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Law, Economics, and the Subprime Mess

By pharrell

In liberal circles, the law and economics movement has a bit of a bad reputation--it's seen a tool that lets large business interests justify relatively small damage awards for personal injuries. But a deeper impact of the law and economics movement has been its contribution to a broad shift in the law's understanding of fault, and of fault's relationship to to the party that should pay for some injury. Ironically, this deeper impact may have a long-term negative impact on the very business interests that supported the movement, for example, by offering a legal justification for banks, rather than homeowners, to bear the cost of the subprime mortgage mess.

Traditionally, law was seen as expressing the moral commitment of a community and required a person to pay for injuries caused by a moral wrong on his part. The wrong could be either an affirmative action or a neglected duty. So, for example, if the owner of a dangerous dog failed to keep the dog leashed and it bit a passerby, the owner would have to compensate the victim for her injuries.

The law and economics movement has shifted the focus of the law from assigning moral blame to maximizing overall economic benefit. As a part of this shift, law and economics suggests that the "least cost avoider"--the party that can most cheaply prevent an injury from occurring--should pay for any damages that result from the injury. For example, a chair maker who makes chairs that tip over easily should pay for injuries caused by his chairs, not because he's committed any moral wrong but because the manufacturer is in a better position than an individual consumer to figure out that the chairs are likely to tip and to fix the problem. This is an economically optimal outcome: it ensures that injuries are prevented at the lowest overall cost by creating an incentive for the least cost avoider to prevent them.

The irony of this is that the large business interests that supported the law and economics movement are often the parties able to prevent injuries most cheaply, even if they haven't done anything "wrong" in the traditional, moral sense of the word. Take the subprime mortgage mess. Given the realities of a modern financial industry with sophistical economic models and access to detailed information about individual borrowers, in all probability mortgage brokers are frequently in a better position than than a borrower himself to know whether the borrower can afford a given mortgage. This is true even if the broker didn't engage in deceptive or misleading sales tactics (and it seems that many brokers did, in fact, engage in such tactics). So strange as it may seem from a moral perspective, from the law and economics perspective it is entirely plausible that lenders, not the borrowers, should bear the bulk of the costs associated with the subprime mortgage meltdown.

Full post as published by Harrell Blog on December 06, 2007 (boomark / email).