Arnold Kling  

Letter of Law, Spirit of Law

Different Forms of Government... Emperor, Clothes, etc....

George Packer writes,

The moral code of these Wall Street executives corresponds to stage one of Lawrence Kohlberg's famous stages of morality: "The concern is with what authorities permit and punish." Morally, they are very young children. The Swiss bankers are closer to stage four, most common among late teens, where a concern for maintaining the good functioning of society takes hold. Stage six, an elaboration of universal moral principles based on an idea of the good society, is a distant dream for the titans of global finance.

Thanks to Mark Thoma for the pointer.

I tend to agree with Tyler Cowen that individual moral propensities are less important than overall social context. To borrow from a different branch of social psychology, I would say that Packer is committing the Fundamental Attribution Error.

In my view, the problem comes from trying to use what I call letter-of-the-law regulation in finance. Call it L regulation. With L regulation, the regulator lays down specific, quantitative boundaries (think of risk-based capital requirements, with fixed numerical weights for various types of assets). The managers of financial institutions are told to stay within those boundaries.

In contrast, think of something I might call S regulation, for spirit of the law. With S regulation, the manager of a financial institution that enjoys some government protection would take an oath to maintain the safety and soundness of the institution. With S regulation, it is wrong to just tiptoe along the edge of the quantitative boundaries, without considering the potential risk to the firm.

Suppose we take it as given that government is going to protect some of the liabilities of some institutions, because of deposit insurance, implicit guarantees, "too big to fail," or other reasons. I would like to see such institutions be covered by S regulation even more than by L regulation.

I would like to see managers of government-protected institutions take an oath to safeguard the soundness of their companies. I would like to see them subjected to prison terms for violating that oath. The oath is a general promise, not satisfied simply by staying within the boundaries of L regulation.

I believe that S regulation would change the motives of bank managers. They would be looking for ways to avoid failure, rather than for ways to stay within the letter of the law.

There can be plenty of risk-taking institutions in our society. But they should not at the same time be institutions that enjoy government protection when they fail.

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COMMENTS (9 to date)
pmp writes:

Arnold Kling,

I like the final paragraph of the post.

But, in general, I find the "Letter" and "Spirit" discussion a little bit unhelpful because it seems that L-regs and S-regs can both be either helpful or unhelpful. Alternately, they seem to be ways of labeling results rather than labeling ex ante.

I think that the "spirit" is a superstructure that comes from the underlying incentives (e.g., payoffs). To oversimplify, people eventually make up stories to explain why they do things they have to do.

The entire lesson of this whole mortgage-credit-financial debacle, it seems to me, is that people don't understand macroeconomics very well.

I can think of two very simple, very "micro" reforms that I believe would have helped avoid--or at least delay and ameliorate--this disaster.

1) Home loans should not be non-recourse loans. If you stop paying, you shouldn't be able to "just walk away. If people knew they were putting all of their life's savings at risk, they wouldn't so easily take out more money than they could afford. This would spread the responsibility for making sure that loans matched ability to pay.

2) Mortgage companies should get their fees over time as people successfully make their mortgage payments. When mortgage companies get their fees up front, they rush headlong into unsustainable situation. They make the loan and then wipe their hands of it. Moral hazard!

There are two other reforms of a more macro nature that I think would have helped.

One, is that there oughtn't be a mortgage-interest deduction. We've been encouraging people to put all their savings in one basket. This violates the first rule of personal finance: diversify.

Second, we should have been allowing housing stock to rise with demand (e.g., we need low-impact or no zoning). Property owners have been voting themselves asset-value increases via increasingly restrictive land regulations. This has priced people out of many housing markets--or forced them to undertake huge mortgages. Enough!

Housing stock should respond to market demand. We never have car shortages or computer shortages--but in many places, zoning and land-use regs have created housing shortages. It's evil. It needs to stop.

Of course, one of the simpler reforms was Arnold's proposal that you need to be able to offer 20% down if you want to be able to get the mortgage.


I don't know if all five of these reforms should be classified as "L" or "S." But I don't think that's a very important question.

Like I said, the spirit tends to grow up around the law.

PJens writes:

In my mind, it all comes down to enforcement.

Nothing changes playground behavior faster than watching a bully get hauled off to the principal's office. Likewise, seeing crimes prosecuted and executives sent to prison will send a clear message to the rest that consequences exist for unlawful behavior.

If the current rules are not working, change is needed. A good addition would be clear definite consequences if the law is not followed.

Jim Ancona writes:


Part of Arnold's point is that there's very little evidence so far that "unlawful behavior" was a major part of the crisis. See Megan McArdle.

This post reminds me of Phillip Howard's The Death of Common Sense from a decade ago, which also dealt with "letter" versus "spirit" issues.


Philo writes:

In my view, regulation should always be “letter regulation,” in which specific, quantitative rules are enforced. If this won’t work, then we should abandon regulation and find some other way
of proceeding. Arnold’s “spirit regulation,” in which the guidelines to be enforced are quite vague, would in practice be a grant of near-arbitrary power to the regulators.

But suppose we replace Arnold’s vague “soundness” by a more definite concept, such as *solvency*. The idea of requiring executives of corporations that carry government guarantees to pledge themselves to maintain the corporation’s solvency, on pain of a jail sentence, has a certain appeal. The difficulty would come in assigning individual responsibility: which actions by which individual executives caused the insolvency? Also, such jail terms would in some cases have to be imposed even in the absence of *mens rea*. So even this more punitive form of
“letter regulation” is not really satisfactory. Better to abandon government guarantees of private debts.

anon/portly writes:

"I would like to see managers of government-protected institutions take an oath to safeguard the soundness of their companies. I would like to see them subjected to prison terms for violating that oath."

More immediately relevant than the threat of prison, isn't a sort of "S regulation" the point of proposals to create regulations tying remuneration to long-run firm performance?

I'm not so sure about the threat of incarceration, I think I'd like to see a stronger threat of personal financial ruin.

This seems to analogous to airline regulation - you can use "L" regulations where you tell the airlines how to maintain their planes and train their pilots, or you can use "S" regulations where a plane crash causes the owners and employees genuine financial distress. As I recall, a switch from "L" to "S" back in the 1970's has been credited with making flying so much safer nowadays. (But maybe this is wrong....)

Less Antman writes:

The "L" vs "S" discussion is interesting, but I'd like to propose a third form of regulation, which I'll call "$" Regulation. A company that engages in activities that, on net, destroy financial resources should suffer a penalty that I propose we call "losses."

So long as the moral hazards of bailouts and government guarantees remain, we might as well just wait for the next unforeseeable disaster to occur, for it is inevitable. We need to turn to the best regulator ever devised, an actual free market of Profit AND Loss.

Tom Grey writes:

Portly got it correct -- financial sanctions only.
No jail.
Proving criminal intent, beyond a reasonable doubt, is far too difficult.
Enron & Ken Lay are NOT a good deterrant to the Moral Hazard problem (although SOX arguably gives all financial folk CYA procedural cover).

We need an 'incompetant excess bonus' tax, covering incomes from the last 5 (10?) years, of all wage earners of gov't bailout companies.

With the President of the US making about $200k, and the US average at $45k, but the mean being only about $30k, any of these can be used in some formula to tax excess cash received:
i.e. 80% excess tax on all income higher than $200.

The Fannie Mae ex-head would pay back some 80% of his unearned $15 mil, in other words he'd pay back $12 mil and keep 'only' 3 mil.

Andrew Garland writes:

You recommendation would lead to greater government control. Imagine trying to defend yourself criminally (or civilly) by saying "Yes, I swore to protect the assets of my institution, and Yes I lost money, but I lost the money in a legal way." You would have to convince a jury that there were risks, but they were the ordinary and reasonable risks, not the risky risks that should bring conviction.

This simple action would lock up lending by any large institution to which the government has granted any favor.

We might as well sign over control to the government of any corporation that has to operate under that oath, because losing money would bring conviction. Only the government run and protected companies would operate.

The financial losses were incurred directly because of a government guarantee through Fannie Mae and Freddie Mac, implicit or not. The answer to the moral hazard of having a government guarantee is to not have those guarantees. A government guarantee is an off-budget operation that avoids oversight and invites sudden and huge losses when the effects of the guarantee come to light.

The free market produced the loans that Fannie and Freddie were willing to buy. Now, various groups want to punish the people who created those loans, or bought the bonds backed by those loans, rather than the government who wanted them to do this as a part of public policy. Rating agencies pressured by government gave AAA ratings to bonds backed by pools of subprime loans. Government has its hands all over this financial disaster, and it is busy doing more as we speak.

Don't take my word for it. See We Guarantee It for a review of the available information published in mainstream sources.

A government guarantee is an unlimited extension of government power and dire risk to us all.

Andrew Garland
Easy Opinions

David writes:

Packer writes:

"In private life, extreme indebtedness, bankruptcy, the ruin of those close to you, and dependence on the government dole are generally thought to be causes for anguish, self-denial, and a degree of shame."

This may be a nice rendering of the Protestant Work Ethic, but I don't think it accurately captures modern American society. The dominant political ethos is clamoring for increased dependence on the public dole. At the dawning of a new Corporatist Age, finance execs are no less deserving of a bailout in support of the good of society than the unemployed obese Type-II diabetic is to government insulin to take the edge off his chili cheese fries.

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