The Volokh Conspiracy

“Everyone loves money. That is why they call it MONEY.” – David Mamet.

The trillion-dollar coin is a proposal to avoid the debt ceiling through a loophole in a federal statute that authorizes the U.S. Mint to coin platinum in any denomination. Platinum is reserved for commemorative issues, and the obscure statutory provision was certainly not intended by Congress to authorize the effective borrowing of a trillion dollars, but as a statutory matter, the trillion dollar coin may work.

I have not examined the matter too closely, but at least one constitutional question pops up here.

Congress is authorized to “coin money.” The proposed trillion-dollar coin is certainly a coin – but is it money? Money is created for circulation. As Justice Story put it in his Commentary on the constitution, the power to coin money is designed to “preserve a proper circulation of good coin of a known value.” Vol. 2, § 1118. That is why it is put into the convenient form of coins or bills. Specie never intended for circulation, one might argue, is simply not money.

The link between circulation and coinage has been noted by courts, though obviously nothing has been decided, at least as far as my brief inquiry revealed. Veazie Bank v. Fenno, 75 U.S. 533 (1869) (“It cannot be doubted that under the constitution the power to provide a circulation of coin is given to congress.”)

Let us turn to the dictionaries. “Money” is “metal coined for public use,” according to the 1788 edition of William Perry’s The royal standard English dictionary. This may lead to a debate about what a “public use” is, reminscent of the “general welfare” question in the Spending power. I would guess it means “use by the public,” a view supported by “Metal coined for the purposes of commerce,” according to the 1789 edition of Sheridan’s Complete dictionary of the English language.

There are of course many potential rejoinders (aside from the possibility that the money/circulation property is specious.) The transfer to Treasury could be deemed circulation, but this I think weak. More seriously, one would point out that all non-circulating commemorative coins would thus be unconstitutional. OK – but has any court said that they are constitutional? Apparently the making of such coins did not begin until 1892, so as an originalist matter, their long-standing existence does not prove much. Presumably no one ever had reason to make issue over their issue. And not all commemoratives are non-circulating.

In any case, I doubt this proposal will gain currency with President. He has previously dismissed the constitutional legitimacy of formalistic gimmicks and “procedural tricks,” like the Senate declaring itself in session to avoid recess appointments. Back them, the White House counsel said that since the Senate was “functionally” in recess, that is what counts. Presumably here they will see that this is “functionally” a money supply policy not authorized by Congress in evasion of a debt ceiling that was.

UPDATE: I have amended this a bit shortly after posting it.

(Update.  Megan McArdle has a number of interesting comments and posts on foreclosure, modification, the effect of securitization, and the processes for recording title and other things.  This blog post has very interesting comments as well.)

Adam Levitin writes at the ForeclosureBlues blog about the Ibanez decision in the Supreme Judicial Court of Massachusetts (pdf via Creditslips blog), handed down last Friday.  (Actually, I think Adam’s post originated at CreditSlips.) This is an important decision in addressing the exceedingly vexed and, as Megan McArdle notes, highly technical legal questions surrounding the property issues – chain of title, etc. – in foreclosures on mortgages that have been securitized.  Levitin offers this assessment of the holding in Ibanez (I recommend also his article with Anna Gelpern, Rewriting Frankenstein Contracts):

The Ibanez case itself is actually very simple. The issue before the court was whether the two securitization trusts could prove a chain of title for the mortgages they were attempting to foreclose on.

There’s broad agreement that absent such a chain of title, they don’t have the right to foreclose–they’d have as much standing as I do relative to the homeowners. The trusts claimed three alternative bases for chain of title:

(1) that the mortgages were transferred via the pooling and servicing agreement (PSA)–basically a contract of sale of the mortgages

(2) that the mortgages were transferred via assignments in blank.

(3) that the mortgages follow the note and transferred via the transfers of the notes.

The Supreme Judicial Court (SJC) held that arguments #2 and #3 simply don’t work in Massachusetts. The reasoning here was heavily derived from Massachusetts being a title theory state, but I think a court in a lien theory state could easily reach the same result. It’s hard to predict if other states will adopt the SJC’s reasoning, but it is a unanimous verdict (with an even sharper concurrence) by one of the most highly regarded state courts in the country. The opinion is quite lucid and persuasive, particularly the point that if the wrong plaintiff is named is the foreclosure notice, the homeowner hasn’t received proper notice of the foreclosure.

Regarding #1, the SJC held that a PSA might suffice as a valid assignment of the mortgages, if the PSA is executed and contains a schedule that sufficiently identifies the mortgage in question, and if there is proof that the assignor in the PSA itself held the mortgage. (This last point is nothing more than the old rule of nemo dat–you can’t give what you don’t have. It shows that there has to be a complete chain of title going back to origination.)

I don’t think it is too much to ask the financial services industry to follow the rules on title and transfer.  I have been surprised by how many people, including lawyers, have simply said that intentions were clear even if the requirements of transfer were not followed.  I don’t think that’s good enough, not for the past and less so going forward.  There are reasons why we treat transfer of property, and real property and associated rights, differently than contract.  I have no doubt that things are much more complicated than I imagine, but with computerization and technology, on a regulatory reform basis, shouldn’t we be able to do a whole lot better than this?

What would a rational, going forward system of title and transfer look like – tell me in ways that take advantage of technology as it is, not some imagined possible world, and tell me ways that match up to things already being done in the securities industry.

While everyone is at it, tell me how we should address the Frankenstein hangover of the past.

(Note: I was writing this on the plane without quite being able to see the computer screen, so I’ve gone back and corrected some grammar and spelling, and tried to make a couple of things clearer.  I’ll post separately as well on the topic of national security and the financial crisis, and the role of executive discretion in responding.  But I also wanted to note that over at The Conglomerate, the compadres there are also having a discussion of Professor Skeel’s book, including my friend David Zaring, who, along with the redoubtable Steven Davidoff, was responsible for a seminal article and concept in this question of discretionary regulation, “Regulation by Deal.”)

Flying to and from meetings this week at the Hoover Institution, I re-read David Skeel’s brand-new book, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (Wiley 2011), for a second time. I am even more impressed with this book the second time around, and I believe that it is one of the short list of essential books on the financial crisis and the regulatory aftermath. If you have any interest at all in these topics, this is a book to give serious consideration to reading.

The New Financial Deal is very far from being a dense, specialist book readable only by a lawyer, or law professor, or bankruptcy or finance expert. You might guess from the title that the book is a technically useful, but, for the general reader, impenetrable commentary on the Dodd-Frank bill. After all, the bill itself runs several thousand pages of impenetrable legislative language and Skeel himself one of the country’s leading bankruptcy scholars. It might seem from the title that it is simply an unpacking – at the technical level – of what Dodd-Frank says. Technical experts can benefit enormously from such unpacking, but not so much the policy person or general reader.

But it’s not that. On the contrary, Skeel’s considerable achievement in this book is to write accessibly and persuasively about the Dodd-Frank bill. Skeel is an an admirably clear and graceful writer on very difficult topics; it shows in the sentence by sentence prose, but equally in the overall organization and selection of topics for discussion. It doesn’t seek encyclopedic analysis of the zillions of legislative provisions, but instead makes a judicious and profoundly informed selection of the main achievements (and lack thereof) of the legislation. It then succeeds better than anything I’ve read on the topic of financial regulatory reform at placing this in the context of “political economy.”  I don’t mean politics in the day to day sense, but instead the interaction of these financial rules with the political process and the intended and unintended consequences.

II

Corporatism and Brandeis-ism, and the New Resolution Authority

The fundamental reform measures of the Dodd-Frank bill correspond roughly to financial institutions and financial markets. As to institutions, Skeel examines the new mechanisms designed to address systemic risk and the mechanisms created to address supervision of those institutions both before a crisis and after the effective failure of an institution.

The political economy of this institutional supervision is given as two alternative tendencies in American economic regulation. One is the “corporatist” tendency to create a quasi-partnership between government and the largest corporations, so that government is able to exercise in some respects closer control over those corporations but also bending them to its political will – but losing the distance between regulator and regulated that usually makes regulation more effective and more importantly ensuring that those privileged institutions will not be allowed to fail, at least if they play political ball.

The other is what Skeel astutely calls the “Brandeisian” tendency to break up the largest financial institutions so that they cannot become too big, or too interconnected, to fail. He notes – this might surprise some readers – that the New Deal, however empowering government in many matters, was essentially Brandeisian on the treatment of banks, insisting on confining them in function (Glass Steagall, etc.) and in many other ways.

The tendency adopted by both the Bush and Obama administrations has been firmly corporatist. It is evident in the definitions in the Dodd-Frank bill of institutions formally designated as systemically important, but also thereby too big to fail. The corporatist tendency is also a founding feature of Freddie and Fannie, and the extraordinarily politicized activities of both firms as integral to their business models – both buying off Congress and yet chanelling the political will of administrations and bureaucracies – is what Skeel suggests will result from the corporatist model, quite apart from the problem of a lack of moral hazard leading to a regime of permanent bailouts.  (Too big to fail is sometimes correctly criticized as really meaning “too systemically interconnected to fail.”  This is right, but that translates to systemically interconnected firms that, with respect to this feature of risk, are “cartelized” as though they were a gigantic, if loosely, connected enterprise.)

Skeel’s other fundamental point concerning institutions is that the nature of regulatory authority is essentially unconstrained discretion. It is not discretion of the kind exercised by a bankruptcy judge – gap filling and interpretive and discretion existing only for defined issues, existing yes, but within a tightly bound box. It is, instead, one single non-discretionary norm – that certain institutions are too big to fail – but that everything else is discretionary (I exaggerate some, but it helps illustrate the point). It is discretion not as filling in the inevitable gaps, but instead deliberately widening discretion to cover as much as possible. Though Skeel does not frame it this way, I would describe it as “discretion as strategic ambiguity” in which the rule of law is set aside for the purpose of making it impossible to know how you will be treated: allowed to fail in some cases, taken over in others, not allowed to fail and not taken over, with no standards for knowing what results in what. This is the criticism that Skeel makes of the new “resolution authority” for institutions.

Skeel’s deepest normative point, however, is that the regulatory model deliberately undermines the rule of law – particularly the careful establishment of judicial discretion contained with bankruptcy’s special rules of law. Instead, the Dodd-Frank model finds predictable rule-based regulation inapposite to the task at hand and seeks to displace it by deliberate uncertainty, on the one hand, infused with government’s political preferences, on the other. The political preferences are analyzed against one of the most provocative but also, to my mind, persuasive turns of Skeel’s argument: to show how the auto bailouts are the template for the future bailout regime of the financial institutions. The short, accessible yet expert discussion of the treatment of senior creditors in the auto bailouts is outstanding – but most important is how Skeel shows that this, rather than the earlier bailouts in the financial services industry, is the template for future behavior under Dodd-Frank. That, and Fannie and Freddie. Continue reading ‘David Skeel’s Excellent Book, and Comparing Discretion in the Financial Crisis and National Security’ »

I am curious as to whether any law school offers a (seminar?) course on the law and regulation of central banking, either specifically on the Fed in US domestic law or else something like “comparative central banking” in the transnational law curriculum.  I’d be interested in responses as to courses, syllabi, reading, and course topics.  Serious responses please; no rants or off topic responses.  (Let me add that I don’t mean exactly what typically features in the banking course, which is, in my experience, less about the law governing central banking than the legal mechanisms by which the central bank interacts with the rest of the banking and financial services sector.  They are not quite the same thing.)

The legal powers of the Fed – and their limits, regulatory, statutory, and Constitutional – are obviously a question of importance today.  The financial crisis, the response, and the continuing unemployment rate make the question of the Fed’s mandate, independence, and limits germane in a way that has only rarely been true in the economic history of the US since creation of the Federal Reserve.  Consider one of the latest arguments – will the Fed move to monetize the fisc, meaning the fiscal deficits of states and municipalities, as a source of – not liquidity of last resort – but instead as a provider of solvency?  A George Will column expressed the concern, set against public pension issues, this way:

People seeking backdoor bailouts hope that the fourth branch of government, a.k.a. Ben Bernanke, will declare an emergency power for the Federal Reserve to buy municipal bonds to lower localities’ borrowing costs. This political act might mitigate one crisis by creating a larger one – the Fed’s forfeiture of its independence.

Will obviously has a side in this debate, but that is not what interests me; it is that the law governing central banking is up for serious debate in a way that is historically not often true.  Please leave aside any comments as to the policies involved, good or bad.  I am interested in understanding the underlying sources of law and regulation at issue here.  If the Fed were so to act, are there legal limits on the ability of the Fed to act in this way – and does it matter one way or another, as a matter of law, if Congress has declined to provide a fiscal bailout?

I am also particularly interested in anything offered somewhere in the law school curriculum on comparative central banking, in universities here in the US or elsewhere.  Again, same interest in curricula, syllabi, readings, etc.

Update:  Thanks for the responses below, they are very helpful, and I’ll be in touch with Eric and some others mentioned below.  I’ve deleted some comments that are not relevant to my inquiry; I’d like the comment thread to be useful to people who are searching for the same materials I mention in the post, and don’t want other things there.  Also, I should add that I’m not actually contemplating teaching a class on this topic – I don’t know whether there is enough material for a course on the law of the Fed or not, although I do think that a comparative central banking course surely offers sufficient materials.  Rather, I would like to know more about the area substantively, and this seemed like an easy way in.  As well as helpful to others looking for materials in the field.  Thanks everyone.

Over at the business law professor blog, The Conglomerate, the book club has been reading Bethany McLean and Joe Nocera’s book on the run-up to the financial crisis, All the Devils Are Here: The Hidden History of the Financial Crisis.  David Zaring introduces the book, his brief take, and the book club discussion here - then scroll up for the other mini-reviews and comments.  The Conglomerators think the book is worth reading, and I’ve just ordered it.  (For my own part, I have just finished a second, closer read of David Skeel’s The New Financial Deal, which is outstanding, and on which I’ll post a short review later.)

Although I have a few reservations about the tone of the article being just slightly conspiratorial, Louise Story’s front page NYT story today on the evolution of derivatives clearinghouses is highly informative and very well done.  The graphics showing how the bilateral trades would turn into centralized clearing are quite good and would be useful with a class.  On balance,  I think the overall shift to centralized clearing is a good move.  But I also have a bad, bad feeling about this in the context of Dodd-Frank and future expectations.  As I have said in past posts, in a future of financial regulation in which the central question of systemic risk and moral hazard has not been addressed, the result of what is otherwise a sensible move (yes, yes I’m skipping over all the concerns about end-users and Main Street, etc.) could turn out to create not so much a central clearing house but instead ... a central address for depositing unwanted risk.

After all, why should any of these leading market participants believe at this point that the government would allow the central clearinghouse to burn down in a crisis?  And if they don’t believe that, then what is their incentive to set terms that will adequately address the risk as a matter of private ordering of fees, margin, whatever form of insurance the central risk-clearer needs? Having a central clearing counterparty is a great idea – if it and the actors that run and control it have the private incentives to make sure it is not a mechanism for accumulating and compounding risks.

Presumably the answer is that government regulators will set those requirements and solve the problem.  But the general theory of financial regulation used to be that systems would be monitored for risk-taking, after private parties (with well-structured incentives forcing them to internalize the risks) had already made the first round of risk-decisions.  Regulators would be kicking the tires for safety and soundness, as a second line of regulatory defense, not the first.  I am an admirer overall of Gensler’s efforts, but he cannot be Batman to Financial Gotham.  The peculiarity is that a structure that ought, in principle, to reduce risk might wind up leveraging it.  The clearing house might turn out to be the one address market participants need to send their unwanted risks.

ps.  Here are a couple of possible unaddressed risk scenarios:

• The clearinghouse turns out to be pretty good at managing fairly predictable, day to day risks.
• The clearinghouse turns out to be okay at managing day to day risks, but is not good at identifying or dealing with risks that arise over a long run of time from relatively minor distortions in the system’s incentives, perhaps arising from conflicts and complexity of those who own and run the clearinghouse and their other activities, perhaps other things.  Those distortions over time start out small but turn out to be large and compounding and structurally invisible or discounted until they blow up.
• The clearinghouse’s private managers turn out to be good at managing day to day risk; Mr. Gensler, et al. turn out to be okay at forcing the clearinghouse and its private owner-managers to internalize risks caused by apparently minor distortions as they arise, because the public regulator is pretty good at spotting conflicts, even amidst complexity, and has an institutional mandate to pry apart conflicts of interest, even if it angers the banks.
• The system centralizes tail-risk, radical uncertainty.

If the clearinghouse system could achieve the third as its long term behavior, then I think it is on balance a good move.  The fact that the fourth exists is not a reason not to create an otherwise rational scheme of regulation; if it is, nearly by definition, unforeseeable with sufficient specificity to prevent it from happening, that might be a pretty good definition of what the role of institutional and liquidity provider of last resort is supposed to be.  One of the peculiarities of financial regulatory reform, after all, is that one can always object to nearly everything on the grounds that there is radical uncertainty and there might be unforeseen and unpredictable consequences ... so better not do that.  Or that, or that, or that.  But of course not doing anything at all is also doing something with equally radical uncertainty.

I sometimes think that we should all re-take Philosophy 101 in Skepticism and Rationality in embarking on academic discussion of financial regulation and risk.  What is the appropriate kind of skepticism about the limits of our rationality in creating regulatory systems for complexity?  Sometimes I ask a question about what I think is a fairly concrete, rationally predictable thing in financial regulation – close, in my mind, to asking what the weather is likely to be tomorrow – and get an answer back that sounds a bit too much like, “We cannot say, because after all we have no proof of the existence of the external world.  La vida es sueno.”

Hmm, I think, vale. It is a little like what the late philosopher of mind Rogers Albritton referred to as the skeptic’s devious willingness to shift to another existential form of skepticism just when we thought we had answered him on this one, but not quite saying that he had shifted skeptical grounds.  (“Shapeshifting skepticism,” one might call it.)  We ordinarily wouldn’t worry much about this possibility, obviously – except that many people think we just experienced this radical uncertainty, come to pass, in the financial crisis.

Other people think, of course, that it was imminently foreseeable, if not because of the actual (disputed) causes, then because the procedural combination of complexity, conflicts of interest, and moral hazard driven complacency strongly implied something that could not go on as it was going – a matter of a visibly flawed process, so to speak.  If that is one’s view, however, then the lurking question of number four is less whether the tail risk was actually foreseeable and preventible, but instead whether relations of complexity of systems, conflicts of interest, and attendant complacency meant that no one had enough at stake to find it.  In which case, the prescription for public regulators in regulation is less to try and find it, than to give all those other, deeply interested, but also potentially deeply conflicted, parties reasons to overcome their complacency and conflicts, and have them dig through the complexity to find it, instead.

(Moreover, the point of providing liquidity as the provider of last resort in number four is in order to allow markets to make an orderly path to price discovery that is not simply a strategically forced run on the banks.  It can’t magically remake insolvency into solvency except by fiat – or fiat money.)

The Wall Street Journal and New York Times each have good, comprehensible explanations of the eurozone sovereign debt crisis on the front pages today.  (The Journal has a particularly useful graphic that breaks out each country.)

While I wait for David Skeel and William Cowan’s new book on the Dodd-Frank financial reform bill to appear next month (The New Financial Deal), I have tried to make my own assessment of what the bill means in the aggregate.  In order to do this, I have read the bill in its entirety twice.  The first time was when the bill was first passed, and this was in order to see if anything in it took me by total surprise.  That amounts to a search for particular nuggets that jump out at you, not the “totality” of the bill.  I’ll add that he experience of reading the entire thing as a “thing” made clear to me why “reading” bills before you pass them, if it is a good idea, needs to mean “reading” in a really different way.  You have to read the bill with all the cross references to other legislation being amended to hand in advance, and a staff of experienced people to make sure that you know the context into which this change or that fits.  One hopes, of course, that this was also part of the drafting of the bill ... but let’s pass over that detail.  (Update:  I just ordered Skeel-Cowan from Amazon.)

The second time around reading it was not for nuggets, but instead to try and understand the whole thing, as a comprehensive thing.  I realize that this makes little sense given that it is not a “thing” but an agglomeration of many things, some of which fit together and some of which don’t.  But this second time, I read it with some research help, and more importantly with the several hundred page bill summary to hand.  This was partly to understand the bill, but partly to get a reality check, at least for parts of the bill in which I have a good grasp of the issues, whether the summary is accurate as to the bill and its impacts.  I can report that for at least sizable chunks of the bill where I think I’ve got a strong sense, the summary is outstanding, and unless someone points out to me big areas where it is not, I’d urge those working with the bill to go to it.  I am open to correction on this point, if you are genuinely expert in these matters.

My one graf takeaway on the bill is this, however.  Parts of the bill have little relevance to the financial crisis, although they might still be part of an overall package of reform of financial regulation; one can always tell a story about how they have an impact on crisis through accumulations of bad issues, but realistically, whatever point they might have or not have – the consumer protection provisions come to mind – they are adjunct.  If the underlying rationale and point of the bill is to alter the regulatory conditions that allowed for the development of the crisis, then it should be fundamentally about addressing systemic risk, too big or too interconnected to fail, and attendant moral hazard; complexity, complacency, and conflicts, as Steve Schwarcz says.  As a substantive matter, however, the bill in total effect does not address too big or too interconnected to fail as a matter of private ordering, and so has the regulatory authority assume the moral hazard.  Which leads to this dismaying conclusion:  There are important parts of the bill that would make a great deal of sense (leave aside various particulars), in a regulatory environment that properly put the moral hazard of systemic risk on the private actors.  To take one example – and leaving aside the WSJ editorial today about Main Street’s risk management issues – the proposal to move OTC standard derivatives onto centralized clearinghouses that would both provide greater transparency and reduce the scary information asymmetries and provide for centralized clearing.  Great idea, with appropriate tweaks, in my view – until it becomes clear that because the bill does not put the risk burden on the private actors ultimately – does not force the private players to internalize their risks in derivatives trading, the clearing house and ultimately the taxpayer serve as the guarantor of last resort.  The effect of an otherwise sensible regulatory change in the derivatives market, under conditions in which moral hazard has not been addressed, is not to reduce systemic risk, but to leverage it up by centralizing it in the ultimate public counterparty.  The ironic result of the bill, in other words, is that by failing to address the systemic risk problem other than by telling the Fed and the Treasury and the “council” to figure it out, and so leaving too big or too interconnected to remain in place, otherwise sensible regulatory reforms that should reduce risk and increase transparency and informed pricing instead turn out to ratchet it up, leverage it up, for the ultimate government counterparty of last resort.  That’s not what I was hoping for.

Long graf, yeah, I know.  But while I await Skeel and Cowan’s book, I am willing to be told that this is not correct and I don’t understand what the bill does.  However, if you’re going to correct me, please confine discussion to the main issue here, which is the overall impact of the bill, taken as a whole, as defined by the systemic risk question.  I should also note, as I have earlier, that a very impressive theoretizing of systemic risk has just appeared from Steven Schwarcz and Iman Anabtawi, Regulating Systemic Risk.  It is the most striking attempt to give an account of systemic risk that I have seen in several years; what it consists in and how it propagates.  (I re-read it yesterday, and looking at the turmoil in the eurozone, wondered whether this same account could be applied to what we might call “sovereign systemic risk.”  I wonder.)

UPenn law professor and corporate finance and bankruptcy specialist David Skeel has an important article in this week’s Weekly Standard talking about the possibility and utility of bankruptcy for states.  The article argues first that a new chapter for states in the Federal bankruptcy statute would be constitutional, and then turns to argue, second, that the benefits to the public would be considerable:

When taxpayer-funded bailouts are inserted into the equation, the case for a new bankruptcy chapter becomes overwhelming. And it’s a case for Congress to move now on the creation of a state bankruptcy law.

With the presidential election just two years away, the pressure to bail out California, Illinois, and perhaps other states is about to become irresistible. As we learned in 2008 and 2009, it is impossible to stop a bailout once the government decides to go this route. The rescue of Bear -Stearns in 2008 was achieved through a “lockup” of its sale to JPMorgan Chase that flagrantly violated corporate merger law. To bail out Chrysler and General Motors, the government used funds that were only authorized for “financial institutions,” and illegally commandeered the bankruptcy process to give the car companies a helping hand. There is, in short, no law that will stop the federal government from bailing out profligate state governments like those in California or Illinois if it chooses to do so.

The appeal of bankruptcy-for-states is that it would give the federal government a compelling reason to resist the bailout urge.

This is an important piece of public advocacy by a leading scholar, agree or disagree with its two main contentions, and repays close reading.  (The illustration above is a thumbnail from the WS.)

Update:  Thanks, Glenn, for the Instalanche – but also for the very interesting updates at Insta, including some important comments and emails that I encourage VC readers to check out.

Also, Co-Conspirator Todd notes above the Stanford Law School conference on the Constitution and the Financial Crisis, at which both he and I spoke a couple of weeks ago.  It was a great conference, and CSPAN, as he notes, has put online a couple of the sessions.  One of them includes a discussion of bankruptcy and the auto bailout, and the lineup includes both Todd and David Skeel, UPenn professor and author of the above Weekly Standard article.

I have not tried to comment on the constitutional questions, as I do not have the expertise to do so.  But I wanted to make a different kind of point about bankruptcy processes that involve quite important areas of judicial discretion – equitable discretion in a generic sense – within a given structure of rules that can force creditor-parties who otherwise would not be likely to overcome collective action problems to come together.  Leaving aside constitutional questions that I am not competent to address, I favor as a policy matter something like Professor Skeel’s position.  Likewise, I favored bankruptcy as the proper process in the auto bailouts, among others.

That said, I express one caution (I’ve put up a longer version of it as a separate, later VC post).  When in a crisis, or contemplating responses to crises, we naturally look around and see an existing mechanism that seems to have worked pretty well.  Bankruptcy judges and courts, for example, in parts of the financial crisis.  We think that they have worked out pretty well how to cabin judicial equitable discretion in these matters within rules, precedents, codified law, etc.  So we collectively think, let’s assign them this big new thing – sure, it’s kind of a stretch (such as bankruptcy for states), but these mechanisms and actors have a stable procedural path that has been well worked out and well trod.

The risk here is that we do not take into account the way in which the addition of this new social and political and legal task is not just stretching existing institutions – taking on these new functions involves addressing whole new categories.  Bankruptcy of sovereign entities, for example.  It is categorically different, and has the effect of altering the nature of judging, because it just is, by its nature, political in way that no commercial activity is.  It alters the nature of discretion, the role of the judges, and how the judges see their role – how they cabin their discretion within a body of rules.  It alters the terms of legitimacy when they shift from purely commercial and private players to sovereign actors.

Now, I describe this as a risk and I perhaps overstate by calling it a category rather than a stretch.  After all, municipalities have been in these processes before, and states have defaulted before, and so an existing system might well simply grow into this role without warping it out of identification.  But it is a risk.  At a minimum, it should not be assumed that the mechanisms established by law for dealing with private actors within a structure of sovereign law can automatically work with sovereigns themselves, without altering the notion of “cabined discretion.”

Finally, note that this problem is by no means limited to this kind of financial crisis and bailout problem.  The same conceptual problem arises whenever judges are proposed to be tasked with some kind of new activity – precisely because we think that they embody both legitimacy and discretion.  Discretion that carries legitimacy because it is limited in many ways.  Think about arguments that we could have federal judges giving advance and necessarily secret review of targeting decisions for drone warfare attacks; or issues related to detention and rendition before the fact; or many other related issues.

The assumption is that judges have this legitimate discretion as an attribute of being a judge and that it can be carried around from political activity to political activity as an independent quality.  But of course it does not work that way.  Legitimacy, and equitable discretion that carries legitimacy, is a function of the activity and how it is not just legally, but also socially and culturally embedded with particular structures of law and sovereignty.  The exercise of those powers in ways that are alien to the terms of the judiciary – a judicial function that is embedded within the domestic structure of constitutional law, not a writ that runs to the world, to start with – seems to me inevitably to shift the nature and self-perception of the judiciary itself.

Judges start out reviewing national security decisions; they are gradually drawn in, as one speculative possibility, to police and enforce some rights concepts, until a bunch of Americans get blown up; and eventually the judges see themselves as being the political actors who make the decisions about the tradeoffs between security and liberty.  The judges that result from that process will not be the same, in their self-perception or legitimacy, as the judges that preceded it.

These are risks, not certainties.  But whether in the national security area or the financial crisis area – I draw here on some of Eric Posner’s comments at the Stanford conference on comparisons between the two – one must take appropriate account of the dynamic social nature of the process by which one assigns activities to actors that are attractive because they have discretionary authority and the legitimacy to exercise it.  The exercise of that authority changes with its exercise in new venues – and in ways that one might not anticipate or particularly want.

Having done a fair amount of work in microfinance and closely related areas (development finance involving business clients with larger-than-microfinance loans) in the developing world, I am overall a big fan.  As many people are.  The question that has long loomed, however, is whether it can or should scale upwards to become a full-fledged part of the global capital markets, or whether it should remain a highly subsidized development activity for very poor people or, most plausibly, some of both.  I wrote about this problem in an article in 2002 – asking whether sufficient attention had been given in the conceptualization of microfinance to the question of whether it was supposed to serve as:

• a genuinely economic connection between very poor people and the capital markets, or instead
• a kind of “faux-market” in which the tools of the market were deployed as a form of artificially sustained discipline over the efficient use of resource, but nonetheless massively subsidized and, in that sense, never genuinely part of the global capital markets but instead always some sort of philanthropy.

I, like everyone else I have known in this field, have wanted to see some of the first, some of the second and, most crucially, some kind of “venture philanthropy” merger of the two that would somehow combine:

• the discipline of genuine capital markets to induce efficient use of capital to promote geniune economic growth;
• access to much larger pools of capital than are available to government aidagencies or NGOs, through the commercial capital markets;
• subsidies or guarantees to facilitate the entry of for-profit entities into the sector, in order to help them gain experience with loan-making, monitoring, default, and other costs of microfinance, and to overcome the problem of microfinance’s problematic diseconomies of scale compared to other commercial lending;
• the many social benefits of microfinance for both very poor people and not-so-poor but still poor people as separate groups; and above all,
• scalability.

So, back in the 1990s, I proposed internally to the Open Society Institute structures of credit guarantee facilities that would allow a consortium of philanthropic and government aid agencies to offer part-guarantees to banking institutions seeking to enter the sector, with the aim of doing all the above good things.  At the time – and in most situations in which I’ve inquired about this since, with the very particular exception of India – the response from the microfinance organizations was, well, that’s nice – but as a matter of fact, at this point we don’t suffer from a general lack of capital.  We can get capital at a zero or negative capital cost in the form of interest free loans from governments or straight out donations.  We don’t need to tap the capital markets, even in a subsidized form at this point, thanks very much.  Maybe someday; not now.

The reasons why this is so are important.  The microfinance providers with whom I was speaking were generally in the business of microfinance for poor people in which the transaction costs were clearly extraordinarily high for the size of the loan and possible rate of return, if one took into account all the monitoring and active involvement with the borrowers, etc., etc.  And that was leaving aside completely the transaction costs of the foreign donors and any other upstead costs; it was just the narrow cost of a local NGO engaging in microfinance loans.  Everyone likes to tout – or anyway did like to tout – the fantastic repayment rates of these microloans as evidence of client creditworthiness .  But within the sector, practitioners have always been very clear that this is on account of large investments at the front end of monitoring and reliance upon the heavy hand of social stigma and joint and several liability (as a substitute for material collateral) of other members of a “lending circle” as disciplinary mechanisms to ensure repayment.

This is nothing new; microfinance practitioners, although sometimes evangelical in their zeal for it as a development tool, have a pretty decently practical streak, and recognize that this is a subsidized – heavily subsidized – activity when it comes to most clients.  It is another instance of the problem that much of development, as William Easterly tirelessly points out and Jeffrey Sachs seems gradually to be acknowledging, is not a scalable activity.  It takes place at the capillaries, and the blockages are not the mass flows of capital – it is what happens in the “last mile.”  Talking with a finance academic who has decided to start teaching in this area – he remarked somewhat ruefully, I can’t get my students interested in this because the whole point of finance is scalability.  But there are many extraordinarily bright and experienced finance experts, people who perhaps made some money on Wall Street and decided to do something more personally satisfying in the last fifteen years, who have been bringing an immense amount of sophistication to the problem of applying finance to development.  Parts of it have worked, and parts of it are showing the problems, which is a somewhat understated way of stating the current banking for the poor crisis in India.

The grail of transforming at least part of the sector into something that is genuinely economically sustaining, in the sense of covering its costs, and being able to scale up to the point that tapping the commercial markets for capital, has never gone away.  The attraction is greatest in India – second would perhaps be South Africa – places with many very poor people, many pretty poor people, many poor people, but globally connected, globally sophisticated, utterly first world banking sectors.

India, particularly, because the size of the internal market – in this as in many other things – but also an underdeveloped and underserved one, with takeoff underway in so many other sectors, has reasons to be attracted to this model.  Economic takeoff is going to require banking models that can reach to poor people in a commercial way; it’s not precisely microfinance, and not microfinance in the “faux-market” development sense I suggested earlier.  It is the search for a genuinely commercial product of banking for the poor that provides capital and banking services – but which manages to cover costs and return a profit.  NGO development programs cannot possibly serve the needs of all those people at that level; their specialization is with a different population of very poor people.

For all these reasons and more, I have been supportive of the efforts to try and commercialize banking for poor people, in India and elsewhere.  I’ve supported rich philanthropists putting money into these businesses in an effort to try and meld the doing good and doing well.  However, the melt-down underway in India of the current model certainly gives me pause, and the belief that a fundamental rethink of the intersection of doing good and doing well is in order.  The New York Times and the Economist each have good stories this week on the crisis in India for a company that went public in India as a microfinance lender.

It’s an economic, political, and social mess in India.  Yet, although it will indeed set back the commercialization of banking for the poor for quite a while, I am persuaded that it is not a bad thing to have to sit down and re-consider the premises of venture philanthropy and combined social-profit motivations.  I say this as someone who if, for example, the Open Society Institute or some philanthropist had invited to get involved in advising things, would have leaped in – I am confident I would have led down exactly this path.  I plead no special powers to have seen ahead.

However, with the benefit of hindsight, a couple of things are becoming clear.  The banking for the poor model has important similarities to the US subprime crisis.  Particular regions of India were deluged with capital that came cheap, in part because of the subsidies for it both implicit and explicit. Lending standards were relaxed, in part because the lenders were seeking to overcome the enormous hurdle of diseconomies of scale in tiny loans – the monitoring and loan-making costs for tiny loans.  But let’s add one important difference.  So far, microcredit – crucially and more exactly, within the analytic terminology of this post, “banking for poor people” – has not yet been securitized directly, nor has it had credit derivatives built on top of it.  As someone who has been occasionally involved trying to dream up upstream financing structures that could do securitizations and derivatives in this sector, I just would like to say that I’m glad that up to this point, the sector has not yet been leveraged up in those ways.  I’m not opposed in principle to the idea that “prudent” leverage could draw more capital efficiently into the sector; I just don’t think we have any way at this point of figuring out short of meltdown what that level is.  This should, of course, sound familiar.

The problems in India are problems of an excess of capital; poor incentives among the lenders (volume not quality, for example); and a failure to be realistic about the rates of return actually achievable by poor people even when they have availability to capital; etc., etc.  But they are still mostly at the level of the limits of poor borrowers; or, again, more precisely, what happens when poor borrowers meet global capital, in the form of expected returns that can’t really be expected (i.e., opportunity cost for global capital).  That is half of it – if you’re going to attract real global capital, you have to somehow manage to pay global capital rates and that requires economic activities that produce at least that net rate of return.

But, crucially, the other half that drives this sector is apparently opposite, but actually helps crucially swell the bubble, ratchets it up, because it is the nip that draws the cat of capital out of some better return elsewhere and into this particular place, so producing a bubble.  That other half consists of rich people, rich philanthropists, for whom the amounts are simply too tiny to worry about, not really.  It helps lead the herd of capital to indisciplined lending – not the only thing, of course, but an important component, and important component in the lack of clarity that surrounds rational choice in the sector.

But it also arises from some of the most celebrated new lending models that take advantage of the “retailization” of every encounter globally via the internet; one can exchange illegal child porn, or play chess, or make microloans all the way around the world.  The model, growing in popularity, for direct person to person lending, individual rich-worlder to individual poor-worlder, is great in one way – but let’s ask ourselves, is it such a good idea to have one-to-one lending on this basis?  Should we maybe ask ourselves why in the developed world, we use intermediaries and banks.  Sure, one answer is that a huge amount of informal lending takes place through friends and family, not intermediaries, and in a sense this model replicates that.  But, well, it doesn’t, because as we all know by now, the internet creates internet friends and family, not actual friends and family.  The social virtues, as Adam Smith would have described them, are not precisely the same across continents and over the internet as they are with people with whom one has actual, not virtual, social intercourse.

And then there is the problem that what is little money to George Soros or to me or you is really big money to someone in the poor world.  They need the money, but its efficient use requires that we take it seriously and that they take it seriously.  We don’t take it seriously.  How could we?  And yet the consequences of us not taking it seriously are an unsustainable bubble, asset inflation in already poor zones, many other bad things.  We just log off and go back to our real lives, but the effects can be – are – very real.

This is what makes The Onion so hilariously right, as it nearly always is – the ludicrousness of anyone in the first world pretending that this “lending” is anything other than “donating”:

Representatives from One World Finance, a U.S.-based microcredit provider, confirmed Monday that they had initiated foreclosure proceedings on a goat in southern India following a borrower’s repeated failure to make her $2.20 monthly loan payments. “I tried to work with Ms. [Subha] Thangam on this, but once she fell a full $6.10 behind, I had to repossess the goat,” said loan officer Michael Conrad, who stated that he was just doing his job and that it was “not [his] fault” if certain subsistence farmers were living beyond their means.

Let me be utterly clear that this is not an argument for not deploying the money; anything but.  It is needed in many places.  But the combination of easy money from the rich world that, if liberated from market discipline on the local end, can create vast problems, is one that has to be re-thought at this point, in the actual practice and alignment of incentives in this sector.  We are not willing to take the goat; but if we wish to avoid bubbles and the very real damage they cause, as well as what we somewhat too anodynely call “efficiently allocate capital,” we need to ensure that our capital goes to some entity that is willing to contemplate something close to that.  Otherwise it is not operating on the margin that matters in that society, and the results are almost certainly a bubble.  I can’t do that; you can’t do that; we need not to interact in a touchy feely way with our borrower-donee, but instead hand our money over to an intermediary that has the right incentives to find that margin.

One can pile up important similarities and differences, in other words, between India’s microfinance bursting bubble and the subprime crisis.  But let me focus on one that is perhaps less noticed.  I notice it as a similarity because it’s something that (as someone who works out in the gym in Fannie Mae’s basement in Washington DC), I have heard a lot over the past dozen years: a tendency to play a self-deceptive bait and switch between doing good and doing well.  I.e., the many conversations with Fannie Mae senior staff who, when things were going well, thought (what they thought of as) their mixed social-profit model must be great, and as things weren’t going so well, took comfort in the idea that they were doing good and this was merely a cost of doing “good” business.  Something like that seems to have been present here – which hardly surprises me because I confess to having been tempted to it many times, working in or advising organizations with similarly mixed motives.

The invitation to self-deception is high, in other words.  Bertolt Brecht wrote a play – famous in its day, and one of his writings that deserves to  live on – The Good Person of Szechuan, in which a young woman of tender and generous heart inherits a tiny shop, but discovers that she cannot keep it afloat because she cannot say no to all the need around her.  So she goes on a journey and then her cousin comes to run the shop – ruthlessly and with an iron hand to make it profitable again.  And so it goes several times round.  Brecht thought of this as a condemnation of capitalism; it is perhaps rather more instructive of the virtues of not mixing motives.  I remain as committed to microfinance, as a development tool for the very poor in “faux markets,” on the one hand; and to banking for poor people as a genuinely commercial activity, on the other, subsidized in various ways.  But I do think it is time for some deep reconceptualization of the latter, particularly, and its model of capital and its social uses.

ps.  There is a vast literature, much of it excellent, on the theory and practice of microfinance.  But if you’re interested in further academic reading on this particular topic, the “upstream” funding issues, let me recommend two recent law articles.  The first is by Kevin Davis and my American University colleague Anna Gelpern.  The second is by my co-author on financial regulation, Duke University’s Steven L. Schwarcz.  My own essay on this topic, as mentioned above, is here.  And, okay, let’s acknowledge, as usual, The Onion got there first.  (HT: Insta commenter.)

In the terrific conference on the Constitution in the Financial Crisis that Co-Conspirator Todd and I were privileged to attend last week at Stanford Law School, one of the panelists (this was a panel looking at the peculiar incentives and disincentives created for corporate governance by having government as a controlling shareholder, as in GM) pointed out something I had completely missed and apparently a number of other people in that highly expert audience, too.  A WSJ article of November 3, 2010, by Randall Smith and Sharon Terlep, points to a little-noticed IRS ruling on GM’s tax-loss carryforwards from years prior to the bailout.  The amount at issue is potentially $45 billion.   (Thanks to commenters for links to ruling.)

Although ordinarily a company in the midst of major restructuring would have limits on its ability to use the carryforwards – and ordinarily the Treasury’s 61% stake would trigger such limitations – the IRS has ruled that companies receiving TARP bailout funds will not be subject to the restructuring limits.  (Someone can correct me, since is from memory (one of my first assignments in practice back when I started as a tax lawyer was on this very question, but I have long since dropped out of corporate tax), but I believe this is a classic section 382 problem (corrected per comment).)  The WSJ story puts the argument and counter-argument over the ruling this way:

But the federal government, in a little-noticed ruling last year, decided that companies that received U.S. bailout money under the Troubled Asset Relief Program won’t fall under that rule.

“The Internal Revenue Service has decided that the government’s involvement with these companies, both its acquisitions plus its disposals of their stock, means they should be exempt” from the rule, said Robert Willens, a New York tax consultant who advises investment banks and hedge funds.

The government’s rationale, said people familiar with the situation, is that the profit-shielding tax credit makes the bailed-out companies more attractive to investors, and that the value of the benefit is greater than the lost tax payments, especially since the tax payments would not exist if the companies fail.

In terms of the “internal” question as between GM and taxpayers, one takes the point that this can be seen as saving money for the taxpayer, or at least simply moving the losses from one pocket to another.   But even granting that, in another way it’s part of the problem.  The tax losses were generated under circumstances in which the losses and associated tax attributes, good and bad and with the tax code limitations as understood then, were about a company in which it was on one side and the Treasury as a revenue collection machine on the other.  All of a sudden, the US government has a very different interest in the company, no longer at arms length, and so now we simply see it as a shift from the taxpayer’s right to left pockets, net position unchanged.  That is true at this moment; it is not true of the situation seen over time.

But probably the biggest question the ruling raises is not about the “internal” question for GM and its USG owner, it is about its relative position to its competitors.  Even if this is just shifting from one pocket to another now that the owner is the USG, it is not merely that for GM’s competitors, who have to cope with a company that, relative to them, now has in effect “found” money.  Which, as the panelists at Stanford pointed out last week, is a real issue for the government as privileged competitor in the marketplace.  Just saying that it doesn’t matter as between government and company is not the whole story; it is also how a change in otherwise long-standing rules changes the relative positions of competitors in the marketplace.

The often very interesting Room for Debate blog at the New York Times has a new discussion on the question of whether it is good policy to allow outsiders to invest in someone else’s lawsuit.  Here’s the opening to how the question is framed:

With litigation costs rising, many plaintiffs and their lawyers do not have the money to hire expensive experts or pay for years of trial preparation. To fill this need,specialized litigation lenders are stepping in to bankroll lawsuits — often providing millions of dollars at very high interest rates because conventional banks typically do not offer such loans.

Richard Epstein, Anthony Sebok, Paul Rubin, Laurel Terry, and Susan Lorde Martin take part.

My overall take is that this creates yet another system of side bet financing, in which there are the typical problems of not having an insurable interest.  The counterargument is that the liquidity provided allows for more socially efficient litigation to take place; the response is that a liquid but also disconnected system of derivatives creates downstream bad incentives.  One does not have to reach to the financial crisis to find examples; the tobacco settlements – pathbreaking achievements in their way in structured finance – solve some problems but create some new ones.

The New York Times Bucks Blog (of August 6, 2010) has a fascinating article by Jennifer Saranow Schultz on the first-ever offering in the United States of divorce insurance, the WedLock policy issued by a start up insurance company in North Carolina, Safeguard Guaranty Corp.  Markets in everything, etc.

The casualty insurance is designed to provide financial assistance in the form of cash to cover the costs of a divorce, such as legal proceedings or setting up a new apartment or house. It is sold in “units of protection.” Each unit costs $15.99 per month and provides $1,250 in coverage. So, if you bought 10 units, your initial coverage would be $12,500 and you’d be paying $15.99 per month for each of those units. In addition, every year, the company adds $250 in coverage for each unit.

Then, if you get divorced and your policy has matured (see below for the maturation rules), you would send WedLock proof of your divorce. In return, you’d receive a lump sum of cash equivalent to the amount of coverage you had purchased.

There are a couple of classic insurance questions explored in the NYT article.  One is how to prevent people who know they are going to get divorced from signing up; the key element is a maturation clause (a little bit like suicide riders in life insurance policies) that requires 48 months (reducible to 36 if you buy an additional rider) before the policy will pay off.  A second is how the company sets its rates – it does so based around the factors summarized,  more or less, in its “divorce probability calculator,” for which it claims a 13% margin of error (curiously, I thought, it does not ask how many years a married person has already been married, but maybe I err in thinking that is especially relevant).  A third is moral hazard, in the sense of inducing riskier behavior, in this case presumably lowering the inhibitions on behaviors that might lead to divorce; the approach of the policy seems to be to treat it like any other accident insurance, as an independently bad enough thing (even if monetarily compensated) so that in effect moral hazard doesn’t really operate.

The article finally explores the question of whether, at the premiums charged, it is such a good deal for a consumer couple; Schultz suggests it is not.  Will this kind of policy catch on?  My guess is not too widely, for the same reasons that prenup agreements haven’t become a standard part of marriages.  I myself would probably try to market this insurance not to couples as such, but as the “responsible” thing to take out with the children as beneficiaries – the economic effects might be exactly the same, but were I marketing it, I’d market it as the right thing to do in advance for the kids.

But the policy is a new kind of insurance, and it is hard to say what will happen.  Might such policies – this one really is modeled closely on standard casualty insurance – evolve into something quite different, something closer to a system of side-bets?  A swap market in divorce annuities, anyone?  How might we securitize marriage – or divorce?  Not to mention the problems of insurable interests and empty creditors.  (I wonder what the newly-wed Megan McArdle thinks, actually.)

(I’ll have more to say about this in another post about ‘theatre for a post-credit society’, but I will add that in some ways, this resembles a bit that very great play from the 1950s, Friedrich Durrenmatt’s somewhat forgotten The Visit of the Old Lady.  I will leave this as a cryptic teaser for the moment, however.)

Update: Folks, I have a worry that the comment thread is going to slide into various proposals for how to scam the policy, based on my summary above. I’d suggest people read the NYT article, and then if you want to propose ways to game the system, go to the company site and read the policy before proposing something. I think you’ll find that the insurance lawyers who drafted the policy are not quite as dumb as one might think based on a two graf summary above.

I have always appreciated the structure of the classic “problem of evil” argument – appreciated it on aesthetic and elegance grounds.  You perhaps recall the general formulation: all powerful, all knowing, and all good.  Any two are compatible with the existence of evil; not all three.  There are many forms of argument roughly set up in this way; this one says that the three taken together are incompatible with an additional condition, the existence of evil.

Another related structure of argument is that any two conditions are compatible, but not the third, as among the three of them (even without reference to a fourth condition).  And so on.  So, just on elegance of structure alone, I appreciated Professor Mankiw’s NYT column from yesterday, setting out the classic argument over incompatible policy goals in international economics, The Trilemma of International Finance:

What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

• Make the country’s economy open to international flows of capital. Capital mobility lets a nation’s citizens diversify their holdings by investing abroad. It also encourages foreign investors to bring their resources and expertise into the country.
• Use monetary policy as a tool to help stabilize the economy. The central bank can then increase the money supply and reduce interest rates when the economy is depressed, and reduce money growth and raise interest rates when it is overheated.
• Maintain stability in the currency exchange rate. A volatile exchange rate, at times driven by speculation, can be a source of broader economic volatility. Moreover, a stable rate makes it easier for households and businesses to engage in the world economy and plan for the future.

But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.

Professor Mankiw goes on to point out that the United States, China, and Europe have each chosen a different set of two in the trilemma – and part of the political and economic pressure they put on each other reflects those preferences.

But back to the form of argument – it is something that shows up sometimes in formulating arguments in the law and other places.  Other instances of recourse to this kind of argument form?  (I seem to recall that corporate law scholar, Dean Bob Clark, used something along these lines in a corporate law setting once.)

Mean Professor Anderson made his first year law and economics class memorize Greg Mankiw’s ten basic principles of economics, including ... incentives matter.  Also, people make decisions at the margin.  One of the interesting questions – more than interesting, genuinely crucial to how one understands and interacts with other people – is when those heuristics don’t apply, however.  Spheres of social, interpersonal, intimate, familial, etc., life in which one eschews making decisions at the rationality margins, and instead goes with relational and affective values that are not “scalable” in the sense that marginal decision-making requires.

And then there is the vexed question of when one might think in terms of one, or the other, or both ... which brings us to the question of the estate tax, as this Wall Street Journal article observes.  Last year, people had an incentive to stay alive, and their heirs had an incentive to keep them alive, until January 1, 2010, in order to avoid the estate tax.  It will go into reverse, however, at the end of the year:

When the Senate allowed the estate tax to lapse at the end of last year, it encouraged wealthy people near death’s door to stay alive until Jan. 1 so they could spare their heirs a 45% tax hit.  Now the situation has reversed: If Congress doesn’t change the law soon—and many experts think it won’t—the estate tax will come roaring back in 2011.  Not only will the top rate jump to 55%, but the exemption will shrink from $3.5 million per individual in 2009 to just $1 million in 2011, potentially affecting eight times as many taxpayers.  The math is ugly: On a $5 million estate, the tax consequence of dying a minute after midnight on Jan. 1, 2011 rather than two minutes earlier could be more than $2 million; on a $15 million estate, the difference could be about $8 million.

It is a question of incentives for the wealthy person, of course – but also a question for their heirs.  There is the question of perverse incentives but also, as the article discusses further, many questions of regulatory uncertainties clouding the very calculation of incentives.  Will Congress act?  At what rates and what exemptions?  Crucially, will any of it be retroactive?  Which leads to another basic principle ... uncertainty raises costs.

Advisers say the estate-tax dilemma is especially awkward for heirs. “At least in December 2009, people wanted to keep their relatives alive,” says Ronald Aucutt, an estate-tax attorney with McGuire Woods in the Washington area. Now he and others are worried that heirs may be tempted to pull plugs on Dec. 31. Economists might call the taking of a life to reap a tax advantage a “perverse incentive.” District attorneys might call it homicide.

I suspect the plug-pulling problem or potential homicide problem by heirs exaggerated.  So I’d like to think, anyway.  Still, perverse incentives are perverse incentives.