Rules versus Discretion in Financial and Other Regulation—Posner

There is an academic literatureon the choice between rules and discretion in regulation. Milton Friedman famously advocated that the Federal Reserve be required to increase the money supply by a fixed annual rate, rather than the Fed’s being allowed to exercise its traditional discretion over the money supply. But the choice between rules and discretion is not limited to the money supply, or indeed to financial regulation. 

It helps to distinguish not just between rules and discretion, but between rules, standards, and discretion. A posted speed limit is an example of a rule; liability for negligent operation of a vehicle is an example of a standard; and the President’s power of appointment of the members of the White House staff exemplifies the operation of discretion. In fact, though, the administration of rules and especially of standards typically involves a degree, often a large one, of discretion. Police officers don’t ticket all speeders, but only those who drive “too far” above the speed limit; and legal standards such as negligence tend to be vague and so operate to grant considerable discretion to judges and juries. So the real issue in choosing among rules, standards, and discretion is how tightly to rein in the exercise of discretion by persons exercising government authority (including pro tem. government officers such as jurors). 

The fact that discretion operates even in the enforcement of precise rules (such as speed limits) is a clue to the limitation of rules. Literal enforcement of rules is unworkable because rulemakers can’t anticipate the full range of circumstances to which the rules they promulgate will apply. For the essence of a rule is to abstract, in the interest of clarity and precision, from all relevant circumstances, a few circumstances to be determinative. Clarity and precision are important values. “65 m.p.h. speed limit” conveys more information (though not complete information, because the de facto speed limit may be considerably higher), more clearly and concisely, than “don’t drive faster than conditions permit” does. 

The choice among rules, standards, and discretion is especially controversial in the law. Rules limit judicial discretion and provide crisp guidance to persons subject to them, while when judges are exercising discretion, as when they “interpret” extremely vague constitutional or statutory provisions, they seem to be stepping out of the proper judicial role and acting as legislators. But really they have no choice. The first duty of a judge is to decide. He can’t refuse to decide a case on the ground that he lacks guidance in authoritative legal materials that are sufficiently clear to dictate the decision. 

The situation with respect to the role of discretion is similar when we switch focus from the judiciary to the regulatory process, as illustrated by the Federal Reserve. The Fed’s principal power is to alter short-term interest rates (though often with an effect on long-term rates) by buying and selling federal securities. If it sells, the cash it receives for the sale reduces the amount of money in the economy and so reduces interest rates, which ration the demand for money rise. If the Fed buys securities, it pours cash into the economy and interest rates fall. Lower interest rates stimulate borrowing and hence spending, unless the rates get so low that no one wants to lend. Also, the larger the money supply, the cheaper the currency is relative to foreign currency, which makes debt held by foreigners cheaper to repay and stimulates exports. Which is one example of the broader point that the larger the money supply is, the greater the risk of inflation (because the ratio of money to goods and services is higher). So creditors, who suffer from inflation, don’t want the Federal Reserve to increase the money supply, while debtors do. W the economy is depressed, cheap money encourages debtors to spend, by reducing their liabilities, and money borrowed because interest rates are low is largely spent, thus increasing consumption, production, and employment. 

Obviously there are huge political and economic stakes in actions by the Federal Reserve, and the Fed is little constrained by rules or standards (though I’ll give an example of where it is constrained), and so exercises very broad discretion. Its mandate requires it to pay attention to both inflation and employment; increasing the money supply can stimulate both, and reducing it depress both, and the economic consequences are very different. 

The Fed’s discretion leads to a concern, fed by the traditional hostility that many people feel toward banking in any form (banking is one of the few businesses which refuse to sell to people willing to pay its price, if they are not good credit risks, though lessors, such as rental car companies, unlike sellers, are often picky about whom they rent to, lest the rented property be damaged), that the Fed’s decisions on increasing or reducing the money supply are influenced by politics. If the Fed refuses to be influenced, the President or Congress may try to curtail its discretion and by doing so reduce its power and maybe harm the country in the long run; politicians typically have a short-run perspective because of their limited terms of office. Milton Friedman’s concern, however, was more with the unpredictability and doubful competence of the Fed’s money-supply decisions. 

Having learned from our recent, unhappy economic experience that depressions are not a thing of the past, I find it hard to accept the proposition that the Fed should be subjected to tight rules. Had it not been for the Fed’s massive purchases, which greatly increased the money supply, of mortgage-backed securities during the financial crisis that began in the fall of 2008, the banking industry might well have collapsed and credit been completely frozen, precipitating a 1930s-style deep depression. Of course this means that any Friedmanite rigid rule governing Fed actions would quickly have been lifted by Congress. 

Let me give an example that illustrates both the difference between a rule and a standard and the hazards of trying to limit the exercise of discretion by the Federal Reserve. It is widely believed (including by me) that the failure of the Fed, in September 2008, to bail out Lehman Brothers precipitated the world-wide financial crisis that ensued immediately. Fed Chairman Bernanke has said that the law forbade the Fed to bail out Lehman Brothers. I am dubious. Section 13(3) of the Federal Reserve Act authorizes the Fed to lend money to a nonbank (Lehman was a nonbank bank, which is to say a financial company that provided banking services but was not regulated as a bank) in “unusual and exigent circumstances,” provided that the loan is “secured to the satisfaction of the Federal reserve bank.” Lehman did not have good security for the large loan it would have needed in order to survive, but in the emergency circumstances created by a collapsing global financial system the Fed could have declared itself “satisfied” with whatever security Lehman could have offered. For section
13(3) establishes a standard rather than a rule, and standards (even rules, as I said) usually don’t extinguish discretion. But they cramp its exercise. It would have been better had the statute just said that the Fed could lend to a nonbank if unusual circumstances justified such a loan—a looser standard, allowing more play for discretion. 

Finally, rules do not really eliminate or even seriously constrain discretion, but rather merely shift the way in which, or the level at which, discretion is exercised. A regulatory agency, having issued a rule, will usually have discretion to amend or rescind it; and if Congress imposes a rule on an agency, Congress always has discretion to amend or rescind the rule.

Comments

[TheDanAbrams]

I think the discussion of discretion versus rules is a bit of a Misnomer. Most failures we can identify are the result of failures of process not of one rule or decision.

Take congress. Congress has rules on voting, committee rules, debate rules etc. But all these votes come down to the discretion of congressmen. The congressmen are selected by a voting process with strict rules which herd the discretion of millions of individual voters.

The financial crises was a failure of process. The rules failed, but individual discretion failed as well. The process in both cases has rules and human psychological factors that encouraged amplification of one school of thought. It was a process that failed from top to bottom: from people taking out loans they could never afford to large institutions that sold bundles of these things to other institutions.

What process is at its core is a collection of rules that guide discretion by individuals or groups. The two are notionally exclusive. Even the fed, which hassle discretion, has rules on how officers are appointed and approved and have rules governing decision making.

But you can't look to any one rule that could have prevented the crisis of 2008, not can you point to any one case of bad decision making. It was a failure of process. Bad rules created bad incentives which lead to poor discretion which lead to more bad rules and so on. The process amplified itself into a bubble rather than something stable.

[Thomas Rekdal]

The problem Judge Posner discusses is as old as philosophy. Plato has an interesting treatment of the central dilemma in his dialogue, "The Statesman," and it reappears, among other places, in every comprehensive discussion of Rule Utilitarianism versus Act Utilitarianism. The question is, are we better off relying on the prudential judgment of people of character and intelligence, or should we attempt to "bind them down" with rules of action, which, in practice, may turn out to be no more than rules of thumb for the guidance of weak minds? There is no generally satisfactory answer, because, while we would all like to expand the discretion of people of competence, and restrict that of those who lack it, there is no reliable method of identifying who is who, or of placing them in, or out, of positions of authority once we have made the correct identification. The fact that we will not always have wise statesmen at the helm is offered by the authors of "The Federalist Papers" as a modest consideration in favor the the Constitution. We can all see how that has worked out. And so the ungoing, futile effort to find an adequate substitute for wisdom. Alas, there probably is none.

[Terry Bennett]

In 1961, Democratic Arkansas Senator J. William Fulbright famously lamented (during the Democratic administration of JFK, the first television President), "...we have hobbled the President with too niggardly a grant of power."

In 1970, with Republican Richard Nixon sitting, he compared the President's power to address the nation on TV as the equivalent of a Constitutional amendment abolishing the co-equality of the three branches.

We want to give discretion to the people who agree with us, and we want rules to constrain those who don't agree with us.

The upside of rules is that they rain on all alike, and are thus inherently fair. The downsides are two: (a) no rule maker is sufficiently clairvoyant to anticipate all the possible scenarios to which the rule might come to be applied, and (b) rules go stale as conditions change.

The Second Amendment right to bear arms is a rule. The Founders thought it was important enough to enshrine in the Constitution Itself, rather than leave regulation to the States. Conditions have changed a lot in these 225 years, and that rule (and the lack of discretion built into it) has caused modern America some serious headaches. When advocates are asked about the practicality of assault rifles, they simply say, "It's a right", which is another way of saying it made sense 225 years ago, and nothing more.

Rules are valuable; discretion is valuable. Any viable system, as Judge Posner points out, must intertwine both.

[Thomas Rekdal]

Terry Bennett: A small quibble. The Second Admendment, as originally adopted, was a restriction only on the powers of the Federal government to interfere with the regulations the States themselves might adopt with respect to firearms; it implied nothing about the scope of the States' authority to regulate. Only a rather complicated, and mostly unpersuasive, judicial construction of the Second and Fourteenth Amendments now suggests that these two amendments, read together, might prohibt all governments from totally extinguishing a personal right to own any type of firearm. But that is all we have at this point. Despite the Second Amendment word magic of the NRA, a wide range of possible gun regulations would still be compatible with some form of gun ownership.

[Terry Bennett]

Thomas - your point is taken. The "incorporation doctrine" is as much an impediment to gun control as the original Amendment Itself (and no doubt contradicts the "doctrine of Scaliality", which I just made up).

Additional pondering: The Second Amendment starts with what is essentially a legislative finding, implying that the reason for the rule was the Framers' recognition that well-regulated militias were needed. In our time when that premise is arguably no longer true, is the Second Amendment self-nullified?

[Thomas Rekdal]

Terry: Yes, that is how I would have read the Second Amendment, but, as you are probably aware, the Supreme Court's Heller majority broke off the Second Amendment's "well regulated Militia" clause, leaving us with an individual right "to keep and bear arms," which presumably may not "be infringed" by either Federal or State governments. But what does that mean? I would argue that any reasonable regulation of the right which falls short of totally extinguishing it is not an infringement within the meaning of the amendment. That brings us back to the question of what would be reasonable, and to Judge Posner's wiggle-room for discretionary interpretation.

Here is another thought: If the militia clause is obsolete, why could we not substitute membership in a well regulated gun club? Why could government not condition ownership of firearms upon participation in such organizations, which might prove better judges of gun competence than mere background checks might afford? Another potentially wide field for regulation.

[Neilehat]

As for the ongoing "Gun Control" issue, the entire Pro-gun faction's position is predicated on the interpretation issue of "lifting out of context". Such that, "... the peoples right to keep and bear arms SHALL NOT be infringed" never mind the controlling clause about "A well regulated militia" and the meaning of Militias. A big "No-No" in Constitutional interpretation...

Returning to the issue at hand, "Rules, Standards and Discretion". This is the fundamental issue of Governmental legislation, "Flexibility vs. Inflexibility". Such that, overly "flexible" systems lead to legislative failure due to human nature and it's tendency towards corruption. Just as "inflexibility" leads to legislative failure by it's inability to respond to the temper and conditions of the times. So a "balanced approach" is required to acheive Legislative aims and acheive a certain degree of Justice. I could go on citing how this has affected many of the issues confronting us today, but that will take an inordinate amount of time and space and in the interest of brevity, I think I'll end it here...

[bean spout]

Friedman suggested a rule to limit what he saw as the growing agency problem of irresponsibility and politicization of the Fed—rising agency self-serving in an unaccountable, too big Government. All rules have to be drafted broadly enough to allow the management enough flexibility to accommodate changing circumstances. Some will be ill drafted, and fail to foresee exceptions. Rules that are too lengthy or mechanical, or seek to control everything in advance, may be well-intentioned but are often unwise. Rules only work when matters are fairly routine and predictable. To me, standards verge onto moral territory, "principles."