Common Law and The Financial Crisis

There has recently been a flurry of popular interest in English common law. Niall Ferguson praised it in his recent BBC Reith Lectures, and British barristers present two separate BBC series exploring the evolutionary adaptive nature of common law, its world-influencing “standards of fairness” and “wondrous strength” in enabling British economic triumphs of yesteryear. Opportunities arose to complain more than a little about the invasion of European law and to cast doubt on the economic efficacy of “rule-bound” continental (civil or roman) law.

The quarrel about the relative superiority of Common vs Civil Law is an old one. I will draw attention to a neglected earlier framing of the opinion that neither system of law is inherently superior. Law of any origin will serve well, goes the argument, so long as it is market-friendly, impersonal, fairly predictable, and -- last but not least -- enforceable.

1. Legal origins

The most commonly cited evidence on the superiority of common law is the meticulous long-running economic research program known as LLSV after the authors -- La Porta, López-de-Silanes, Shleifer, Vishny. A downloadable 2008 article - Economic Consequences of Legal Origins - is most important as a summing-up and response to critics.

I say here only that LLSV/2008 generally and persuasively shows civil law is associated with heavier government intervention that impacts adversely on markets in various ways, whereas common law is associated with lighter intervention and better functioning markets.

There are caveats to bear in mind. They can be found in LLSV, but I highlight them:

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i) The economic effect of the legal system varies, regardless of legal origin, according to the quality of its procedural implementation.

For example, counterintuitively “formalism” (which might imply rigidity) is on some measures greater in common law systems. LLSV report studies findings “that formalism is higher in common than in civil law countries in 2000, but also in 1950. Perhaps more surprisingly, formalism is extraordinarily stable”.

I assume (previous post) formalism could be either positive or negative for the adaptation potential of a legal system depending on the magistrates, the remit of law and scope of judicial action, and the surrounding political and economic incentives. Formalism, which might make it difficult to escape the constraints of bad rules, judges, and procedures, is not itself a problem if the rules, judges, and procedures are the well-adapted ones.

ii) Most systems are, in fact, hybrids of common law and civil law. LLSV are unequivocal on this too: “no country exhibits a system of social control that is an ideal type; all countries mix the two approaches. Common law countries are quite capable of civil law solutions, and vice versa.

iii) Common and civil law systems may be more or less successful under different temporal and perhaps cyclical conditions. LLSV conclude that common law is good for economies in calm times, but civil law tends to be more useful in the crisis times. I will return to this.

The work of LLSV does not assert that common law always works best or that civil law is in all respects inferior and incompatible with economic development. Their conclusions are carefully measured and extremely informative about specific legal mechanisms and rule transplants that are likely to perform better and more efficiently irrespective of ‘origin’.

2. Sociological support for common law

Talcott Parsons and earlier sociologists concluded without the advantage of the research undertaken by LLSV that common law and market capitalism are naturally complementary and have thrived together.

American sociologist, Parsons, wrote in a famous essay 1964 Evolutionary Universals in Society that common law with its developed property and contract rights, procedural propriety and consistency, adaptive efficiency, and guaranties of judicial independence, had been ‘a fundamental prerequisite’ of the industrial revolution in England. Common law evolution preceded parliamentary legislation, and there existed a clear separation of powers. In continental Europe, by contrast, law became ‘intertwined with government’ to the extent of a ‘legalization of bureaucracy’ or a ‘bureaucratization of law’.

Always we must go back to the German sociologist Max Weber. The partial autonomy of law and legal professionals, he explained, is a reason why capitalism has coexisted with at least two legal traditions of European origin, Anglo-Saxon common law and continental Roman law.

3. System equivalence and non-equivalence

Weber perceived a good fit between capitalism and common law particularly in nineteenth-century England. But, crucially, he did not draw general conclusions about the superiority of common law.

Having compared the character and qualities of each, Weber remarked that ‘once everything is said and done about [the] differences in historical developments, modern capitalism prospers equally well and manifests essentially identical economic traits under legal systems containing rules and institutions which considerably differ from each other’.

Weber also argued that neither common nor continental law are pure cultural types, since in most cases legal systems are hybrids conditioned by the responses of legal professionals to particular political histories and the structures of domination in each society. Even English common law, which in some respects was less formal, had absorbed influences of Roman law in its systematic structure, definitions, and legal principle.

In the early stages of the transition to capitalism when property rights were still privileges, the costliness of common law, which effectively denied non-propertied classes easy access to justice, may have provided support for the capitalistic system.

However, the decisive factor was that law should be formally calculable with respect to property and contract rights. Weber again: ‘Capitalistic interests will fare best under a rigorously formal system of adjudication, which applies in all cases’.

Weber believed that English common law was calculable. The strict application of precedent produces a ‘calculable schemata’, he said. This is the condition of calculability:

“Juridical formalism enables the legal system to operate like a technically rational machine. It guarantees to individuals and groups within the system a relative maximum of freedom, and greatly increases for them the possibility of predicting the legal consequences of their actions. Procedure becomes a specific type of pacified contest, bound to fixed and inviolable rules of the game.”

In this respect, formalistic Roman law could be adjusted to the needs of capitalism, as could more adaptive but nonetheless also formalistic common law drawing on precedent, which produces ‘a practically useful scheme of contracts and actions oriented towards the interests of clients in typically recurrent situations’.

But, Weber went on to say, since even ‘primitive procedures for adjusting conflicts of interest between kinship groups are characterized by rigorously formalistic rules of evidence’, it is clearly not formalism per se that determines the calculability, objectivity and impartiality of law. Legal formalism can be turned to any end, not just capitalism’s ends.

In capitalism the decisive factor is that functionally equivalent common law and Roman law systems are equally and similarly freed from patrimonial (informal) forms of justice. Legal power and legal procedure in patrimonial society are personalistic, ambiguous, and arbitrary. Particularistic forms of justice are actively preferred by ‘robber capitalists’ (rent seekers, crooks, and cronies) and also by groups that resist capitalism.

Among despots and demagogues one encounters ‘the inevitable conflict between an abstract formalism of legal certainty and their desire to realize substantive goals’.

It goes without saying (though Weber makes sure to say it often) that no system of law will be effective without the credible threat of enforcement. If the prospect of suffering and punishment in return for committing a crime is not credible the main incentive and purpose of regulation by law is lost. No amount of ethics and morals will ever make up for that loss. It was, after all, the regulatory inadequacy of informal ethics that led societies to law.

4. Reasons for avoiding common law hubris

Writing in 2008 La Porta, López-de-Silanes, Shleifer (LLSV) make a startling observation:

“The world economy in the last quarter century has been surprisingly calm, and has moved sharply toward capitalism and markets. In that environment, our framework suggests that the common law approach to social control of economic life performs better than the civil law approach. When markets do or can work well, it is better to support than to replace them. As long as the world economy remains free of war, major financial crises, or order extraordinary disturbances, the competitive pressures for market-supporting regulation will remain strong and we are likely to see continued liberalization. Of course, underlying this prediction is a hopeful assumption that nothing like World War II or the Great Depression will repeat itself. If it does, countries are likely to embrace civil law solutions, just as they did back then.”

In 2012 it looks as though we could be in such a situation. Undoubtedly some countries, perhaps France for example, might draw the conclusion that civil law style solutions will be more appropriate and effective during economic crises. Let us not forget that during this very week the eurozone crisis has been -- quite remarkably and literally -- placed on hold by the deliberations of Germany’s constitutional court while it considers the permissibility of the country’s involvement in some proposed European bailout or rescue mechanisms. Germany’s legal system is a hybrid, but it leans clearly toward civil law.

The ideal type or extreme type civil law system is the one long ago described by the Austrian legal scholar Hans Kelsen, in which:

“the creation of general legal norms is entirely centralized, that is, reserved for a central legislative organ, and the courts are restricted to apply the general norms... Since the legislative procedure has to surmount many obstacles, especially in a parliamentary democracy, it is difficult to accommodate the law in such a system to changing circumstances… It has the advantage though of legal security; this means that the judicial decisions are foreseeable to a certain extent, and therefore calculable enough that the individuals subject to the law can adapt their behaviour to the foreseeable judicial decisions.”

Kelsen described law, regardless of the peculiarities of the content of each system, as a universal process of delegation connecting the highest impersonal norm-creating authority (the constitution or equivalent) to the legislature to the courts to judges to contracting parties. Almost by definition law is objective and non-political procedure.

Neither should law now be confused or fused with morals; the difference is that law is (should be) a coercive normative order. Law is an evolutionary outgrowth of morals which became sanctionable. During crisis, law may appear unable to perform credibly as an enforcement mechanism. A nostalgic return to moral suasion would be a regression toward pre-law.

5. Popular mood -- what’s wrong with English law now?

I ask the question, like everyone. The enormous advantage of common law, so the recent BBC programs inform us, is that it is wonderfully flexible and adaptive over the historical span. But what if it is not adaptive over the short term, or has somehow been weakened by excessive caution, bureaucratization, discretion? What if the British legal profession is suffering the unintended consequences of impregnation by social justice ideologies?

Is common law at a disadvantage during economic crises? I noted the BBC programs are full of praise for common law. Yet I am interested in how they pulled the audience in:

Helena Kennedy QC 1: “For many it looks as though our mighty legal system was outmaneuvered by the ingenuity of the bankers. Despite the mis-selling of dodgy products, despite recklessness and risk taking of a questionable kind, and despite the rigging of interbank interest rates, the law appears supine. Where are the prosecutions? people ask. Where is the law when you need it? Where’s the justice?”

Helena Kennedy QC 2: “In spite of all appearances of financial impropriety the law seems to recoil, with questions of legality or illegality left in doubt. Has there been a capture of the law by the financial sector? It certainly would appear that the law has been observed more in its circumnavigation than in practice. The relationship between capital and law runs deep. At its root is a shared sense of permissiveness -- that which is not forbidden explicitly is allowed. But it’s also relied on something else running alongside, a code of honour, a framework of unspoken ethics, a sense of good form.”

You see where it’s heading. It’s about culture and morals. I expressed my irritation with the culturalist approach to banking scandal in the comments section of a recent John Kay op-ed. Mine is the first comment, easy to find at the bottom of the page. In interviews and writings Kay often refers to problems of culture and morals, but infrequently to fraud. 

Now listen to what Paul Moore (legendary whistleblower) had to say yesterday on the BBC’s Today Programme. He exemplifies the growing (and brave) willingness of some commentators to discuss the inadequacy of enforcement in Anglo-American systems:

Paul Moore:“we have totally inadequate enforcement of existing laws and regulations, we need better quality regulators, we need company law changing so that fiduciary duties are appropriate for big companies, accounting doesn’t work, audits don’t work… There are definitely criminal offenses that apply to Barclays rate fixing, there’s been totally inadequate investment in enforcement and investigation, there has been no will, there are revolving doors, there is political interference, the regulators are embarrassed due to their own earlier failures, so they don’t enforce. You get quasi-Nuremberg defense where [bank chairman accused of Libor rate fixing] says ‘Oh I told the regulator’. If the regulator was told about rate fixing then they’re guilty of criminal offense as well, and I can give you four criminal offenses that they’ve been guilty of…”

6. Conclusion

I found the definition of fraud - “Dishonestly making a false (untrue or misleading) representation with a view to gain or with intent to cause loss”. Here is the 2006 Fraud Act. It does not look difficult. So flexible, so easy to interpret. Where’s the enforcement?

Where in either the common law or civil law system is the credible, simple, and enforceable bank bankruptcy law? If common law is so evolutionary, so attuned to the Darwinian notion of well-functioning economy, why is it not easier for banks to fail?

In my book I warn of “losses in society’s adaptive efficiency when the ultimate penalty of extinction for non-compliance with structural laws of the market is absent in economic life”. I explained why a country’s “economic success depends on the economic actors knowing that the consequence of failure could be the loss of market power or extinction”.

Lots of questions. The post must end. Hope I sowed a seed of doubt about the superiority of the marriage between common law and capitalism in a contemporary crisis-hit country. Could British reawakened interest in its world-shaping system of common law be the last prideful gasp of an England heading fast toward ruin because its governments and people are so ‘good’ at saving their banks and yet so bad at saving their money?;

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