Risk, Uncertainty, and Rule of Law

 
 

An uncertain legal landscape puts future prosperity at risk.

It has been two years since Wall Street’s implosion plunged the American economy into its most acute state of uncertainty since the Great Depression. Although there is fierce disagreement about the causes of the crisis, few question that excessive risk-taking contributed mightily to the meltdown.

Now, however, there is reason to worry that America is lurching too far in the opposite direction. The Economics journalist Robert Samuelson recently observed that signs of undue risk adverseness are creeping into the American economy. Among other symptoms, Samuelson cites a 50% decline between 2007 and 2009 in the amount raised by venture capital funds, a reduction in the number of investors in the stock market, and the fact that of all new job hires, approximately half are from temporary hire firms—a clear sign of employers’ hesitations about full-time hires.

Given the severity of the 2008 financial crisis and the associated recession, such trends are understandable. But another element in play is the degree of uncertainty now characterizing the American investment climate.

In everyday speech, the phrases “risk” and “uncertainty” are used interchangeably. But as the Chicago economist Frank Knight demonstrated in his famous 1921 book Risk, Uncertainty, and Profit, they are different phenomena.

In economic terms, Knight explained, risk concerns those probabilities that can be reasonably measured. This is expressed in terms such as “there is a 40% risk that the gold price will collapse this year.”

Measurable risks are thus no deterrent to the making of economic choices. If we take them seriously, they help us to calibrate our economic choices to be consistent with our responsibilities, resources, and opportunities. The same measurements also allow us to distinguish between prudent risk takers and the reckless, and reward them appropriately.

Uncertainty, by contrast, involves those risks that cannot be quantified. It can occur either because of the sheer complexity of a given situation or because the subject matter cannot be reasonably measured. As long as a situation of uncertainty persists, it will deter many people from even considering whether to take economic risks.

A good example of the workings of uncertainty is the American tax system. As one 2010 Wall Street Journal report noted, “The U.S. tax code is slowly being turned into a temporary patchwork of provisions that need to be addressed every year or two, depriving individuals and businesses of the predictability they need for long-range plans.” Everyone knows that the recent extension of Bush tax cuts comes up for review in two years. But approximately 141 tax provisions already require annual renewal. That’s up from fewer than a dozen in the 1990s.

Which of these will be renewed at the end of 2011? Which will not? As the end of 2011 draws closer, taxpayers and investors may be able to quantify the odds of extension or expiration of these tax provisions. For the present, such calculations are extremely difficult, if not impossible. We thus have uncertainty. And uncertainty deters prudent people from investing and entrepreneurship.

But in America’s current economic climate, the degree of uncertainty may well be heightened by the gradual impact upon the economy of another factor: a notable weakening of several conditions that make up vital elements of the rule of law.

Over the last century, economists and legal scholars from different schools of thought have concluded that the rule of law is indispensable for sustained economic development. As Friedrich von Hayek once observed, “There is probably no single factor which has contributed more to the prosperity of the West than the relative certainty of the law which has prevailed here.”

The faltering of the rule of law is usually associated with failed states or emerging dictatorships. Compared to countries such as Mugabe’s Zimbabwe, Chavez’s Venezuela, or the near anarchy of Somalia, the United States exemplifies a country in which the rule of law prevails rather than the “rule of men.”

Yet the rule of law embraces more than the absence of either tyranny or anarchy, and there are several reasons to worry that the rule of law in America is weaker than it ought to be.

There is surprising agreement among scholars writing from a variety of jurisprudential positions concerning the rule of law’s content. In Natural Law and Natural Rights (1980), for example, John Finnis argued that legal systems embody the rule of law to the extent that: (1) their rules are prospective rather than retroactive, and (2) not impossible to comply with; (3) rules are promulgated, (4) clear, and (5) coherent with respect to each other; (6) rules are sufficiently stable to allow people to be guided by their knowledge of the content of the rules; (7) the making of laws applicable to specific situations is guided by rules that are promulgated, clear, stable, and relatively clear; and (8) those charged with the authority to make and administer rules are accountable for their own compliance with the rules, and administer the law consistently. Finnis’ list closely parallels the conditions famously identified by Lon Fuller in his Morality of Law (1964).

Even brief contemplation of these conditions underscores the rule of law’s indispensability for reducing uncertainty. A legal environment in which governments reconfigure the rules governing commerce on an almost daily basis will deter potential investors from making decisions. Similarly, the inconsistent administration of property and contract law will make most people hesitate before risking their capital.

In this light, we begin to see significant erosion of aspects of the rule of law for a number of institutions especially important for America’s economic growth. Once again, a good illustration is the United States Internal Revenue Code.

In February 2010, the Internal Revenue Code consisted of 9,834 sections. Each one is subject to the official interpretations found in the federal tax regulations issued by the Department of the Treasury, many of which are themselves shaped by various court decisions. Then there is the Internal Revenue Bulletin (IRB). This is issued weekly and described by the Internal Revenue Service (IRS) as “the authoritative instrument for the distribution of all forms of official IRS tax guidance.” The IRS cautions, however, that “Rulings and procedures reported in the IRB do not have the force and effect of Treasury tax regulations, but they may be used as precedents.” The precise force of these precedents remains unspecified.

A tax code of this size and complexity which is subject to so many sources of potentially conflicting official and semi-official explanations is bound to embody significant contradictions, and offers considerable scope for arbitrary decision-making. Uncertainty is the result. It’s also valid to claim that the same tax code may well be impossible for large numbers of honest law-abiding citizens to understand and comply with—not to mention difficult for conscientious civil servants to administer justly. As a result, many people may unintentionally violate the law or simply choose to forgo making any number of potentially wealth-creating opportunities for fear of violating the law.

Tax law is complex in most countries. But there are other subtle diminutions of the rule of law that have little to do with complexity but which affect the workings of key American economic institutions. One is the Federal Reserve’s charter. This specifies that the United States central bank is responsible for “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.”

The difficulty with this dual mandate of avoiding inflation while promoting the highest possible employment level is that it charges the Fed with realizing goals that are sometimes mutually exclusive. In high inflation situations, central banks can only stabilize prices if they are willing to tolerate, even for relatively short periods of time, high unemployment.

From this perspective, the Fed has been given responsibilities that may well be impossible to fulfill in certain conditions, or which effectively require the Fed to ignore one of its two primary legislated responsibilities. In both cases, space is created for the rule of men in the form of the Fed knowingly pursuing policies that, however economically sensible, don’t meet the requirements of the legislation determining the Fed’s objectives. Again, the resulting lack of predictability when it comes to monetary policy will encourage many investors to opt for security rather than even moderately risky entrepreneurial ventures.

Then there are the rule-of-law problems associated with the sheer volume of law that directly shapes American economic life. The 2010 healthcare reform legislation, for instance, amounted to 2,700 pages. Not far behind it in length was the 2010 financial overhaul act: a mere 2,300 pages. More than a few legislators have confessed to never having read either piece of legislation in its entirety. Nor should we assume any great familiarity on their part with the thousands of pages of legislation which these acts superseded, integrated, or reinterpreted. The possibility that many laws governing healthcare and financial services have subsequently been rendered unclear, inconsistent, and impossible to comprehend is high.

Indeed, the amount of legislation affecting these industries is now so great that it is likely that even good judges with no interest in judicial activism are issuing rulings that are ad hoc and arbitrary in nature. Many centuries ago, Thomas Aquinas stressed the need for the rule of law over the rule of men precisely because he considered it desirable and just that, as much as possible, laws would determine in advance what judges decided, thereby reducing the scope for arbitrariness from the bench.

Here we should remember that judicial arbitrariness doesn’t always proceed from the desire to use one’s judicial authority to advance private ideological agendas. Arbitrariness can also occur because of a prevailing incoherence of legal principles, legislation, and precedents, in the midst of which judges often can’t help being arbitrary if they are to make any decisions at all. If there is anything in the legal system certain to discourage long-term investment in a given economy, it is judicial arbitrariness.

It is true that the extent to which the different conditions of the rule of law prevail in any society is usually a matter of degree. Human fallibility alone means that rule of law can only be imperfectly realized, even in those communities that understand its importance for reducing uncertainty and promoting human flourishing.

Imperfection, however, is one thing; decline and erosion are quite another. If America is going to retain its economic place in the world—a preeminence underpinned by its continuing edge in the realms of entrepreneurship, risk-taking, and venture capital—then attention to these troubling rule-of-law issues is indispensable. The rule of law is hard enough to build. Once lost, it may be gone forever.

Samuel Gregg is Research Director at the Acton Institute. He has authored several books including On Ordered Liberty, his prize-winning The Commercial Society, and Wilhelm Röpke’s Political Economy.

 

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