last fall said, “There are no atheists in foxholes and no ideologues in financial crises.” Pistor is unimpressed by arguments suggesting that regulation will distort market forces that allocate capital. Regulation will “by definition” conflict with what companies want, she wrote in a VoxEU article in February, adding, “Insisting that this is market ‘distorting’ misses the very purpose of regulation.”

Pistor’s ideas are getting a favorable reception in some circles. Columbia’s Nobel Prize–winning economist Joseph Stiglitz, in a recent interview, called Pistor’s work “interesting and important,” noting that “she’s not a market fundamentalist.” Dani Rodrik, a professor of political economy at Harvard’s Kennedy School, referred to her February online article as “one of the best recent commentaries—by which I mean one that I wish I had written.”

Some of Pistor’s colleagues
at the Law School favor a more cautious approach to reform; among them is Jeffrey Gordon, the Alfred W. Bressler Professor of Law. Gordon, a specialist in corporate law and governance, as well as in mergers and acquisitions, warns against making extreme changes to the framework of international finance that could have unintended consequences.

“My approach is to look at specific examples of institutional failure,” says Gordon. “I don’t think the system needs to be transformed root and branch.” Rather, he says, “there needs to be a more concerted effort to take account of the systemic effects of [financial] innovation.” Among the innovations Gordon mentions as having unintended consequences are securitization of subprime mortgages and the rise of credit default swaps, which obscured who would bear the losses from a borrower’s default while at the same time revealing the market’s nervousness about the likelihood of default by critical institutions, such as big banks.

In Gordon’s view, one big step would be to empower the Treasury Department and the Federal Reserve so they can deal with crises in the future without having to ask Congress for special powers. He says the crisis got worse last fall when the Bush administration was forced to go to Congress and explain precisely how bad things were, so as to justify its request for new powers. The extreme language scared the American people, Gordon says, and, “A crisis largely confined to the financial sector broke out to the real economy and therefore became much more difficult to manage.”

Gordon, who worked for the Treasury Department in the late 1970s and early 1980s, had a front-row seat for the successful financial assistance to New York City and to Chrysler. But that did not give him any confidence in the government’s ability to fix the banking system through extreme measures like nationalization. In his paper “The Glib Nationalizers,” cited in February by The Economist, Gordon warned that it would be dangerous for the federal government to take over big, weak banks, pay off depositors, and then sell their assets for whatever the market will bear, forcing banks’ creditors to take big losses. Forcing heavy losses on creditors, he asserted, could destabilize the financial system, while the nationalization of one bank could stir fears that other banks are at risk, causing even more instability.

Gordon says he admires Pistor and doesn’t minimize the current problems, but with respect to the current institutional structure, he is quick to point out: “We didn’t do so badly. It was 75 years. A couple wars. Dramatic changes in the world economy. The Depression-era structure held up.”

While he favors trying to prevent crises, he believes that they are inevitable and thus stresses the importance of having “enough ex post authority to cabin the fallout” when they do occur. “I’m not looking for a new form of capitalism,” Gordon says. “I’m a fan of muddling through. I guess that’s because I think it is very hard to foresee the effect of even changes in old institutions, much less new institutions.”

Merritt Fox, the Michael E. Patterson Professor of Law, shares some of Gordon’s views. He says he is concerned that excessive regulation could make financial institutions less efficient at allocating capital to promising firms and withholding it from weak ones. “Ultimately, that’s where the generation of wealth comes from,” Fox argues. “That’s why the U.S. and Europe and Japan are 10 times as wealthy per capita as they were 100 years ago.” While Fox favors more supervision for firms in the shadow banking system, he says, “I don’t think you need to restrict capital flows.”

For her part, Pistor asserts that fighting credit bubbles does not have to mean surrendering efficiency in the allocation of capital. In fact, she says that letting credit bubbles grow out of control is a worst-case scenario for efficient allocation of capital because, in a bubble, lenders give money to deserving and undeserving borrowers alike. As for bank nationalization, Gordon’s bête noire, Pistor’s recent scholarship mentions the idea only in passing in a list of options for dealing with weak institutions.

One thing becomes clear from the recent intellectual engagement of Pistor and Gordon: When attempting to address a problem as complex as this one, there’s plenty of room for diverging viewpoints, even among the most knowledgeable scholars. John Coffee, for example, is addressing the crisis from a different direction, focusing on the best way to control U.S. financial institutions. In March, he told the Senate Banking Committee he favors a “twin peaks” model, with one regulator for systemic safety and a different one to focus on transparency and investor protection. The enduring problem for all the scholars is that whatever system is designed, smart people will put enormous energy into trying to get around it. Compared to this, building safer bridges is a breeze.

Peter Coy is the economics editor at BusinessWeek.

Illustration by Heads of State