Lawrence White drills down to fundamentals (pdf):
at the core of the “rule of law” concept, as I understand it, is the liberal principle of non-discretionary governance that stands in contrast to the arbitrary or discretionary rule of men in authority. In shorthand, a political community faces a choice: either “the rule of law” or “the rule of men”. When I hear or read the simple phrase the rule of law, I
find that I can usually clarify its meaning by adding “and not of discretionary authorities”.
Friedrich Hayek in his classic work The Road to Serfdom contrasted “a country under arbitrary government” from a free country that observes “the great principle known as the Rule of Law. Stripped of all technicalities,” he continued, “this means that government in all its actions is bound by rules fixed and announced beforehand — rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge.”
In other words: Under the rule of law, executive agencies of government do nothing but faithfully enforce statutes already on the books. Under the rule of men, those in positions of executive authority have the discretion to make up substantive new decrees as they go along, and to forego enforcing the statutes on the books.
The rule of law clearly does not prevail in our current monetary and financial systems. We do not have, to use Hayek’s words, “government in all its actions … bound by rules fixed and announced beforehand”. Not when participants in financial markets hang on every word from the lips of the central banker, trying to guess his future policy actions. Central bankers today are discretionary rulers over the economy’s monetary and financial institutions. Defenders of the rule of law, who in general decry the arbitrary rule of men, should specifically decry the rule of central bankers. Central bankers today are not “slaves of the law” but exercise wide discretion in monetary policy and regulatory rulemaking under the legislation that created and empowered the central bank.
In their policies for addressing the current crisis, central bankers have not limited themselves to the “orthodox” crisis policies of injecting reserves into the banking system in the aggregate and making short-term last-resort loans to particularly illiquid commercial banks, policies that are already disturbingly discretionary. They and Treasury ministers have been unorthodox and undeniably arbitrary, bestowing favors on some firms and burdens on others. Let me count the ways in the case of the Federal Reserve System and the Treasury of the United States. Forgive my focus on the United States, but it is where the global crisis started, and it is the case I know best.
1) The Bernanke Fed – normally I wouldn’t personalize the Fed, but here we’re talking about actions that exhibit rule of man rather than rule of law – the Bernanke Fed has without precedent created “facilities” for lending to certain classes of non-banks and for buying their illiquid or toxic assets. It has decreed and printed up so many hundreds of billions of dollars for lending at below market rates to brokerage houses, so many hundreds of billions for buying assets from mutual funds, so many hundreds of billions for buying mortgage-backed securities, so many hundreds of billions for buying commercial paper.
2) Through the Federal Reserve Bank of New York, then headed by Timothy Geithner, the Bernanke Fed set up a special subsidiary (called “Maiden Lane LLC”) to sweeten an acquisition deal to protect the bondholders of the investment house Bear Stearns. It did not do the same for the investment house Lehman Brothers. It has set up other subsidiaries (Maiden Lane II, Maiden Lane III) to buy and hold bad assets from a single failed insurance company, AIG.
3) The Paulson Treasury forced an arbitrary set of nine major banks to issue and sell new preferred shares to the Fed. I say “forced” because, although some banks wanted to make the deal, others didn’t. $125 billion of taxpayer money was crammed into Citigroup, Bank of America, Wells Fargo, JPMorgan Chase, Bank of New York Mellon, State Street Bank, Merrill Lynch, Morgan Stanley, and Goldman Sachs. The last three were newly converted investment banks, given commercial bank status just in time to qualify for the infusion. Goldman Sachs is the former investment bank once headed by Treasury Secretary Paulson. From the nine banks, the Treasury took “preferred shares” with fixed 5 percent dividends (increasing to 9 percent if the shares have not been repurchased in five years). The Treasury explained that it did not make participation voluntary because it did not want to stigmatize as weak the banks that chose to participate. The same treatment was later extended to other banks.
4) The Fed arbitrarily jammed the failed investment bank Merrill Lynch down the throat of a major commercial bank, Bank of America. The Fed had decided that Merrill Lynch needed to be immediately acquired rather than liquidated. The Bank of America’s CEO Ken Lewis initially agreed that BOA would be the acquirer, then changed his mind. An acquiring firm has every right to back out when its due diligence reveals (as it did in this case) that the target firm’s are more toxic than previously suspected. In one journalist’s account, here’s what happened next:
“[A]ccording to Lewis’ testimony, confirmed both by Paulson and by official minutes of meetings, Paulson and Bernanke pressured Lewis into violating his own legal fiduciary duty to his shareholders, who had to approve the deal based on accurate information. Relying on no legal authority whatsoever, the Fed and Treasury threatened to remove the board and management of Bank of America if they refused to go forward and demanded that Lewis not divulge the conversation.”
As Hayek warned in The Road to Serfdom, giving an executive agency (or legislature) the discretion to bestow benefits and burdens on known recipients is a recipe for partiality: Where the precise effects of government policy on particular people are known, where the government aims directly at such particular effects, it cannot help knowing these effects, and therefore cannot be impartial. It must, of necessity, take sides, imposing its valuations upon people and, instead of assisting them in the advancement of their own ends, choose the ends for them.9
The eagerness of Ben Bernanke and Hank Paulson – and now Timothy Geithner – to substitute their own judgment for the dispersed judgments of a freely competitive financial market may reflect simple intellectual error. Or, less innocently in the case of Hank Paulson, former CEO of the investment bank Goldman Sachs, it may be error compounded with partiality …