Law and macroeconomics – the global evolution of macroprudential regulation

When we say law and economics, it usually means micro. In this speech, Randal Quarles of Federal Reserve in this speech says law and macro are connected as well:

Yet, while we have called this law and economics, it would be more precise to call it law and microeconomics. Both law and microeconomics are centrally concerned with incentives—how are they constructed, how do they operate, how do legal or economic actors respond to them—and the interplay between these different ways to think about incentives has been a natural and fruitful focus of investigation in a broad range of legal studies: tort law, property law, criminal law, contract law, corporate law.

But both law and economics are also centrally concerned with systems, the performance and relationships of broad aggregates of laws or economic activity. Not merely how do individual actors react to changes in incentives, but how do large-scale combinations of actors respond to changes in systems: how are legal or economic systems constructed, how do they operate, how do those systems constrain wide areas of human activity. The interplay between those two ways of thinking about systems would seem to be as natural and fruitful a focus of investigation as is law and microeconomics, but it is only just beginning to be thought of as a field in itself.

For a concrete example, think about the often observed fact that corporate profit margins have been increasing steadily over the last few decades. Law is likely to have been a significant element in this evolution, but not any individual law. Rather an entire system of laws—laws relating to corporate governance, corporate combinations, taxation, litigation, labor—have evolved over an extended period of time. And, under this theory, one outcome of this system—higher corporate profit margins—would likely give firms greater scope to increase wages without increasing prices, thus offering a potential explanation for the flattening of the Phillips curve, the traditional macroeconomic relationship between the unemployment rate and inflation. For a policymaker who accepted this theory, his comfort in maintaining a very low rate of unemployment could depend significantly on his understanding of that underlying legal system and his estimation of how its evolution would likely proceed in the future.

Thus, the formal union of law and macroeconomics should seek to examine the interplay between a legal system and macroeconomic outcomes, above and beyond the connections a particular law may have with its impact on human behavior. Scholars and policymakers have spent our time primarily thinking about the impact of single laws, but it is appropriate to focus more broadly, especially since we have in fact repeatedly sought over the past century to revamp our system of laws to improve macroeconomic outcomes.

He says in Great Depression both law and macro (which emerged as a new field) collaborated:

Consider the roaring debate in the half-dozen years after the 1929 market crash that led to the establishment of the foundations of federal financial regulation in the United States. Laws creating the Federal Deposit Insurance Corporation and a federal deposit insurance and receivership framework, establishing the Securities and Exchange Commission, and greatly expanding the responsibilities and capabilities of the Federal Reserve System were very purposefully intended to help restore confidence in the U.S. financial system as a necessary condition to foster a recovery from the devastation of the Great Depression. In essence, we designed and implemented a new system of financial regulatory laws to alter macroeconomic outcomes, not only to affect individual behavior. The debate around those laws, in the 1930s, was not an academic one, because the pain and suffering of that era was evident—at the time Congress was debating the Banking Act of 1935, which established the modern framework for the federal bank regulation and supervision, the unemployment rate in the United States was still 20 percent.

I will leave to others the question of whether every detail of the laws passed in this period was equally effective, in the short or long term, in promoting macroeconomic stability. But we should recognize that rules to promote financial stability and a healthy economy have deep roots in the American legal tradition.

Same thing in 2008-09 crisis:

The events of 2008–09 redefined our mission by more explicitly connecting macroeconomic and financial stability, as in the 1930s. Congress and the executive branch embraced a sweeping response, designing a system of laws to reflect a recognition that the cumulative, interconnected behavior of financial institutions had implications for financial stability and that even the behavior of a single large and complex institution could have implications for financial stability. This new system was also adopted at the international level. Starting with the G20 summit in Washington, D.C., in November 2008, the global community established the runway for a structural change. The subsequent G20 summit in London led to the establishment of the Financial Stability Board (FSB), with a strengthened mandate as a successor to the Financial Stability Forum. Subsequently, including at the following summit in Pittsburgh, world leaders agreed that the supervision of individual financial institutions had to account for the financial system as a whole, and it was recognized that shocks could originate from within the system and could spread to institutions with common exposures. In other words, the supervisory framework had to be macroprudential—focusing on mitigating systemic risk and accounting for macroeconomic consequences.3 This reorientation was a defining part of the 2010 Dodd-Frank Act, and internationally, in the Basel III Accord.

Section 165 of the Dodd-Frank Act, in particular, requires the Board to implement heightened capital and liquidity standards, concentration limits, and stress testing—all to further the macroprudential purpose of preventing or mitigating risks to the financial stability of the United States. As I will discuss later, the Board has followed through with rules such as the G-SIB surcharge, the liquidity coverage ratio, and single-counterparty credit limits, just to name a few; and, importantly, we have used macroeconomic considerations in calibrating some of these rules.



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