10 June 2014

The Case Against Cost Benefit Analysis

This Article draws lessons about the theory of law and economics from the recent financial crisis. It argues that the financial crisis teaches us that allocative efficiency, the main goal of law and microeconomics, proves an unattainable and relatively unimportant goal for laws addressing complex systems. It shows that complexity and the institutional role of law make calculation of optimal rules impossible for complex systems like those addressed through financial regulation, intellectual property, antitrust law, environmental law, and national security law.

Drawing primarily on the financial crisis, this Article identifies the features of complex systems that make mathematical calculation of costs and benefits impossible. Apparently recognizing that complexity defeats identification of optimal rules through cost-benefit analysis, law and economics scholars have used assumptions of rationality and perfect information as a substitute for quantitative analysis. The financial crisis teaches us that this CBA-substitute dangerously supports deregulatory ideology. Furthermore, the dynamic nature of complex systems renders any equilibrium between costs and benefits short-lived and therefore of relatively little value.

This Article also shows law’s institutional function as providing a framework that can accommodate a variety of transactions makes prediction of efficient outcomes extremely unlikely. For this institutional role implies that law does not usually determine resource allocation.

This Article addresses the question about what to do about law and microeconomics’ failure by proposing a more macroeconomic approach to law. This economic dynamic approach would treat law as an effort to countervail negative trends over time with a goal of avoiding systemic risks while keeping a reasonably robust set of economic opportunities open. It sketches a methodological approach to accomplishing these goals rooted in institutional economics and the best practices of law and economics scholars.
From the Abstract to David M. Driesen (Syracuse University - College of Law) has posted Legal Theory Lessons from the Financial Crisis (40 Journal of Corporate Law, 2014, Forthcoming) via the Legal Theory Blog.

I agree that economics has failed at the goal of making complex systems sufficiently predictable to legislate based upon those predictions, although I would fault macroeconomics more than microeconomics.  In particular, even state of the art sophisticated macroeconomic policy is insufficient to prevent the boom-bust business cycle from progressing, or to identify and prevent economic harm from bubbles in particular microeconomic markets.

I further agree that given the impossibility of preventing serious recessions, the better course is to adopt policies that make the economy more robust and mitigates systemic risks where possible.

I also agree that Cost Benefit Analysis is more art than science and can be grossly inaccurate, although it bears recognizing that in some policy areas, such as environmental regulation, Cost Benefit Analysis tends to underestimate the benefits of policy action relative to the costs, rather than to overestimate it.  And I agree that the assumption the lassiez faire deregulation with lead to maximal economic and allocative efficiency is naive.

On the other hand, the fact that the available policy tools provided by economics are imperfect does not mean that they aren't valuable.  Every policy decision ultimately has a theoretical underpinning.  It is better to have a well validated theoretical underpinning than one that is ad hoc and may actually be strongly contradicted by empirical evidence.

Many of the policy antecedents of the Financial Crisis can be well understood from a microeconomic perspective, even though the fact that the consequences of failing to heed microeconomic directives would be immense at a macroeconomic level was not at all obvious.

For example, one of the core proximate causes of the Financial Crisis was a housing bubble.  It turns out, in fact, that this housing bubble was not a national issue, but was overwhelmingly driven by a housing bubble in states where state law provided that residential mortgages were "non-recourse" which is to say that losses from a collapse in housing prices in excess of the down payment were solely experienced by the lender and were not the responsibility of the borrower.  This created a moral hazard encouraging borrowers to buy new homes on a leveraged basis even if they could not afford them because the down side risk was small.  Thus, flawed state mortgage foreclosure laws in a handful of economically important states like California and Florida, led to the collapse of the financial institutions that capitalized this lending which led to a severe national recession.  Better microeconomic policy analysis might have discouraged states from adopting non-recourse mortgage policies and prevented the financial crisis.

In sum, the part of economics that failed in the financial crisis was largely macroeconomic.  Refocusing macroeconomic policy on making a complex economy more robust, rather than maximizing economic growth, the traditional focus of macroeconomic policy, would be a worthwhile step to take.

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