A research agenda for the Legal Theory of Finance

Marcos Reis1

AREA 1: MACROECONOMIA, POLÍTICA ECONÔMICA E FINANCIAMENTO DO DESNEVOLVIMENTO

Abstract: This article presents the Legal Theory of Finance (LTF) and compares it with the Financial Instability Hypothesis (FIH), identifying points of convergence and divergence. This paper aims to contribute to the literature by connecting these theories and provides the following main conclusions: First, the LTF incorporates aspects of the FIH, as the theories share several key elements, particularly the presence of fundamental uncertainty, the constraint of liquidity, and the necessity of governments to act as lenders of last resort. Second, the liquidty concept used in the LTF can be better comprehended with the use of the Post Keynesian literature on the topic. Third, the LTF aims to advance and update certain aspects of Minsky's theory, particularly with regard to the globalization of markets, power relations, and the interdependencies of the political economy of finance. Finally, the paper concludes that the theories are more complementaries than divergents and future studies should be made in order to create an analytical framework that integrates the most their respective insightful aspects.

Keywords: Financial Regulation; Legal Theory of Finance; Financial Instability Hypothesis. JEL classifications: E12; K00; G28

1. Introduction

The beginning of the XXI century witnessed the emergence of one of the largest financial crises in world history. Known as the subprime crisis because of its origin in low-quality mortgages issued in the US market, it spread rapidly after its conflagration, reaching both developed and emerging countries to a greater or lesser extent.2 To prevent future such crises, discussion on the functioning of the financial system and the possible role of economic regulators in curbing and addressing financial emergencies and crises is necessary. For this purpose, the strengths and limitations of new theories seeking to explain financial crises must be analyzed.

This article presents the Legal Theory of Finance (henceforth, LTF), proposed by Katharina Pistor (2013a), and identifies points of convergence and divergence with the Financial Instability Hypothesis (henceforth, FIH) designed by Hyman P. Minsky, which is, according some authors, the theory that have the most predictive power to describe the development and to explain financial crises, including the subprime crisis.3 The LTF highlights the centrality of the legal system and institutions to the understanding of modern financial systems, at both the national and the global level. The theory is based on two key assumptions, namely, fundamental uncertainty and the volatility of liquidity.1 Postdoctoral researcher at the Institute of Economics at the Federal University of Rio de Janeiro (IE/UFRJ), Brazil. 2 For an analysis of how the subprime crisis started in America and became global, see Eichengreen et al. (2012). For a historical narrative, see Blinder (2013).3 This view is common within authors within the post-keynesian tradition. See, for instance, Wray (2011) and Bellafiori and Halevi (2009).

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Given that the LTF is a very recent theory, literature on the LTF is limited4. Hodgson (2013) argues that the emergence of the LTF opens a new research agenda for the multidisciplinary field of law and economics. The author further argues that the approach adopted by Pistor may engender the emergence of a "new institutionalism" that challenges mainstream economics, which fails to incorporate elements from other social sciences into analysis. Deakin (2013) concludes that the LTF plays an important role in recognizing the endogeneity of law related to finance and the need for law to become more elastic to combat financial crises.

This paper aims to contribute to the literature by making connections between the LTF and the FIH and identyfing the limitations of the LTF regarding the concept of liquidity and fundamental uncertainty and how the FIH, and the post-keynesian literature, can advance the LTF on this point. The main conclusions are as follows: First, the FIH is nearly entirely incorporated into the LTF, as theories share several key elements, particularly the presence of fundamental uncertainty, the constraint of liquidity, and the necessity of governments to act as lenders of last resort (hereafter, LLR). Yet, the use of these two key assumptions in Pistor’s theory lacks more solid ground, which is this paper; we propose as to be found in Keynes’ fundamental uncertainty and his theory of liquity preference. Second, the LTF aims to advance certain aspects of Minsky's theory that was not covered in Minsky’s seminal works on FIH, particularly with regard to the globalization of financial markets, the hierarchy of power relations in international finance, and interdependencies of the political economy of finance. Finally, the paper concludes that research is needed to integrate the two theories by investigating how the characteristics of the FIH converge with the points raised by the LTF. The paper is structured as follows: After this brief introduction, section 2 presents the FIH, and section 3 discusses the LTF. Section 4 then discusses the differences and complementarities between the two theories. Finally, section 5 concludes the article.

2. Minsky and the Financial Instability Hypothesis The FIH, as proposed by Minsky (1982, 1986), indicates that the economy possesses

endogenous mechanisms that render the system increasingly likely to reverse the prevailing economic situation in face of increasingly less relevant shocks. Therefore, the theory addresses explanations for the collapse of economies into the "abyss" and the irrelevance of the magnitude of the shock that can lead them to collapse. From this perspective, economic collapse due to a cumulative process is a natural occurrence.

In his work, Minsky seeks to demonstrate the contradictory character of banking. While an essential element in the financing of investment activity and a prerequisite for the successful operation of a capitalist economy, banking may induce or amplify financial instability. This occurs especially in times of economic boom, when the degree of indebtedness of entrepreneurs tends to increase substantially (Minsky, 1982; 1986).

There are no physical limitations, such as tangible costs and capacity limits that prevent banks from offering money and credit. For this reason, banks tend to grant more credit than is prudent in times of economic expansion, underestimating the risks. Minsky thus emphasizes markets’ inability to achieve some structural measure of self-regulation and the highly cyclical nature of credit. Hence, expanding economies are inherently unstable, and financial fragility characterizes their operation under normal conditions.

4 Most of the new works on this research program was published in an edition of the Journal of Comparative Economics, in 2013. See Pistor, 2013b for an brief exposition of the papers on this subject in this edition.

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The FIH is based on variations in the fragility of the economy. Such fragility arises from a slow and often unnoticeable erosion of the safety margins of individuals, firms, and banks.5 As a fragility model, the FIH is based on cumulative movements that render the economic system increasingly vulnerable to small shocks. To present his theory, Minsky divides financial agents into three different groups: i) Hedge, which is both liquid and solvent in short and long run, as for each period, the earnings from cash flows are sufficient to pay obligations; ii) speculative: illiquid in short run, but solvent in long run (because the sum of the present value of all expected income is greater than the sum of the present value of all financial commitments); iii) Ponzi¸ wich are both illiquid and insolvent in short and long run.6

It is not the degree of leverage that defines the position but the liquidity condition of an agent. Economic growth renders agents more likely to take on debt. Thus, with economic growth, the volume of debt grows, and the debt composition changes. As the cycle develops, hedge agents can become speculative agents and even Ponzi agents. The degree of fragility of a financing structure thus derives from the uncertainty surrounding the future income of the debtor and the debtor's degree of dependence on external sources of funding to sustain its financial commitments.7

To illustrate his theory, Minsky notes that in the context of euphoria, the financial dynamic gains autonomy to the growth. The increasing fragility of the economy, as indicated by the lower capacity of the economy to absorb shocks without suffering severe economic damage from the erosion of safety margins, is not perceived by economic agents, remaining hidden until unforeseen changes in macroeconomic conditions occur.8

According to Fisher’s (1933) formulation of debt deflation, a sharp decline in the monetary value of assets presents a threat to the soundness of the financial structure as a whole, which leads the economy to a state of financial crisis. Such asset liquidation and credit contraction imply decreases in asset prices, profits, current production, and employment. In Minsky’s analysis, this point is stressed out, with an additional problem: the fact that financial layering exacerbates the risks inherent to a system which works by debts and expectations on future income to honor these debts, by agents or institutions which are interrelated in complex

5 The margins of safety provide protection against unexpected losses in every period of the project-funded events. According to Minsky (1986), these margins are set according to the cash flow to the capital value of the firm and the balance sheet. The “cushion” covers the margin of error in the anticipated returns from an investment project. On this subject and its relation with the subprime crisis, see also Kregel (2008).6 In specific, for speculative agents, expected returns are lower than the total interest expense (principal amortization plus interest) but are sufficient to cover the interest for one or more periods. Any cash deficits are offset by surpluses in other periods such that at the end of the term of the contract the agent can settle any debts and still have additional net income. The solvency condition is respected; however, the liquidity condition is not respected. The viability of a speculative financial structure depends on both the revenue stream to pay interest on debts and the functioning of the financial market in which such debts are negotiated. For Ponzi agents, however, the payment of amortization needs to be completed during some periods with new borrowings. Such agents do not meet liquidity or solvency conditions.7 Quoting Minsky on this instability as a function of a growing proportion of speculative and Ponzi financial postures in the economy: “For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy, the greater the stability of the economy, whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.ˮ (Minsky, 1980a, p. 22). As noted by Knell (2014), when Ponzi agents are highly prevalent in the economy, as evident in the subprime crisis of 2008, the financial demise of such individuals can bring about speculative agents and even hedge agents, who will lose their financial position after a sudden change in economic conditions.8 As Minsky states: “It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy.ˮ (Minsky, 1977, p. 66, italics added).

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commitments of debts. On the very beginning of a downturn some agents needs to sell positions to make positions (e.g., to honor past commitments, fearing that falling prices drives his financial commitments impossible to pay). This, with financial layering, has sufficient power to accelerate the development of a downturn into a full-blown crisis (Minsky, 1969; 1980a).9

Minsky (1986) argues that the decision to invest is always a decision about the structure of liabilities of an economic agent, in terms of which proportions of his/her liabilities is funded with internal funds, and which is funded externally, by issuing debts. In this fashion, the stability of the economy largely depends on how investment and capital asset positions are funded: the more firms and individuals invest by issuing debt, the more unstable they render the economy. Thus, according to Minsky, the capitalist economy is unstable by the very nature of the capitalist economy: accumulation of capital is dependent of, and simultaneously has impact on, the conditions of generating and collecting cash flows from the business process.10

Therefore, the economic system is endogenously unstable, i.e., there are no internal mechanisms to stabilize the economy in terms of the level of full employment and the available factors of production. Even if the economy reaches an equilibrium position, this equilibrium will not last because of endogenous forces. Consequently, the system is inherently flawed, and regulation is needed. As Minsky observes: “A sophisticated, complex, and dynamic financial system endogenously generates serious destabilizing forces so that serious depressions are natural consequences of non interventionist capitalism: finance cannot be left to free markets” (Minsky, 1986, p. 324, italics added).

The considerations raised by Minsky regarding the functioning of the monetary economy allows the understanding of the mechanism of generating economic crises. In an economic growth scenario, agents analyze their portfolios and observe a lower delinquency rate. As this raises optimism, riskier projects begin to be validated. Liabilities grows up in risky debts on proper time.

In times of prosperity, safety margins are naturally reduced. This process is rational: when banks observe defaults and falling equities, given that maintaining margins entails costs, they begin to reduce safety margins, as they come to be viewed as excessive.11 However, with a reduction in safety margins and with a greater proportion of Ponzi and speculative agents in relation with hedger agents, any small shock in the economy can result in a financial crisis. Thus, according to Carvalho (2009, p. 16): “[…] preventing systemic crises […] does not require

9 On financial layering, see also Papadimitriou e Wray (2010), Kregel (2010), Nasica (2010). 10 For an earlier treatment on this subject from this author, see also Minsky (1960; 1969). According to Cooper (2008, p. 171), “Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability.” On this issue, it is of particular importance to the Minsky’s FIH the presence of fundamental uncertainty in the economy, is the same fashion proposed by Keynes (1937). Minsky (1982, p. 65) further highlights the role of uncertainty: “An economy with private debts is especially vulnerable to changes in the pace of investment, for investment determines both aggregate demand and the viability of debt structures. The instability that such an economy exhibits follows from the subjective nature of expectations about the future course of investment, as well as the subjective determination by bankers and their business clients of the appropriate liability structure for the financing of positions in different types of capital assets. In a world with capitalist financial usages, uncertainty—in the sense of Keynes—is a major determinant of the path of income and employment.”11 Regarding rationality, Kindleberger (1978) notes, as does Minsky, that financial crises are recurrent in the economy. The author argues that an initially rational movement of price increases can turn into a fundamentally irrational speculative process (euphoria), necessarily leading to a stage of panic. The situation is only controlled by a drop in commodity prices, market regulation, or external intervention. However, in contrast to Minsky's proposal, this argument highlights the possibility that markets become irrational, which would manifest itself in price bubbles.

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preparing against major surprising adverse shocks, but, rather, preventing fragility from becoming so acute that even a minor shock could derail the operation of the financial system, cause a debt deflation and lead to economic contraction.”

Therefore, considering the hypothesis proposed by Minsky, one could see that the concept of systemic risk in which any shock is considered a possible trigger of a major crisis provides the theoretical background necessary for the recognition of the importance of prudent banking/financial regulation. According to Minsky, the main purpose of financial regulation is to avoid reaching an extreme point of financial fragility. Financial fragility can be measured by the ratio between hedgers and speculative plus Ponzi financial postures,12 ratio which tends to decrease in a growing economy. Before an extreme point of fragility is reached, financial regulation should thus restrain the growth of Ponzi-type financial postures. However, according to Minsky, because of the difficulty in doing so, a regulator may not be able to identify these Ponzi-type positions, and thus, the same control leverage may be used to restrain such positions.

Thus, regulatory authorities must find the best way to intervene in the market by generating the least possible distortion from an efficiency perspective and by seeking to minimize the costs involved in such intervention. Given the characteristics of the financial system, the solution proposed by Minksy (1986), then, involves the recognition that an active federal government must assume a crucial role in the economic system (a Big Government, in Minsky’s terms)13 and that a central bank must serve the system as a liquidity provider of last resort, i.e., the Big Bank.

3. The Legal Theory of Finance The LTF proposes that finance is legally constructed, i.e., legal systems are base for

functioning, enforcement and maintaining financial systems. After all, financial assets are contracts for which the value largely depends on the legal justification. Which financial assets are claimed depends on the legal rules and the interpretation of such rules by courts and regulatory agencies. In short, law and finance are locked in a dynamic process in which the rules governing the game are continually challenged by new contractual arrangements.

Financial systems comprise a complex network of interdependent contractual obligations, LLR, or promissory notes, in which market participants are connected to each other. Note that these contractual obligations can be created and passed on by public and private entities. In addition, agents can be financed through the assets or debts of third parties (Pistor, 2013a).

3.1. Motivation and Features of the Legal Theory of FinanceProposed in 2013 by Katharina Pistor in the article “A Legal Theory of Finance,” the LTF

is an attempt to understand the financial market from a predominantly legal perspective. As Pistor (2013a) notes, her theory is inductive—born from observation of a broad spectrum of financial markets, including stock, credit, sovereign debt, foreign exchange, and derivatives markets.14

LTF has two key assumptions: fundamental uncertainty and the volatility of liquidity. Uncertainty and liquidity have a reciprocal relationship. If the future were known, this knowledge could be taken into account to address liquidity shortages. Moreover, if liquidity were always available, there would be no need to worry about the future, given the possibility of endless refinancing of commitments.12 Financial Fragility is measured by the ratio Hedging / (Speculative + Ponzi). In a growing and optnimistic economy, hedging postures decrease as well as specultative plus Ponzi postures increases, increasing overall fragility.13 For a detailed discussion on the role of Big Government in minskyan perspective, see Vasconcelos (2014).14 In this sense, one can argue that LTF is not yet theory, but a set of hypothesis from which a theory might be built. Regarding this possible objection, in this work we will use the word theory in the sense of Pistor’s work.

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The fundamental uncertainty that is used in the analysis is Knightian uncertainty. First proposed by Knight (1921), such uncertainty refers to the existence of events that cannot be quantitatively measured. Given the impossibility of knowing all the possible events and calculating their probabilities, the future cannot be predicted, and any investment strategy planned today will have to be adjusted if the future deviates from the assumptions that are made in the present. This fundamental uncertainty introduces a crucial element into decision-making. According to Kindleberger (1978), the sequence of financial crises in the history of financial markets confirms the acceptance of such a theory.

In turn, the volatility of liquidity is associated with the inability to sell assets or to exchange them for other assets at any time. At times, liquidity is abundant, and at other times, liquidity is extremely restricted, as evident in the recent international financial crisis, during which liquidity conditions changed sharply over a short time. Therefore, the conjunction of fundamental uncertainty with the volatility of liquidity creates inherently unstable financial markets. Given these conditions, the existence of non-negotiable legal commitments can trigger and deepen a financial crisis and even lead to the collapse of the economic system.

LTF starts from the premise that financial operations are developed and implemented within legal parameters. As financial assets are nothing more than contracts, their value depends on their legal validation, which is central to the functioning of international capital markets. It is through laws, both domestic and international, that access to capital and the liquidity of the system are ensured. Thus, contracts and obligations, aiming to protect officers against losses and to ensure the health of the system, can lead to opposite results under fundamental uncertainty and the volatility of liquidity. As Pistor notes (2013a: 318): “(…) while perfectly rational from the perspective of individual contractors, predetermined, non-negotiable obligations designed to mitigate the effect of future contingencies on individual parties, such as collateral calls and margin calls, can increase the financial system’s vulnerability to crisis.”

Thus, when no liquidity constraints exist, contracts and obligations undertaken by public and private entities may be perceived to be near-perfect substitutes for currency and may be sold or exchanged for other assets with relative ease. However, an abrupt search by various agents to change their portfolios in the same direction makes it apparent that certain assets no longer meet the liquidity conditions previously reached. Assets perceived to be safer, such as paper currency and sovereign bonds, then become even more attractive. Thus, one can argue that the financial system is not levelled but rather hierarchical (Mehrling, 2012).

It follows that in the last instance, the only agent that is capable of serving as a lender and/or as a trader of last resort is an agent with the power of an infinite money supply. In the modern economy, only one type of entity has this capacity: states (or their central banks) that have their own currency on which they issue debt.15

3.2 The Four Pillars of the Legal Theory of FinancePistor (2013a) identifies four elements that compose the pillars of the LTF. They are the

follows:I) The Legal Construction of Finance: all financial assets and contracts are designed to be legally accepted. A set of laws and regulations was essential for the development of today's large-scale financial markets. Therefore, there are no unregulated financial markets, and even talk of "deregulation" seems to be a misnomer because the markets are not unregulated per se but, as evident in the years before the outbreak of the subprime crisis, are exposed to self-regulation.

15 The sovereign state, through the central bank, is the most qualified LLR agent in modern capitalist society but has not historically been the most qualified such agent. See Tallman and Moen (1990).

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Thus, as proposed by Harvey (2013), "deregulation" does not mean the absence of regulation but the implicit delegation of rulemaking predominantly to private actors, that must comply with these rules while enjoying the full protection of the judiciary. In short, the "Legal Construction of Finance" pillar highlights the importance of the legal system in the construction of the modern financial system. Therefore, an analysis that does not account for such a crucial aspect is incomplete, and it will likely not provide the correct explanations for the phenomena observed in financial markets.

II) The Law-Finance Paradox: there is a paradoxical relationship between law and finance: legal background secures finance, but strong enforcement of law (or weak commitment to the law) can break it. Although necessary to provide reliability and predictability to the financial market, agreed upon laws could lead to a collapse of the system if full compliance with contracts is required. However, if laws are relaxed or suspended to save the system from collapse, laws lose their credibility. In such a case, because agents know that the laws will not be fulfilled, they have no incentive to follow them.

The propensity of the financial system to reach a crisis point or even to self-destruct, the only solution to which is the suspension of prior authorizations, is determined primarily by how the system is institutionally designed. As the previous section shows, according to Minsky (1986), a greater number of refinancing agents increases the fragility of the system, as the number of speculative and Ponzi agents increases.

To address uncertainty, market participants seek to avoid risky positions and seek transactions that allow a hedge position. However, when many agents follow the same strategy, an adverse event can destabilize the system because of previous legal commitments. Upon reaching this point, the system can only be saved with the relaxation of these contracts. Thus, external liquidity injections (bailouts), mergers, partial defaults, and nationalization, among other measures, appear as extreme measures. Thus, to preserve a fragile system, it is necessary to relax the previously assumed governing laws and/or to provide liquidity commitments. Pistor (2013a) notes that, in general, the law tends to be binding on the periphery. At the apex, the law has greater elasticity. This concept is a cornerstone of the LTF.

III) The Elasticity of Law: as the previous pillar appointed, generally, the collapse of the financial system16can only be avoided when it relaxes previous commitments, creating a paradox. However, when and for whom would the law be "more elastic"?

According to Grant and Keohane (2005), the elasticity of the law would be entirely discretionary and would be subject to "those in power." Pistor (2013a) indicates that, nationwide, a sovereign country with its own currency would be at the top of the power range, as it would have access to infinite resources, given its ability to issue currency. Moreover, within a country, there are apex and peripheral institutions. The law is more elastic for the former than for the latter.

At the international level, some differences arise. Similar to the domestic level, a center and a periphery exist. The global financial system comprises many individual and interdependent systems. Those in the periphery benefit from the expansion of the financial services of the central agents during boom periods; however, they suffer from the downturn in the financial "center," regardless of whether they contributed to the crisis. Judge (2013) summarizes this separation, stating that nations are different also in its places in the international finance and legal hierarchy: in the international context, there is a center and a periphery in hierarchical terms, and the

16 Which means: in situations where a full blown crisis (in Minsky’s words: “It”; Minsky, 1982) is nearby to occurring

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elasticity of the law gets more or less greater according to the position of a particular country on this hierarchy.

This distinction—between central and peripheral financial centers in the international context—is crucial for understanding the dynamics of global financial regulation. Pistor (2013a) notes that emerging countries are consistently underrepresented in global governance. Efforts aimed at international financial regulation provide an example of the misalignment of interests between developed and emerging countries. The adoption of a single international strategy in banking regulation, for example, (currently, Basel III) would be counterproductive to emerging countries, as a unified strategy represents the interests of more central countries.

The elasticity of the law can be summarized as the probability that a previously assumed requirement can be relaxed or suspended in the future. Nevertheless, power agents that are closer to the center tend to benefit from such elasticity. This tendency can be observed from three recent examples: the unfolding of the subprime crisis, the crisis in the Eurozone, and the "default" in Argentina in 2014.17 Also the central role exerced by the US in international financial system is linked to fact that the US dolar is the principal reserve and currency in international markets.18

The modern financial system has, thus, a true "hierarchy" (Mehrling, 2013). Pistor recognizes this characteristic of the modern financial system but goes further with the LTF. She notes that despite being inherent in agents’ position in the system, the hierarchy is not natural. Rather, the hierarchy results from the power exerted by other agents. Regarding the conditions assumed by the countries in the current scenario, Pistor (2013a: 320) notes: “The countries at the top of the global hierarchy owe their position to historical contingencies, for example as winners of world wars (the US) or beneficiaries of cold wars (Germany). Their position has been enhanced by the fact that they (the G7) also controlled the rules of the game for global finance set

17 The unfolding of the subprime crisis presents several examples of the law of elasticity. To rescue several financial institutions, the United States government relied entirely on ad hoc considerations, and even within a "central" power group of financial institutions, the government rescued some agents but not others, indicating the existence of a hierarchy within subgroups as well (the insurance giant AIG was saved; the investment bank Lehman Brothers was not; on this subject, see Sorkin, 2009). Nevertheless, the owners of the properties under mortgage, who were the trigger for the crisis, were not aided by the government, and their mortgages were executed, in accordance with their previously entered agreements. In the case of the crisis in the Eurozone, the European Central Bank (ECB) has proved inflexible with regard to the problems experienced by "peripheral" countries (those designated by the market with the unfortunate acronym PIIGS, Portugal, Ireland, Italy, Greece, and Spain).With the deepening of the crisis, the ECB decided to act, specifically through the European Financial Stability Facility (EFSF), which was launched in 2010, and the European Stability Mechanism (ESM), which was implemented in 2011. One explanation for the ECB’s late response is that the ECB acted once it became clear that financial institutions from the "center," particularly German and French banks that were exposed to public and private bonds issued by the PIIGS, would suffer substantial losses if these countries experienced a financial collapse. As an example of inelasticity of the law against a peripherical contry, we can see Argentina’s "default" in 2014. Argentina was prevented by an american federal judge from following through with payment to creditors who accepted the restructuring of debt caused by the default of 2001. As some creditors—so-called "vulture funds"—did not accept the debt negotiation, the judge ruled that the country could not follow through with payment to creditors who accepted the agreement. Stiglitz and Guzman (2014) observe that this case demonstrates the inflexibility of the system in favor of the central agents, as the federal judge protected the interests of American investment funds.18 Mehrling (2013) notes that in the foreign exchange markets the dollar is the reference currency for all transactions, even for transactions held in other central countries. As the dollar has higher demand and therefore higher liquidity than other currencies in the market, the demand for the dollar increases even in panic situations when the American economy itself is responsible for the market apprehension. A crisis generated by the US affects the whole market. Given the increased uncertainty, investors seek safer assets and greater liquidity. Paradoxically, such an asset is the dollar itself and the securities issued by the American government, generating a paradoxical situation whereby even a weaker but central country experiences greater demand for its currency and bonds.

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forth in the Basel Concordat and the Basel Accords, and not coincidentally, by the prowess of the financial intermediaries they house.”

The location within the hierarchy of power is therefore crucial to the survival of the agents. The closer that an agent is to the center of power, the more likely the agent is to benefit from a favorable "relaxation" of the law. The hierarchy of power thus affects competitive distortion at the international level and affects many spheres beyond competitiveness at the national level.

IV) The Essential Hybridity of Finance: the nature of the modern financial system not as dichotomous public/private, free market, and statist systems but rather as a hybrid system. According to Pistor (2013a), the hybridity of the financial system is particularly clear in times of crisis, when financial asset holders seek to convert their portfolios into cash (the most liquid type of asset), the issuance of which is controlled by sovereign states.

As previously discussed, securities may be issued by public and private actors at any time. However, liquidity conditions are volatile. As the exclusive issuer of a currency, sovereign states that use their own currency become the only agents that are capable of serving as LLR. Therefore, sovereign states are crucial to the functioning of the financial system.

In short, international financial markets developed and expanded into their current form only because of the presence of agents that provide infinite liquidity. Therefore, the system is naturally hybrid, and an analysis that does not consider this essential role of the state will necessarily be incomplete.

3.3. Implications of the LTFCollectively, what do the four elements of the LTF implies? Pistor (2013a) notes that the

cruciality of laws on finance can be observed in three different aspects. The first is that Laws validate the means of payment: Through a defined set of rules, a framework is created to ensure that contracts are designed and enforced. The legal tender issued by the state serves as the backbone for the modern financial system. In addition to being the reference price for other assets, this currency is also the most liquid asset in the system, responsible for oiling the gears of a paralyzed system.

The second is that the set of laws is responsible for determining the agents, activities, and tools that the government must regulate and those that will be left for private regulation: With greater tolerance for competitive regulatory regimes comes a greater possibility that regulation takes an arbitrary shape to meet solely the interests of the institutions within the financial system. Lastly, the rule of law should recognize contracts and define the contours of their applicability: Because financial innovations often aim to reduce regulatory costs, regulators should continually assess their validity.

According to Pistor (2013a), the LTF main conclusions are: i) financial systems will never reach an equilibrium condition, always remaining unstable; ii) although both central and peripheral agents take advantage of periods of expansion, in times of economic downturn, agents and institutions that are peripheral to the system generally face a system of inelastic laws, increasing their risk of default and economic stress (hence, the centrality of agents determines their survival): iv) the goal of agents and institutions is to gain access to the center so that they can take advantage of such benefits as the elasticity of the law, leading to an increasing concentration of agents near the center, which, in turn, will engender a need for greater resource mobilization to stabilize the system. Finally, v) given that the mobilization of substantial resources by a state in its role as LLR will be a political decision, the state becomes the real protagonist of the global financial system.

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3.4. A critical analysis of the LTF missing issues: the liquidity preference

Pistor’s work is a promising branch to be developed in the research on finance, and its links with institutions of capitalism. It brings to the post-Keynesian analysis a new perspective on the institutional and political side of financial markets, which is a significant gap to be filled in this school. Nevertheless, LTF lacks better foundation. In specific, it requires a better definition of one of its crucial concepts, the volatility of liquidity.

The LTF, as stated above, has two key assumptions: the fundamental uncertainty in financial markets and the volatility of liquidity. A discussion of fundamental uncertainty, if it is more in the Knight’s fashion (Knight, 1921) or in in Keynes’ sense (Keynes, 1936; 1937), does not constitutes a significant problem in the theory. LTF does not consider, as the mainstream theory does, that uncertainty is reducible to some calculable probability. Uncertainty is ignorance about what the future can bring, and in this sense LTF is very akin to the post-Keynesian school.

However, the LTF’s liquidity analysis can be discussed. LTF states that the volatility of liquidity is one of its key assumptions, but LTF takes liquidity exogenously. The proposed theory does not cope with an explanation of why something (e.g. a financial asset or cash), is more or less liquid than other assets, and why liquidity is not a complete attribute of an asset for all times and/or situations. The central point that LTF states is that liquidity is “the ability to sell any asset for other assets or cash at will” (Pistor, 2013a, p. 316). This is a telegraphic definition of liquidity, and if one does not have an explanation of liquidity, how is it possible to use a concept that is so deeply linked to it?

LTF needs to treat liquidity in a more proper way, and after that, apply the concept. The whole idea of the volatility of liquidity is redundant, in some sense, because liquidity is volatile by definition, but the concept is limited, also, because liquidity is more than volatility of asset prices.19 From a post-Keynesian perspective, we propose that LTF should start from the analysis of liquidity proposed by Keynes. In Keynes’ proposition, there is no liquidity per se in the multitude of financial or capital assets, but liquidity-preference that economic agents reveals conditioned to expectations, uncertainty, and conventions.20 In the way that it is presented in Keynes’ works, liquidity is volatile, but this volatility reflects agents’ preferences in face of different economic contexts.

According to Keynes’ liquidity-preference theory, individuals wants to grant that opportunities to yield from his/her assets, as well as their needs to cope with past committed payments are fulfilled using their wealth (accumulated savings in all possible forms of assets). In doing so, individuals differentiate assets with which they can do these tasks considering assets’ attributes in terms of possibilities of gaining yields (or quasi-rents) from it, the possibility that the asset can obtain some positive valuation if it is sold in secondary markets (if these secondary markets exists), the asset’s carrying costs, and, the most important characteristic of an asset in Keynes’ proposition, its liquidity premium. The liquidity premium, as stated in the Keynesian liquidity-preference theory, is the most proximate concept that is usually stated in discussions about liquidity, as we see in Pistor (2013a).

In Keynes’ theory, however, these attributes are characteristics of assets that can be changed for other assets in a monetary economy in which money is not neutral. In those

19 As we will see, following Keynes seminal treatment, liquidity is a relative attribute of assets, and it is not an stable attribute, but is a confidence state dependent one. 20 Keynes‘ liquidity-preference theory has been well discussed in the post-keynesian literature, but the principal references to this discussion remains the writings of Keynes himself. See Keynes 1937; Keynes 1973a and 1973b).

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economies, economic units behavior in conventional forms, and considers uncertainty in developing those conventions.21 When uncertainty is fundamental, as it is in an enterprise economy of the kind in which we live, agents needs to find which class of assets to maintain and which to sell at each circumstance, and this is a decision that changes as the economic scenario changes. Under greater uncertainty, this relative attribute changes between different types of assets, and not only in terms of specific asset prices, as it has been proposed in LTF's terms. Liquidity is not volatile, only, but is state-dependent on the liquidity-preference, and liquidity-preference reveals that some assets are preferable to others in different states of expectation and confidence scenarios. Only when someone takes liquidity-preference as it is stated in Keynes’ formulation it is possible to deal with the problem that when uncertainty is the highest, people chooses money, even knowing that money has no yield or valuation (in its own), because money possess, amongst all classes of assets, the bigger liquidity premium of all.22

To the economic units, as stated by Carvalho (1995, p. 21), “liquidity is flexibility”. In post-Keynesian perspective, liquidity is a complex result bring to the markets, each moment in time, by interactions between economic units behavior in face of uncertainty, the options they have in hand when they are trying to manage uncertainty, and the assets they have at their disposal.

On treating this in the limits of LTF, one could consider how these assets are granted or not by the institutional environment, reflecting in this fashion the legal structure of the financial markets. Legal enforcement of contracts is a grant of more liquidity, in relative terms, as we can see in markets that are legally well organized, compared with OTC markets. Nevertheless, liquidity is not entirely granted even by strong and sound legal institutions because liquidity is checked only when someone needs to sell something. Even if there is legal enforcement, if there is not a buyer for something that a seller wants to sell, the liquidity is not granted at all.

LTF has a limited perspective about liquidity, and in particular states that the principal characteristic that brings to currency his extraordinary liquidity is the fact that it is the legal tender issued by the state. In this view, this renders money as actually being the backbone of the financial system, which means being the reference price for other assets. Moreover, money is viewed as responsible for oiling the gears of a paralyzed system. However, it is not an accurate statement that the mere fact that the presence of currency in the economy can turn a paralyzed system into a well functioning one. What we see from the Keynesian liquidity-preference theory is that individuals run to the money when they face exacerbated uncertainty. This run does not solve the problems of the economic system, notwithstanding it can address the problem of a particular economic unit. Liquidity is not a question of selling assets in markets, only. Liquidity is skewed in the economic units’ point of view, in the sense that when uncertainty is very high, they will prefer maintain money, which has the highest liquidity premium of all assets, so those that wants to sell other assets than money maybe can not find anyone to buy it, even when there is plenty of money issued by the state.

This lack of a proper treatment of liquidity (in particular, liquidity in terms of liquidity-preference), weakens some important normative issues that LTF needs to consider. The liquidity of private financial assets, like debentures, commercial papers or securities (financial instruments

21 In doing so, individuals and firms operates under some state of expectation and confidence built on a very complex environment and behavior, as it is stated in Keynes` General Theory, chapter 12 (Keynes, 1973[1936]).22 It is worth to remember that, according to Minsky’s reading of Keynes’ General Theory, Keynes deals with two pricing systems: the price of physical product and wages on the one hand, and the price of capital and financial assets on the other. The theory of liquidity preference is the source of the pricing explanation in this second market (Minsky 1977, p. 60-1).

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that are supported and granted by the law, as the LTF highlights), is not the same in periods of euphoria and periods of depression. The liquidity of money, however, remains, in terms of the liquidity premium, in any phase of the business cycle.23 The problem in depressions is that there is a run to cash, and economic units that already have cash does not want to spend it, or change it to other assets.

In such cases, the liquidity of corporate bonds, for example, may collapse unless other institutional mechanisms – financial regulation and ultimately LLR actions by central banks – come into action.24 LTF needs to consider these issues, and starts from the fact that liquidity is volatile by its very nature, as Keynes strongly showed this in his works.25

4. Similarities and Differences between the FIH and the LTF4.1 The Financial Instability Hypothesis and its limitations

Nearly thirty years after its creation, the FIH is regarded by some authors (Daziel, 1999, Dymski, 2004) as one of the most important contributions to monetary and financial theory of the twentieth century. In particular, after the outbreak of the subprime crisis, it received substantial attention from academia, media, and governments. Although it certainly does not provide the only explanation for the international crisis triggered by the subprime crisis, according to Palley (2010), the FIH elucidates the primary financial factors driving the emergence and deepening of this crisis.

However, the theory has some limitations. According to Passarella (2012), the difficulty of identifying macroeconomic variables that capture the weakening of agents predicted by the model is one of the main barriers to its development. He notes that the leverage rate of the economic system is commonly used as a proxy for the level of financial fragility of the economy. However, the difficulty of predicting the leverage rate of the economy is a challenge to the development of the literature on the FIH, as determining the leverage rate of the economy in advance is a difficult task. As Passarella suggests (2012: 571): “(…) the trend of the leverage ratio cannot be (ex ante) determined starting from the analysis of the behaviour of the ‘representative’ investing firm, since it (ex post) arises from firms’ decisions on the whole. This trouble highlights a possible missing link between micro (or individual) and macro (or systemic) levels in Minsky’s theoretical model.”

Sinapi (2011) draws attention to an additional limitation of the FIH: the lack of clear definitions of the roles and institutions in the financial system. The author notes that assembling a complete regulatory system is a difficult task, as the institutional framework should reach all the agents in the financial system and should help develop system accounting and financial innovations. It is true that Minsky recognizes the need for constant institutional evolution by a regulator. If a regulator does not take a proactive stance or evolutionary approach similar to financial agents in the pursuit of profit, the regulator will fail to provide greater stability for the

23 Subject, obviously, to inflation, as high inflation rates affects preference for money.24 In the subprime crisis, the fire sales of subprime securities stopped when the Fed started to accept these assets (with a haircut) in bailing out operations. The US’ commercial banks stopped selling these assets, and its proportion of the banks’ total assets grew up after these Fed’s action (Vasconcelos, 2014). It was not an operation of issuing money, but of using the power of the state (or the law, in LTF terms), granting that the kind of assets which the Fed accepts as collateral gets relative liquidity. Moreover, if the lender of last resort accepts it, the other economic units will accept it too. This is typical of LLR actions. The liquidity, here, results from the new convention that Fed brings to the market, acting as LLR.25 Additionally, LTF has to consider if the way laws are interpreted and/or enforced changes the liquidity of all financial assets, particularly in regard of the issue if this interpretation/enforcement is a more stabilizing or destabilizing force.

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system. In his words: “[T]he Keynesian view recognizes that agents learn and adapt, so that a system of intervention that was apt under one set of circumstances can become inept as the economy evolves” (Minsky, 1991, p. 7).

However, despite being a crucial element in the prevention of financial crises, an institutional framework that would allow a financial regulator to mitigate the weakening of the system is not central in the FIH. Nevertheless, the theory lacks an essential component in economic analysis, namely, politics. Who answers to the regulator—in the form of the power groups that influence government—and whether an interdependent relationship exists between the regulator and regulated entities are not the primary objects of study in research on the FIH. Finally, Dickens (1999) notes that Minsky's theory does not account for conflicts between social classes, i.e., power relations within the system. Therefore, the FIH, although extremely promising, has limitations.

4.2 What Does the LTF Represent? According to Pistor (2013a), even theories that recognize the inherent instability of

finance—such as the FIH—fail to recognize the centrality of institutions and the law. Based on the assumptions of fundamental uncertainty and the so called volatility of liquidity, the LTF concludes that the structure and functioning of financial market regulation may be responsible for not only economic success but also economic ruin, if this regulation fails.

The LTF considers the role of the government in the financial market, through either regulation or LLR, to be indispensable. It further highlights the need for a customs control for each country/region. The interdependencies in the system must be recognized, but the system must serve "domestic" purposes. Thus, Pistor (2013a, p. 328) states that:

Most financial regulation remains at the national level, with regulatory standardization the most important mode of transnational coordination. However, agreeing on standardized rules today that shall apply in an uncertain future does not address the core problems of contemporary finance: uncertainty and liquidity volatility. On the contrary, it hamstrings domestic regulators, as these rules are impossible to alter short of another crisis. This makes the transnational regulatory regime unresponsive to future change and as such unfit for dealing with an inherently unstable financial system.

The FIH shares some similarities with the LTF with respect to its assumptions and implications, regarded the flawed basis in which liquidity is treated in LTF, as we discussed above. Although they are not completely embedded in his work, Minsky recognizes the importance of legal structures and institutions. The author states that despite the inherent instability of the market, maintaining relative financial stability is a matter of social choice and institutional design (Minsky, 1986 apud Pistor, 2013a). Nevertheless, government interference in the economy as a stabilizing force—as previously stated in Minsky’s discussion on Big Bank, Big Government—is a crucial element of both theories.

The LTF aims to advance certain aspects of Minsky's theory, particularly in its institutional side of modern finance. Pistor (2013a) notes that at the time of the creation of the FIH, financial markets were not as globalized as they are today. Thus, the current configuration of the market requires a framework of analysis that is not adapted to individual economies. At the other side, in this perspective, Minsky’s exclusive analysis of embrittlement based on private credit also has limited applicability today, given the indisputable importance of sovereign debt.

Pistor also seeks to incorporate a missing element in the framework of analysis for the FIH: the political economy of finance. The LTF not only identifies but also attempts to propose

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solutions for addressing the power relations in the financial system. As Pistor summarizes (2013a, p 327):

LTF expands the institutional analysis from banks to credit markets and from domestic to global markets. The theory helps identity patterns of vulnerability to financial distress that operate across legal systems and provides the starting point for a more in-depth analysis of the kind Minsky offered for the US system. Moreover, it develops a framework for tackling the political economy of finance by relating it to the intersection of finance’s hierarchy and the elasticity of law.

4.3 The LTF and the FIH: Complementarities and Possible DevelopmentsOpponents of proposed self-regulated market and minimal state intervention in the

economy should praise the emergence of the LTF. As Deakin (2013) notes, the idea that financial markets can stabilize on their own has enjoyed great intellectual appeal during the last decades of the 20th century and the early 21th century. Moreover, this assumption has received legal validation with, for example, the international capital agreements of Basel II and III.

Regulators apparently has recognized that allowing agents to supervise themselves was the most efficient scenario. In a competitive market, such institutions were expected to protect themselves against losses, given the possibility of a loss in market share and even bankruptcy. Internal models of risk management were considered too complex for regulators to supervise. Deakin (2013: 341) summarizes this view: “The assumption was that legal regulation was more likely than not to be an impediment to efficiency, and that, on balance, benefits would accrue from allowing powerfully-placed parties to waive the rules or to choose when and how to comply with them (hence the ‘soft core, hard periphery’ effect when it came to enforcement).”

The LTF uses the Minskyian concept of financial instability. As observed by the FIH, investment occurs under conditions of fundamental uncertainty. At the time of investment, an investor is thus betting on a future that cannot be predicted. Hence, the investor must accept the liquidity risk of the project. Changes in liquidity conditions may hinder refinancing and thereby generate system instability. From this brief consideration of these two premises, the assumptions of the LTF, fundamental uncertainty and the liquidity constraint, seem to be the exact same assumptions used by Minsky in his theory.

The use of Knightian uncertainty in the LTF is one of the main points of divergence within the mainstream literature. As Hodgson (2013) notes, fundamental uncertainty has been widely recognized to be one of the primary factors underlying the great financial collapse that began in 2008. According to Hodgson, such recognition is not sufficient for the concept to be incorporated into analyses of economists working within the mainstream theoretical framework because of the difficulty of incorporating fundamental uncertainty into mathematical models.

In other words, a known feature present in the modern capitalist economy is neglected for the benefit of mathematization. By contrast, the FIH and the LTF choose to take the hypothesis of uncertainty and direct the model to capture other aspects of the economic system. Hodgson (2013) deduces that the goal of science that seeks to explain economic phenomena by incorporating the hypothesis of uncertainty is to understand the causal process to provide a basis for analysis of effective interventions in the economic system.

The LTF also converges with the FIH in the recognition that the financial system is unstable and that financial crises are therefore inevitable. Indeed, Minsky (1982) notes that financial crises are inevitable. What can be avoided is the assumption of extraordinary proportions, as evident in the Great Depression of 1929. Accordingly, Minsky argues for monitoring of the weakening conditions in the economy and, when necessary, a response to the outbreak of a crisis that includes effective government action as LLR.

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Ultimately, the power to provide liquidity is held by the only agent that never suffers from the liquidity constraint: the sovereign state that issues its own currency. In the LTF, Pistor reaches the same conclusion. The LTF thus reaffirms the importance of having a central bank that is capable of providing unlimited liquidity, namely, a bank that does not operate in a currency issued by third parties, such as countries with a dollarized economy and countries in the Eurozone. However, the LTF expands the boundaries of the FIH by adding the four essential pillars of finance presented in section 3.2.

The LTF advances the understanding of the functioning of the financial system, not only to promote the idea that the financial system is duly constituted—a fact that, as Deakin (2013) observes, is not necessarily an innovation—but also to provide valuable insights into how and through which channels the law interacts with finance. The LTF states that the financial system cannot function without a legal system. Given the undeniable importance of the institutional and legal system in the functioning of financial markets, a theory that does not incorporate these elements is incomplete. Understanding the essential role of the legal system and the development of the legal system is necessary to better regulate the financial system.

Finally, the LTF is a highly promising theory, incorporating various elements from the FIH and extending the FIH by adding the perspective of legal analysis. The LTF provides a better understanding of a wide range of movements that occur within the international financial system.

There are few points of disagreement between the LTF and the FIH. Under a more holistic perspective, the LTF applies the FIH in a broad approach to the functioning of the financial system, recognizing the power relations and the subordination of pre-established agents and institutions operating within the legal system and institutional boundaries. Regarding the regulation of the financial system, the two theories converge on one essential point: the centrality of the government—through the central bank—as LLR in a system that operates under fundamental uncertainty.

5. ConclusionThis article discusses the relationship between the LTF and the FIH. The emergence of

the LTF is auspicious, as it provides another theoretical alternative to the mainstream economic analysis. The various crises experienced after the Great Depression of 1929, notably the colossal subprime crisis and its aftermath, indicate that much work remains in the identification and implementation of suitable measures for the regulation of the financial sector. Deakin (2013) notes that the failure to provide stability to the system, in the long run, paradoxically, results from the mistaken assumption that stability has been achieved in the short term. As argued by the FIH, restoring stability creates intellectual and political conditions for erroneous assumptions about stability. Under such conditions, the relaxation of regulation can be defended, placing the system back on the path of gradual and continuous weakening.

As stated by Pistor (2013a), the LTF extends beyond the fundamental uncertainty and liquidity constraint assumptions of the FIH to emphasize that financial interdependencies are legally constituted. The LTF further suggests that such a condition can amplify liquidity constraints when past investments are fixed in light of new facts. Accordingly, the LTF can define the dual character of law: while law is necessary for the functioning of the system, law may also be responsible for the destruction of the system if the law is not sufficiently elastic.

The LTF offers a new conceptual framework for the analysis of both domestic and global financial markets. As Pistor (2013b) advocates, the dichotomy between states that are more favorable to markets and nations that are more favorable to state intervention is obsolete because the performance of the central bank merges with that of private market actors in all markets.

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Private institutions hold public assets, and public institutions hold private assets. Therefore, what matters is which states and markets issued those assets and what their hierarchical position is in the financial structure. The LTF suggests that such relations can only be understood if the essential role of law concerning finance is recognized.

Finally, the points of convergence between the LTF and the FIH overcome the discrepancies between them. As has been pointed out, the principal problem with LTF, which needs to be enhanced, is its limited concept of liquidity. Thus, potential exists for research seeking to integrate the two theories. For instance, the LTF emphasizes power relations and the interdependence between sovereign states and the market, which are not present in Minsky’s analysis. The LTF thus facilitates the evolution of a theory developed outside the mainstream framework of analysis that may provide a better understanding of the operation of the financial system and better solutions for the regulation of the financial system.

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