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.




I know that the bias on this website lies heavily in favour of de Tocqueville's 'tutelary deity' of the state and that few of its commentators have any faith in the ability of those arrangements which might emanate spontaneously and co-operatively from the private sphere to solve the manifold problems of life, but the cartoonist has misfired badly here in his/her attempt to denigrate the free market by means of this imagery.

In the first instance, I think you will find that where such 'shared space' experiments have been conducted - starting with Drachten in the Netherlands - the removal of traffic signals and the concomitant increase in the perceived 'riskiness' of the approach to a junction have LOWERED, not raised, the accident rate.

More fundamentally, under our pernicious contemporary system of state-backed and state-controlled banking, the contrasting illusions that (a) the ilk of the Greenspan caricature so depicted can and must 'regulate' away all the dangers associated with banking and (b) that legally-privileged, taxpayer-supported, central bank-cosseted commercial and investment banks, as presently constituted, are in any way paragons of the free market, much less exemplars of individual- or corporate-responsibility, represent a gross misperception of the truth.

In fact, banks are little more than the creatures of those omnipresent, intrusive, 'soft totalitarian' regimes whose chronic financial difficulties they do so much to allay and whose yawning 'democratic deficits' and constitutional flouting they thereby help to paper over. The quid pro quo for their routine complicity in Leviathan's worst excesses is, of course, that they are the prime beneficiaries of that Monster's discriminatory largesse (one derived, of course, from the lavish disbursal of Other People's Money).

If we not only had no stop lights, but no Greenspanian traffic cops to police them, whether or not such oversight was well conducted, then, much like a motorist anxious not to occasion harm either to himself or others at an unmarked crossing, free-standing banks would never have put themselves in a position to crash the economy. Nor would they have subsequently enjoyed the relief of having politicians, bureaucrats, and biens pensants of every stripe falling over themselves to ensure the survival of those few who did, nonetheless, miscalculate, all the while hypocritically blaming the 'banksters' for the failings of their, the political elite's, own policy preferences!


Interesting article that responds well to the above comic.

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