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Is harmonization of legal rules an appropriate target? Lessons from the global financial crisis

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Abstract

This article deals critically with the call for a comprehensive harmonization of legal rules, against the background of the lessons from the recent financial crisis. Before coming to the topic of harmonization of legal rules, it first briefly deals with the question of why rules are necessary at all, and what the functions of rules are. Then it deals with the lessons from the recent financial crisis for the topic mentioned. The article conducts a kind of cost-benefit analysis of legal harmonization by looking at arguments in favor of and against uniform rules. It shows that not only the arguments in favor have increased after the recent financial crisis, but also the arguments against. It also shows that integration of global markets has not only increased the need for new uniform rules but also decreased the chances of their implementation; and that therefore today it is often better to improve the implementation of current rules instead of laying down new uniform rules.

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Notes

  1. “Institutions” are grown and intentionally created systems of mutually respected rules whose execution can be controlled and which cause mutually reliable behavioral expectations of the individuals (see, e.g., Schotter 1981, pp. 8f., and North 1990, pp. 4ff.).

  2. This is discussed for example in the time-inconsistency literature in macroeconomics.

  3. This is the reason for the “general preference for offending against rules” mentioned above.

  4. Externalities are costs or benefits transferred between agents, without any related economic transaction between those agents. This means, there are ‘missing markets’ so that negative or positive benefits remain uncompensated.

  5. For the recent financial crisis see, e.g., Wagner (2010).

  6. As will be shown in the following sections, legal uncertainty and legal diversity are main causes of such non-transparency and asymmetric information.

  7. For the costs of discretionary policy coordination see, e.g., Wagner (2009), part 3. One example of such costs is currency depreciation races, which tend to end up in inflation without any positive real macroeconomic effects.

  8. Uncertainty increases; externalities become more extended (esp. via contagion); (global) public-good production becomes (relevant and) more difficult since in open economies exit-opportunities of investors and owners of scarce factors, even of governments (see, e.g., Wagner 2001), arise.

  9. This means it has to be looked at the concrete circumstances that are different across locations and time.

  10. Sometimes it is even claimed that “(D)oing business abroad without fully understanding local laws and tacit customs can lead to a legal nightmare.” (‘The Independent on Sunday' 29 August 2010, p. 8).

  11. Beyond that, legal uncertainty can be introduced endogenously. On the theoretical derivation of the dynamic costs of legal uncertainty see, in more detail, Wagner (1995a, b, 1997, 2005).

  12. Studies of these kinds mainly apply the method of Ordinary Least Squares (OLS) regressions and therefore sustain the problems of mutual dependency and reverse causality due to the endogeneity of the institutional variable independently of how it is measured.

  13. And in this case a multi-level principal-agent-problem has to be solved.

  14. See also Rodrik (2009) who emphasizes: “One problem with the global strategy is that it presumes we can get leading countries to surrender significant sovereignty to international agencies. (…) A second problem is that even if the leading nations were to agree, they might end up converging on the wrong set of regulations. (…) But the most fundamental objection to global regulation lies elsewhere. Desirable forms of financial regulation differ across countries depending on their preferences and levels of development.” (Emphasis by the author, H.W.).

  15. Den Butter and Mosch (2003) tried to capture this effect by estimating an augmented gravity equation adding a variable of “informal trust”, which they build from the Eurobarometer 1996. Their estimation results indicate that a change of one standard deviation of this variable leads to a change of 24 to 34 percent in trade volume. Another argument put forward by Carbonara and Parisi (2007) points to substantial switching and adaptation costs as a possible hindrance, or reason for delay, in full legal harmonization.

  16. See in this context, e.g., the war of attrition models in political macroeconomics, see Alesina and Drazen (1991) or Drazen (2000).

  17. As an example, the crisis has made it painfully clear that the world’s banking system needs new international rules to impose lending discipline and guard against any temptation to migrate to the weakest regulatory regime. Consequently, a new set (“Basel III”) has been proposed to do the job.

  18. De facto implementation means that the formal implementation of rules (legal harmonization) is not enough, these rules also have to be abided by.

  19. “Locational competition” refers here to the new competition in open economies between governments for mobile production factors and foreign investment (see, e.g., Siebert 1996). Early models of locational competition were developed by Tiebout (1956), MacDougall (1960) and Kemp (1964).

  20. For more detail see Wagner (2010), and Wagner and Berger (2004). These effects of globalization are regarded as driving forces for arguing for international policy coordination (see, e.g., Wagner 2009).

  21. The following discussion leans closely on Wagner (2010).

  22. Capital requirements have been pro-cyclical as well. Regulation focused on the asset side of the balance sheet, but it did not focus on the externalities that contributed to systemic risk.

  23. Furthermore, the question can be put as to when international harmonization is an option, and when it is a must, and it can be answered as follows: International harmonization is an "option” if it is only a question of increasing efficiency, or avoiding (locally) limited or microeconomic risks. It is a “must” if it is a question of avoiding systemic (global) risks (see also point d) in the following list). However, even if something is a “must”, it is not automatically implementable (see the arguments discussed above in Sect. 3.2.2).

  24. I can here only give some shorthand explanations (due to page limits).

  25. This has been impressively proved by the recent financial crisis.

  26. One example here is the pensionable age: with similar structural conditions in ageing, some EU countries with low pensionable age (such as Greece) will create higher debt to finance their pension system, and thus higher crisis vulnerability, the effects of which will have to be shouldered (in the case of a crisis) by other members with higher pensionable age (and therefore lower future debt-burden) to ensure the survival of the union.

  27. See also the statement of the IMF in its report for the G-20 (IMF 2010): "International cooperation would be beneficial given the importance of complexity of cross-border financial institutions. (….) Unilateral actions risk being undermined by tax and regulatory arbitrage, and may also jeopardize national industries’ competitiveness. Coordinated action would promote a level playing field for cross-border institutions and ease implementation. Effective cooperation does not require full uniformity, but broad agreement on the principles, including on the base (adjusting for accounting differences), minimum rate, risk-adjustment, and on avoiding double taxation across countries." (IMF 2010, p. 21; italic emphasis by the author, H.W.; first sentence in original in bold).

  28. Stiglitz argues that we should investigate and differentiate between alternative architectures: Simple architectures include autarky, regional arrangements, and global or international arrangements.

  29. There have been many calls for legal harmonization in different fields, not only after the recent financial crisis, but also prior to this crisis—particularly within the European Union. There have regularly been problems with respect to finding and implementing common rules, even in assumingly less conflictive, i.e. purely business-related, fields. One example is the attempt to implement the so-called “Small Business Act” (SBA): Small and medium-sized firms (SMEs) in Europe have long called for a matching legal form valid across the EU (similar to that of the European company (Societas Europaea, SE) for large firms). Associated with these calls has been the expectation of significant cost reductions for businesses and further integration of the internal market. In response, the European Commission put forward a proposal in 2008 (“Small Business Act”) for Europe that was passed by the European Parliament in March 2009 with some amendments, but did not achieve the unanimity required for it to be adopted. This means that the statute was not able to come into force as originally intended on July 1, 2010. For more details see Deutsche Bank Research (2010).

  30. A lesson suggested by this experience is that it may not be optimal or sensible to stick to very ambitious goals (such as global rules, or comprehensive rules) for too long, but to try to have always a less ambitious worked-out solution plan or compromise (such as regional rules, or basic rules) in reserve. See the following lesson (5.6) on this.

  31. Different countries usually not only have different rules and different technologies but also different preferences. Even if the rules and the technologies are themselves nonrival ideas that can be copied from abroad, it is still true that for rules and for technologies, incentives and preferences matter. Preferences, however, are not nonrival goods. On the one hand, some legal rules on property rights are more likely to lead to the implementation of new technologies, and, on the other hand, some political rules may more likely lead to Pareto improvement in other rules. See Romer (2010).

  32. A topical example for attempts to water down proposals for rule reforms is the struggle of the banking industry in its lobbying against the introduction of proposed higher equity capital standards and other financial regulations. The reasoning is: to meet some of the new requirements, banks would need to raise large amounts of capital. Heightened global demand for capital would cause the costs of that capital to rise, so that, in order to compensate for those higher costs, banks would have to charge more to borrow money. This, however, would supposedly have a significant negative impact on lending, businesses and ultimately growth and employment. These objections have successfully been brought forward for watering down the original proposals, although recent studies (see, e.g., BIS 2010) suggest that the relationship between capital levels and the costs of loans is not nearly as straightforward as the banking industry often contends.

  33. Transparency can also be strengthened by good communication policy (see Knütter and Wagner 2010, for the example of central bank policy).

  34. See, e.g., Vinals (2010), who emphasizes that “having the right rules and tools in place is no guarantee that they will be used effectively (…) in many jurisdictions, supervisors faced impediments to enforcing fully all supervisory regulations.” (Vinals 2010, p. 10).

  35. Meta-rules are rules that are intended to serve to survey and force individuals to implement existing rules (better) or to abide by them (better): searches for such meta-rules are likely to be more important than the harmonization of rules (meta-rules must be national because of cultural diversity of attitudes, habits, etc.).

  36. A topical example is again Greece with its very low tax take ratio. Greece has rules of taxation, but relatively weak extractive capacities. A lot of evasion is down to “tax rebellion”: people simply do not feel that the services the state offers are worth paying taxes for. This, however, significantly depends on culture and past experiences.

  37. Another reason is the activities of lobbying groups in individual countries.

  38. This means that particular interest groups prevent a transition towards superior rules (what is typical for necessary reform processes often prevented or delayed after structural changes such as globalization); see, e.g., Wagner (2001, 2006).

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Acknowledgments

The author thanks Eva Matanovic and Hilke Turke for useful comments on a first draft of the paper.

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    Helmut Wagner

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Wagner, H. Is harmonization of legal rules an appropriate target? Lessons from the global financial crisis. Eur J Law Econ 33, 541–564 (2012). https://doi.org/10.1007/s10657-011-9278-z

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