For economic commentary on the current financial crisis, I am not the equal of Dani Rodrik, or Tyler Cowen, but I might as well comment on the topic du jour, since I'm supposed to be
an expert a specialist of sorts. Latest news:
- With Goldman Sachs and Morgan Stanley turning into bank holding companies to escape the fates of Lehman Brothers, Merrill Lynch, Bear Stearns etc., the once-mighty investment bank is no more. (I remember hearing Harvard undergrads chattering to one another with starry-eyed greed about "i-banking" jobs. The recollection now has the flavor of one of those historical anecdotes with a built-in moral, like the Titanic.)
- The Bush administration/Hank Paulson is pushing for fast action on what is being called a $700 billion bailout of Wall Street.
Lest I violate my personal taboo on political blogging, I'll leave the news and retreat into arcana.
Suppose I promise to do A in return for your promise to do B. We have a contract, maybe we even write it down with the help of fancy lawyers. But am I willing/able to do A, and you to do B? If not, will a court enforce the contract, and how?
As the economy gets bigger and more complex, the types of contracts that it is advantageous for people to sign keeps increasing, as a means to incentivize effort or innovation, or to spread risk.
Suppose that at time t, the economy is sufficiently developed that three types of contracts would be advantageous for private agents to sign; we'll call them Contracts X, Y, and Z. Contract X is well-understood by regulators and courts. Contract Y is not dealt with in any extant legislation or case law, but the private sector is aware of it. Contract Z, no one has thought of yet.
Some agents will choose not to engage in contracts of type Y, but some will, hoping that either (a) counter-parties will keep their end of the bargain voluntarily, from honor or for repeat business or their reputations, or (b) courts and/or regulators will find out about, approve, and enforce Contract Y if forced to do so by a breakdown of some instance of it. If Contract Y is more advantageous in some circumstances than Contract X, market forces will cause it to spread, and eventually some breakdown will force courts/regulators to catch up with the private-sector-driven evolution of contract law. Once they do, the margins for Contract Y-type deals will be reduced by competition, and some clever entrepreneur may have an idea for Contract Z.
One interpretation of financial crises is that they reflect the painful learning curve as those to whom justice and property rights are entrusted learn to cope with the ever-growing sophistication of markets.