Monday, February 16, 2009

Law and Economics and the Global Economic Crises

As Avishalom Tor wrote in the previous posting, an interesting discussion on the causes of and remedies to the global economic crises took place in the EMLE midterm meeting in Hamburg. The discussion, however, was conducted in the framework of the dominant economic paradigm – trust in the operation of markets, focusing on traditional market failures and extensive discussion of the failure of regulation in correcting these market failures, under the assumption that wealth maximization is the prime goal of policy makers including the law. I believe that the current economic crises ought to prompt us to re-think about the paradigm and indeed about Law and Economics and its future development. I would like to mentions here two points among many others meriting discussion– psychology and fundamental values.

The behavioral approach in economics and in Law and Economics established itself in recent years as an important addition to economic analysis. However, until now this approach has focused on various phenomena on the level of the individual player and mainly in the context of micro-economics and individual behavior in market conduct. The recent global crises prove the need to extend this approach in additional avenues, among which are macro economic theory. Trust in the economic system, for example, can be of major importance to economic results. It has been thus far assumed, for example, that despite individual psychological effects, which distort individual conduct in the stock markets, on the aggregate level one has to analyze stock markets in a pure rational framework. The current crises prove this to be wrong. Overall fall of trust can bring to irrational micro and macro market activities. If people would not trust their countries economy and government, rescue packages introduced by various governments in order to stimulate the economy might not do the job. Economists analyze real economic activities but it seems that the psychological factors exercise a significant role in economic performance.

Beyond shaking the crud rationality assumption used by traditional economic models, the behavioral approach so far has not produced other methodological tools and models to analyze operation in economic and non-economic markets. Likewise, its findings negate the accuracy of traditional economic models but are far from being rigorously incorporated into existing models. This is an important challenge for the years to come.

The second point is in the realm of normative economic analysis and the philosophical foundations and values that has been dominating economic theories in the last few decades. One of the sources of the current global crises is borderless greediness. The corporate world and its actors were trying to make more and more money, far beyond is needed for good life. This behavior is reflection of the prime and sole normative goal set by economic policies in recent decades – maximization of wealth and growth, which is also reflected by most of scientific writings including Law and Economics work. The success of the Chicago school, intertwined with the Regan-Thatcher ideology leaving its marks on the policies of both left and right in the western world, affected not only policy-makers and scholarly analysts and advisers, but also individual conduct, as the very ones that brought to the bubbles causing the financial crises.

Behavioral studies have shown the there is no perfect correlation between wealth and happiness, growth and utility, and these findings are another reason for change of values within economic policy and indeed the economic science. I think that we – the Law and Economics community - have to take seriously a re-visit in the philosophical foundations of our own works.


  1. One can only agree about crud rationality assumptions ( It is another matter whether behavioural studies and L&E represent a decisive break with such assumptions. If one is to understand (inter-twined) market and regulatory sentiment and shortcomings, then one may have to look to wider issues of social structure and culture. And to the ways in which the above may have been supported (and are still support) by conflicts of interest - not just in the rating agencies etc, but also in regulation and policy-making.

  2. This is thought provoking. But I disagree that "borderless greediness" should be an element of analysis or even moral critique. The miraculous wealth of entrepreneurs is a necessary element of markets as long as entrepreneurs are allowed to fail. Nobody has blamed Bill gates for being greedy though his wealth was at times as large as that of the 1 billion poorest people in the world taken together. The difference between Gates and the bankers is that banks cannot be allowed to fail. They have to be bailed out with the money of ordinary people. Therefore they should not be allowed to take the same risks as entrepreneurs. We need a World Financial Organisation to guarantee just this.

    Hans-Bernd Schaefer

  3. That is an interesting post, Eli. I have a couple of remarks.
    It may be true that psychology plays an important role in economic behavior that is not fully captured by existing theories (including the theories that stress cognitive biases), but it is not clear to me what kind of behavior you have in mind in relation to the present crisis. During the bubble many people believed that the economy was doing fine, that macroeconomic policy had become so effective that business cycles were a thing of the past. The equilibrium was one of herding, and perhaps also one of conformity (as modeled by Bernheim). Even the most sophisticated investors made some very bad decisions, believing (rationally but wrongly) that the world was different from what it really was.
    Morever, due to rapid financial innovation, analysts could not form an overview of what was really going one, who were buying what new instruments and with what risk; the system had become opaque to even the best trained financial theorist.
    It is just very difficult for anybody to know what the correct model of the world is.
    So I would like to see good examples of irrationality before considering giving up the (in my view) very valuable rationality assumption. I think it is interesting that when we attempt to explain human behavior, even in daily discourse, we instinctively look for self interest- that is how deeply ingrained the rationality assumption is in our thinking - and (I tend to think) rightly so.

  4. Economy performed a very vital role in developing of any country of the world.In my point of view the economice crises is a major problem.The meang og econominc crises,its point out the unemployment,low level and the low prices of investment and trade.