The Institute Blog

Katharina Pistor: The Legal Theory of Finance

Bad theories can have very real consequences.

The most recent example was the 2008 financial crisis, which showed that inadequate theories about the financial system can help create a systemic collapse.

But did economists learn their lesson?

Despite the examples of both the failure of rapid privatization in formerly socialist countries in the 90’s and the recent crisis in 2008, there is still a very big gap in the economic theories underpinning the financial system: the interaction of law and finance.

According to Institute for New Economic Thinking grantee Katharina Pistor, economists still conceive of law too narrowly, mainly as a means to reduce transaction costs and protect investors.

With her grant from the Institute, Pistor, a professor at Columbia Law School and the director of Columbia Law’s Center on Global Legal Transformation, developed a Legal Theory of Finance (LTF) that makes big strides in filling this blind spot.

Pistor focuses in particular on the paradoxical relationship between law and finance. On the one hand, finance needs law to provide credibility. After all, financial assets are contracts, the value of which depends on their legal validation. But on the other hand, changing conditions in the financial world over time necessitate flexibility in law. An overly rigid legal system can bring down the entire financial system in times of crisis.

Pistor’s theory yields many new insights and raises important questions about the financial system.

One of these issues is the tradeoff between systemic stability and fairness in the financial sector, which was examined by Kathryn Judge in the first post of a new series hosted by Columbia Law School’s Blue Sky Blog that looks at finance through the lens of Pistor’s recently published article in the Journal of Comparative Economics, “A Legal Theory of Finance.”

Looking at Pistor’s framework, Judge highlighted the case of 2008 when the Fed provided support to AIG to illustrate Pistor’s finding that “liquidity support can function as a substitute for treating law as elastic.” In another post in the series, Jeremiah Pam acknowledged the insightfulness of Judge’s article but suggested that the key choice for the role of law in financial crises was not a binary one between inelastic or elastic enforcement of legal obligations but a more complicated decision that included a third alternative, which he called the “bailout option.”

Cathy Kaplan took a slightly different angle, focusing on the US mortgage market, specifically the creation of Freddie Mac in the 1970s, to show the development of markets as a result of changes in legal structures. Similarly, Richard Shamos used the example of the Dodd-Frank bill to illustrate that the alterations in financial products and markets were triggered by the introduction of new regulatory laws. James P. Sweeney called Pistor’s results a welcome change from the neoclassical paradigm and identified her work as a new attempt towards an old goal – understanding the financial system. 

Other comments on Pistor’s work in the series included “Elasticity, Incompleteness and Constitutive Rules” by Bruno Meyerhof Salama and Osny da Silva Filho, and “Rules, Institutions and the Legal Theory of Finance” by Anna Gelpern.

Concluding the series, Katharina Pistor responded to the comments on her work in her post “LTF – The Work Ahead.” She emphasized the initial stage of LTF and explained that there are many difficult questions the theory has yet to answer. Pistor expressed her hope for developing answers for these questions further with the Global Law in Finance Network, which is a collaboration between Columbia Law School and Frankfurt and Oxford Universities.

As Columbia’s series shows, Katharina Pistor’s project is proving to be increasingly important in an attempt to create a comprehensive theory of the relationship between law and finance. Pistor’s framework challenges how we view the financial sector and will help fill key gaps in our understanding of it. Her innovative work is exactly the kind of interdisciplinary thinking that economics needs in order to stop repeating the same old mistakes.

To see all the posts in the series on Pistor’s Legal Theory of Finance, visit Columbia Law’s Blue Sky Blog.