The Constitution in the Financial Crisis

The Stanford Constitutional Law Center’s fall conference addressed The Constitution in the Financial Crisis. The government response to the financial crisis raises a number of “constitutional” questions in a broad sense—basic questions about how the government is structured, what its role is, and how its decisionmaking power is allocated between branches and distributed over time. Unfortunately, I missed the first day but was able to attend and take these rough notes on November 12, 2010.

9:30 The Federal Reserve in Our Constitutional System

Larry Kramer

Moderator: Larry Kramer, Richard E. Lang Professor of Law and Dean, Stanford Law School. Panelists: John Steele Gordon (author); Allan Meltzer (Carnegie Mellon); John Taylor (Stanford); and Michael W. McConnell (Stanford).

In the government’s response to the financial crisis, a central role has been played by the Federal Reserve. Is the Fed performing a new function? Should we distinguish between its banking functions, its regulatory functions, and its effective spending power? What is the relation between the structure of the Fed—and especially its seeming independence of political actors—and its approach to policy? Is the Fed genuinely independent? If so, who determines its policies and priorities, and to what interests is it responsive? What are the lessons to learn from the history and antecedents of the Fed, such as the First and Second Banks of the United States? Does the Fed embody, or subvert, the Madisonian project? And is there any necessary relation between the structure of political and governmental institutions and the task of a central banker?

John Steele Gordon

John Steele Gordon: Thinks once the Fed has purchased other securities, it will be easier for them to do so in the future. Precedent has been set.  See also, Empire of Wealth: The Epic History of American Economic Power (P.S.) and Hamilton’s Blessing: The Extraordinary Life and Times of Our National Debt: Revised Edition.

Michael McConnell

Michael W. McConnell: The Federal Reserve Bank is independent of both Executive and Congress. Budgets are generally under the control of Congress and the Government Accountability Office (GOA) can audit. Not true of Fed. (However, I see section XI of Dodd-Frank gives the GAO authority to conduct a one-time audit of the Federal Reserves emergency lending during the credit crisis.) A few years ago, the Fed held $850-900 billion in reserves. When the latest announced round of quantitative easing has been realized, they will hold $1.7 trillion. Agreed with Taylor for the need for audit of Fed purchases of securities other than Treasuries. We need to flush out favoritism. Force the Fed into telling why it is doing what it is doing. Might provide more predictability. Would prefer to see regulatory functions taken away from Fed and shift back to a more orthodox focus on banking. Good for monetary policy but not regulating the economy. Sees such intervention as bad constitutionally.

See also, McConnell, Michael W., The Ninth Amendment in Light of Text and History (September 16, 2010). Available at SSRN.

John Taylor

John Taylor: Passed out a nice chart that showed the recent financial crisis may have been avoided or at least severely constrained if the Federal Reserve had followed the Taylor Rule, raising interest rates beginning in 2002, instead of 2004. Argued that when the Fed buys and sells Treasuries it doesn’t matter which bank it buys from because all boats rise and fall. However, when it began buying mortgage instruments, stock, etc. from Bear Sterns, AIG, etc. these instruments are risky and results are unevenly felt. The independence one might want for ordinary policy (to avoid a prolonged foot on the accelerator that politics would always demand) could now turn into favoritism based on campaign donations, ties to specific banks, etc. Taylor argues these risks of appropriation should be transparent and subject to audit. With the election of Tea Party members, we could see an alliance from right (Ron Paul) and left (Bernie Sanders) that gives more audit authority to the GAO over the Fed.

As least two other charts used by Taylor were also very interesting. One showed the Libor OIS Spread, with dramatic pre-panic, panic and post panic phases, as further described by Taylor. Another graph showed Federal Reserve Balances going along for years at a few $ billion with giant spikes for TARP and again with quantitative easing 2 to reach $1.6 trillion. Reaction around the world is negative to the most recent phase of quantitative easing. See Taylor’s letter to the Fed and one of many responses that doesn’t seem to pick up on nuances, as well as a long list of publications on his blog. Also Ending Government Bailouts as We Know Them (Hoover Inst Press Publication).

Allan Meltzer

Allan Meltzer: Opined that Volker was the most independent chair ever at the Federal Reserve. Greenspan was independent. Bernanke, not so much. Apparently, the Fed isn’t even supposed to buy government bonds to support the economy but they found a loophole. Discussed other institutions internationally. European Central Bank very independent… with no political control. Bank of Japan became independent in 1995. China, not independent. Notes that Milton Friedman wasn’t in favor of independence. He thought it it wasn’t independent, we may have avoided the Great Depression.

Meltzer thinks political control of the Fed is a bad idea. We don’t want a central bank under control of government. Wants to go back to the Fed being the lender of last resort, require higher collateral – higher capital standards for banks will allow FDIC to intervene while it still has a position. Monetary policy would be a quasi-rule. We should have an understanding of where the Fed is going so that we can plan.  Tell the public where it is going and what results are expected. New Zealand did something like that. See The European Central Bank: Credibility, Transparency, and Centralization (CESifo Book Series) and Meltzer, Allan H., Learning About Policy from Federal Reserve History (February 4, 2010). Available at SSRN. A History of the Federal Reserve (text only) by A.H.Meltzer

12:15 The Government as Shareholder: The Implications for Corporate Governance
Moderator: Joseph Grundfest, W. A. Franke Professor of Law and Business, Stanford Law School. Panelists: Jonathan Macey (Yale); Edward Rock (Penn); Lynn Stout (UCLA); and J.W. Verret (George Mason).

One of the most notable features of the government response to the financial
crisis has been the government’s seemingly new role as shareowner. Government-owned corporations raise new corporate governance questions and also new “constitutional” questions—again, in the broad sense of basic questions of governmental structure and the rule of law. Are government- controlled corporations “state actors” for purposes of constitutional limitations, such as due process? Are their employees constitutionally protected in the way state employees are, from arbitrary dismissal or political pressures? Do such corporations enjoy the freedom of speech? May they make expenditures to affect political campaigns? What are the implications of sovereign immunity for corporate liability and for veil piercing? Are they exempt from state law, on the model of McCulloch v. Maryland? What should be the rules for “entry” and “exit” by the government as a shareholder? What are the implications for corporate governance? For the theory of the corporation? Under what circumstances should the government have a seat on corporate boards, and what should be the decisionmaking criteria for government directors?

Joseph Grundfest

Joe Grundfest – Role of gov to regulate externalities. Let them slug it out in a Darwinian struggle. Let’s do the social accounting. Brought up interesting case of a bond offering in the US in 2004. Seems quaint now.

Edward Rock – Why we should care. Novel legal questions. Gov controlled corp behaving differently. Shorthand US Treas. may not have same goals as private shareholders… might favor max employment, green dif than max firm value. When gov has portfolio, may be temptation to use one firm to pressure another in portfolio. DE law provides robust protections with regard to related party transactions. Cause of action for derivative suit. Apply fairness doctrine (price and process) Treasurer soverign immunity kicks in. Procedurally, can’t sue in DE court. Second, can only sue to extent sovereign allows.

Edward Rock

S-1 filing for IPO outlines potential conflicts of interest with gov ownership of GM. Is there a discount because of gov ownership? Page 23 Treasury will continue to own and interests may differ. May influence through ability to vote, product offering, exec compensation unions, promoting growth and jobs. Slower shareowner growth. Reversed getting rid of many dealers.  First version lacks second paragraph from bottom. Did SEC give GM slack? SEC Probably asked them to add a paragraph.

Sovereign immunity paragraph. US Treasury is a federal agency. Ability to bring a claim against it may be limited. Investing public is being told you won’t be able to sue Treas. for misrepresentations in prospectus. GM may get tax breaks that may be worth up to $45B, according to WSJ (additional is mostly pension plan). Usually, it is the firm that lost the money that gets to take net operating loss carry forward. Changed law for GM and Chrysler.  In prospectus (S-1 filing). Back in exhibit F-127 note they list $18 billion. Huge subsidy. Net, net. What’s better?   Value should be about $44 per share but coming out at $30 or $35 a share. So, investing public sees it as a drawback, not a plus.

Look at gov ownership of Fannie, Freddie, AIG. Why were 20% of shareholders kept in. Keeping it at 20% or above so debt didn’t go to debt ceiling (avoids recognizing full liability) It looks like many would rather find a way back than forward. GM started lobbying again, making campaign contributions again. (not in prospectus) Potential for bad outcomes is huge. Simple answer is to make gov ownership very short. Interesting note that FOIA now applies to GM. See Rock, Edward B. and Kahan, Marcel, When the Government is the Controlling Shareholder: Implications for Delaware (September 23, 2010). Delaware Journal of Corporate Law (DJCL), Vol. 35, No. 2, p. 409, 2010. Available at SSRN. Also of general interest: Kahan, Marcel and Rock, Edward B., The Insignificance of Proxy Access (October 21, 2010). U of Penn, Inst for Law & Econ Research Paper No. 10-26; NYU Law and Economics Research Paper No. 10-51. Available at SSRN.

JW Verret

J.W. Verret – immunity with fiduciary duty problematic. Historic precedent, US ownership of German companies during WWI. regulatory preferential treatment, implicit backing by gov., subsidize transfers to interest groups, gov is controlling shareholder in AIG. Treasury Dept to take 90% has a health company.. preferential treatment by gov to them under ObamaCare seen as a potential problem. Use AIG to provide subsidized low cost insurance. Harsh critic of AIG trust. Fiduciary duty was to the Treasury, not the company. Why is it that some gov. controlled firms pay back but others don’t? Why does gov. let some of them go? Company leverage, principle agency costs within rent seeking agreements, bet. politicians and bureaucrats. Thinks debt of corps owned by gov debt ceiling must be raised. Include all the TARP debt. Gov track record doesn’t take broad view. Tenure too short. Complicit. difficulty of accountability. Preferential treatment.

See: Verret, J. W., The Bailout Through a Public Choice Lens: Government-Controlled Corporations as a Mechanism for Rent Transfer (October 14, 2010). Seton Hall Law Review, Forthcoming; George Mason Law & Economics Research Paper No. 10-53. Verret, J. W., The U.S. Government as Control Shareholder of the Financial and Automotive Sector: Implications and Analysis (February 23, 2009). George Mason Law & Economics Research Paper No. 09-13.  Verret, J. W., Defending Against Shareholder Proxy Access: Delaware’s Future Reviewing Company Defenses in the Era of Dodd-Frank (August 8, 2010). George Mason Law & Economics Research Paper No. 10-37. All available at SSRN.

Lynn Stout

Lynn Stout – shareholders hold different interests. Universal ownership (shareholder fictional concept). Most believe corporation should maximize firm value. But that only really works if you are an undiversified shareholer in that company. I need to worry how it will harm value of my other holdings, human capital. Universal investor is not addressed by corporate law. Structures to max wealth may actually lower universal wealth.

Most shareholders are rationally apathetic. Nondiversified shareholder most likely to deviate from universal values, pushing one company to maximize return.  When compounded at many companies, results in a tradgedy of commons. Pushing one company at a time could destroy commons. Remorseless logic of tragedy. Gov involvement may not maximize but it may prevent externalities or encourage them to provide external benefits (e.g., R&D subsidized). If gov is going to be a shareholder, under what conditions? Permit gov investment but not for rent seeking. Gov control doesn’t necessarily mean executive control. Could be an independent commission. Conceive of formal administative solutions. Rule of law, not rule of men.

See Cultivating Conscience: How Good Laws Make Good People and looking forward to an update and greater elaboration of Stout, Lynn A., Crowding Out Conscience: The Perils of Material Incentives (May 15, 2010). Gruter Institute Squaw Valley Conference 2010: Law, Institutions & Human Behavior. Anabtawi, Iman and Stout, Lynn A., Fiduciary Duties for Activist Shareholders. UCLA School of Law, Law-Econ Research Paper No. 08-02; Stanford Law Review, Vol. 60, 2008.  Available at SSRN.

2:30 Rules and Standards Revisited: Discretion in the Financial Crisis

Jane Schacter

Moderator: Jane Schacter, William Nelson Cromwell Professor of Law and Associate Dean for Curriculum, Stanford Law School. Panelists: Kenneth Anderson (American); Louis Kaplow (Harvard); Eric Posner (Chicago); and Kenneth Scott (Stanford).

Cutting across many of the questions considered by the preceding panels is a broader theme of government discretion. In legal scholarship, one of the familiar ways of describing the tensions and tradeoffs in government discretion is the concept of rules versus standards. What does the concept contribute (if anything) to our understanding and appraisal of the government’s response to this crisis? And what does the concept contribute to how our legal system can or should prepare for future crises? How does the contribution of rules and standards help us think, more generally, about the relationship between legal theory and the world? Is it true, as some have said, that the lack of predictability in the government’s response to investment bank failures (bailing out Bear Stearns, not bailing out Lehman Brothers) was a cause of the meltdown? Does the recent financial regulatory reform legislation provide a stable basis for intervention in the future? And how should we as legal scholars even talk about discretion in the government’s response? Should we use the language of economic analysis and rational choice and precommitment and the costs of uncertainty for private actors? Or is it better to look to the language of political theory and speak in terms of the legitimacy and democratic accountability of public institutions?

Kenneth Anderson

Kenneth Anderson:  In addition to the issue of time raised by Kenneth Scott (see below), the issue is trust. How do we achieve trust? We need a trustee in the larger context. Within financial theory, we have not adequately taken into account the moral sense that Professor Stout was talking about. We don’t impose any moral psychology. Behavior finance interesting but we need a deeper concept of trust — rules based with enough slippage to address uncertainties.

Dodd-Frank increases uncertainties by giving the government authority — in fact, they are “leveraging” uncertainties. We’ve left a number of important questions unanswered – other than to assume a ton of bricks may fall on “violators” (my words) with little or no warning. I picture the leveraged uncertainties as something like living close to someone with an atom bomb, not really knowing what will set it off. Anderson sees the need for a clearer path to increasing known moral hazard for those causing the problem. Rules based with a conceptual base to cover slippage? Maybe the real problem is that the system is so complex, we haven’t got a grip on cause and effect.

See also, Anderson, Kenneth, Do Lawyers and Law Professors Have Any Comparative Advantages in Opining on Financial Regulation Reform? A Brief Essay (April 25, 2010). American University Washington College of Law Business Law Brief, Forthcoming; American University, WCL Research Paper 10-22. Available at SSRN.

Louis Kaplow:  Ex ante ex post promulgation – rules more expense to formulate than standards. Enforcement – more expensive under standards than rules.

Louis Kaplow

Intermediate – rule easier to comply with, don’t have to guess. Fact that agency may later get it right doesn’t appeal. Important to distinguish safety/soundness favors rules.

Main virtue of rule predictability. However, that’s also one of its vices. Rules allow you to circumvent. Financial wizards will drive everything through what you got wrong — the small cracks in the sytem. Circumvention – tax system rules, overlaid with standards. Dodd-Frank 243 areas of rulemaking required. Setting up a system to create rules. How formulated? Money. Does Congress appropriate money for the regulations? What resources have we allocated for the 12 month due date? In addition to money, we need human capital. Most brilliant people being hired on the other side (the regulated side). Implications. Rules will be circumvented (esp. given resource capital issues).

How will regulators get info needed? From regulated community. Defer to regulated community. Concerns for abuse. birbery, corruption, softer kinds like revolving doors, political rewards. Rules help. Massive discretion with so many rules. Equal treatment under the rules… but everyone is unique. Can we do any better? Given huge complexity can we rely or do we need ex post flexibility. Rely more on different types of control. Break into simpler pieces. Also, these are international problems. Need to coordinate rules internationally.

Disagrees with Posner’s view that we can simply judge success or failure after the fact. By then it may be too late and those we might hold accountable are long gone, even if we could sort out the complexities and assign blame. The armed forces have war games to think through scenarios. Where are the counterparts for our financial system? See also, The Theory of Taxation and Public Economics

Eric Posner

Eric Posner: financial crisis and securities crisis. Securities crisis is like 911. People expect the President to lead the response. Might not have statutory authority. Rely on existing law and stretch. Draw on contested Constitutional authority. Always go to Congress for additional authorities that are unbelievably broad. Rules best for situations that reoccur. Standards better for unique events. Cost to enact rules in advance high. Presidents will act during crisis and be judged later. Congress makes policy, President executes — doesn’t happen during security emergencies like the fall of 2008. President/Treas. in partnership with Fed. Relied on existing authority. Stretched, then moved to get authority. At first get extraordinary authority, simply written. Gave vague authorities in whatever way they deem appropriate. Only required to comply with political standards. Rules didn’t work ex ante. Need rules in advance to access risk but with computer technology it is too easy to game the rules.

Dodd-Frank ultimately depends on vague standards (like commission to intervene on systemic risk). Rules crucial if Congress deliberates and executive executes. Courts can’t fill the gap. We live in a world of executive primacy…. not with Madisonian separation of powers. President constrained by public. That it their constraint. Rewards or sanctions on that basis.  See Posner, Eric A. and Vermeule, Adrian, Crisis Governance in the Administrative State: 9/11 and the Financial Meltdown of 2008 (November 13, 2008). U of Chicago Law & Economics, Olin Working Paper No. 442; U of Chicago, Public Law Working Paper No. 248; Harvard Public Law Working Paper No. 08-50; Harvard Law School Program on Risk Regulation Research Paper No. 09-04. Available at SSRN. In response to the attack on his reliance on Carl Schmitt (see below), Posner said the public will generally blame the President when the economy goes wrong because they won’t be able to figure out what the real causes are. They expect the President to do that and to make any needed adjustments. (Yes, and how realistic is that?

Kenneth Scott

Kenneth Scott. Need to avoid the problems of executive power. Disagrees that Madisonian view fails. Housing crisis was not unforeseen. Data were quite accessable. Financial regulators had ability to push back but not the will. 2007 hundreds of downgrades, redemptions halted, Bear Sterns collapsed. Gov didn’t act sooner. What was lacking was insight into the magnitude of the fall. Congress kept pushing high risk lending.

Most of the regulations required by Dodd-Frank have nothing to do with the origins of the crisis. Sees a question around due process for liquidations. Under Dodd-Frank, if the Treasury Secretary makes a determination there is 24 hours to appeal and judge. That provision is nothing but a fig leaf.

Scott strongly took issue with Posner’s reference to the account of lawmaking in the administrative state offered by Carl Schmitt (a Nazi), as opposed to the standard Madisonian view. In his opinion, we must find practical solutions that include and honor separation of powers. For more on the debate surrounding Schmitt, see The Anatomy of Antiliberalism. See Scott, Kenneth E., The Financial Crisis: Causes and Lessons – Ending Government Bailouts as We Know Them Part I – The Crisis (December 10, 2009). Rock Center for Corporate Governance at Stanford University Working Paper No. 67; Stanford Law and Economics Olin Working Paper; Journal of Applied Corporate Finance, Vol. 22, No. 3, Summer 2010. Available at SSRN.