We have an increasingly complex financial system and a correspondingly complex system of regulation to go with it. Constructing a proper regulatory framework not only entails an understanding of economics and finance, but also law, since much of the regulation is enacted via legislation.
So how does the law interact with finance?
To answer that question, Katharina Pistor, a grantee of the Institute for New Economic Thinking, professor at Columbia University Law School, and the director of Columbia’s Center on Global Legal Transformation, is developing a Legal Theory of Finance that makes big strides in this area.
In this interview, Pistor focuses in particular on the paradoxical relationship between law and finance. On the one hand, finance needs law to provide credibility. After all, financial assets are contracts, the value of which depends on their legal validation. But on the other hand, changing conditions in the financial world over time necessitate flexibility in law. An overly rigid legal system can render regulation irrelevant if financial innovation ultimately surpasses laws designed for another era. In a worst-case scenario, legal rigidity also can play a role in causing a financial accident.
In the United States, the Dodd-Frank legislation represents one response to this challenge. In Europe, the melding of finance and the law is even more complex because policy makers, regulators, and legislators are dealing with 17 different nations, all of which operate with a common currency but in a series of different national jurisdictions with vastly different legal traditions and precedents.
The tension in Europe has become particularly acute in relation to some of the unconventional measures undertaken by the European Central Bank in response to the existential threat to the euro itself. The supranational powers that the ECB has arrogated to itself under the guise of maintaining “financial stability” or “improving the monetary transmission mechanism,” have come under challenge in Germany’s Constitutional Court. Can a national constitutional court effectively invalidate an entire program undertaken by a supranational central bank, which ostensibly is responsible for a common monetary policy?
This is one of the issues that Professor Pistor discusses in the exchange below. As the interview illustrates, this is a highly controversial area where no definitive answers have been reached. But ultimately this tension between law and finance represents yet another profound challenge to the survival of the European Monetary Union.
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