Driesen on Cost Benefit Analysis (CBA) vs. Economic Dynamic Analysis (EDA)

There are several ways to read The Economic Dynamics of Law by David Driesen. One is as an attempt to construct and defend a new normative foundation for law in fields as diverse as property and financial regulation. This reading judges the project against the extremely ambitious expectations that it sometimes seems to set for itself. Another way of approaching the book is as a set of reform proposals to the standard cost-benefit analysis methodology that has been practiced by federal administrative agencies in the United States for the last three decades. This reading is more modest conceptually but more demanding of political and practical realism.

Viewed as an alternative to the law and economics tradition of cost-benefit analysis, the “economic dynamic analysis” (EDA) that Driesen proposes runs into a number of substantial difficulties. It lacks the clarity and rigor of these more established perspectives. Sometimes, it seems to mirror the methodologies that it purportedly opposes. Where EDA departs from cost-benefit analysis or the law and economics framework, it often seems to stray in normatively troubling directions.

Dismissing EDA as an unattractive conceptual alternative to law and economics, however, would miss what is most useful in Driesen’s effort. By highlighting areas where cost-benefit analysis, as practiced, fails to live up to its promise, while broadly endorsing the goals of rigorous policy analysis, The Economic Dynamics of Law makes a valuable contribution that falls somewhere between the now familiar opposing camps that, on the one hand, downplay the difficulties in cost-benefit analysis methodology and, on the other, seem to question the value of careful ex ante comparison of regulatory alternatives. By inhabiting this middle ground, Driesen demonstrates what productive conversations about the future of cost-benefit analysis can look like, and in the process makes a number of helpful reform proposals that ought to be taken seriously by policymakers.

The threats that motivate Driesen are real. A chapter on the 2008 financial crisis points to the failure of regulators to identify and aggressively mitigate risks in the banking and mortgage sector. The effects of the crisis continue to reverberate, and there is no guarantee that the seeds for the next crisis have not already been sown. Similarly, a chapter on climate change notes that, despite a decades-long scientific consensus on the issue, there is still no global regime to cut greenhouse gas emissions. Uncoordinated domestic policies have proven altogether inadequate to the scale of the problem.

For Driesen, the “neoclassical economic framework” bears substantial blame for these policy failures. For the most part, this view serves as a starting place for his analysis, rather than a conclusion that is vigorously argued. The evidence that Driesen does introduce is unlikely to persuade anyone who does not already agree. For example, Driesen cites the work of a leading climate economist, William Nordhaus, as an illustration of how the economic mindset leads to policy timidity on environmental issues. [p.207 et seq.] But in more recent work, Nordhaus has offered a strong defense of aggressive measures to control greenhouse gas emissions, and his models, along with those of other climate economists, have been used by the Obama Administration to justify its regulatory moves in this area. If economic reasoning supports the most important measures currently in the works to confront the problem of climate change, it is hard to see how it is the source of our failure to act.

In fact, the economic dynamic analysis that Driesen proposes shares much in common with the mainstream economic perspective. While EDA is not formally defined in the text, Chapter 4 provides a general description, and the many affinities of Driesen’s DEA with mainstream economics are readily apparent. For example, Driesen describes EDA as involving the study of “the economic incentives [that] law creates” as well as “countervailing incentives [that] might counteract legal ones.” [p.68] Of course, viewing law as an ex ante system of incentives rather than a set of ex post remedies for past wrongs remains one of the enduring contributions of the law and economics movement. Driesen also describes EDA as attending to the public choice consequences of policy making; what he calls “empowerment analysis.” Such public choice analysis is a staple of law and economics reasoning (see, e.g., the Wikipedia entry for public choice). Driesen also asks that EDA make predictions based on a “bounded rationality assumption,” [p.64] a concept that, although it has its origins in psychology and behavioral economics, is now well accepted within the mainstream economics community. Driesen also counsels “choosing the most efficacious way of achieving the goals the society has agreed upon,” [p.69] “consider[ing] a range of alternatives,” [p.70] and “choos[ing] among efficacious measures that avoid undesirable consequences.” [p.70]. This all sounds much like cost-effectiveness (the selection of lowest-cost measures to achieve social goals), a mode of thinking that is far from foreign to basic economic analysis.

Driesen sometimes seems to recognize as much, straining at times to distinguish EDA from cost-benefit analysis. One passage is particularly telling:

At this point [after a discussion of policy alternatives to address financial risk], readers accustomed to the neoclassical economic perspective may find it difficult to distinguish economic dynamics from standard CBA. Although economic dynamic analysis can take both the advantages and disadvantages of economic arrangements or proposed policy changes into account, it does not do so by quantifying costs and benefits. . . . Without ruling out the possibility of some quantitative analysis entering the picture, [EDA] requires qualitative judgment, including an imaginative exploration of alternatives that might be possible if energy now devoted to CBA gets employed to think about alternatives. [p. 92]

But these purportedly distinguishing features of EDA (a wide range of alternatives and the exercise of “qualitative judgment”) are included in President Clinton’s executive order 12,866, John Graham’s A-4 Circular, EPA’s Guidelines on Conducting Economic Analysis, and President Obama’s executive order 13563—the foundational texts defining the methodological aspirations of cost-benefit analysis in the American administrative state.

At other times, Driesen does more clearly depart from standard economic rationality. And it is here that he runs into more serious trouble. Driesen returns several times to the theme that “law does not function as a master allocator of resources, but provides a framework for avoiding economy-wide disasters and creating opportunities for economic development.” [p.53] Few would probably argue that law should be a “master allocator” of anything, but limiting the role of law to avoiding economy-wide disasters and establishing a framework to growth is a surprisingly conservative proposal for a scholar affiliated with the Center for Progressive Reform. A large number of environmental regulations, for example, would not meet these demanding criteria. The Environmental Protection Agency estimates that tens of thousands of people die every year from exposure to particulate matter. This is a grave problem, but is neither an “economy-wide disaster” nor a serious impediment to “opportunities for economic development.” EPA is contemplating new rules to require power plants to install expensive new technologies in order to reduce the number of fish that are killed when they are sucked into water-cooling structures. These fish kills are problematic, but again, they do not amount to a serious threat to economic growth. Were decision makers exclusively focused on economy-wide risks, they would weigh the effects of a stringent water-cooling rule on energy prices more heavily than the harm to fish in the status quo. Similar examples abound in many policy domains: payday lending might pose no existential threat to the economy, even if the practice severely disadvantages certain consumers; the occasional unsafe product is unlikely to substantially affect GDP. Only when we introduce some measure of welfare, and accept a role for government as at least partially about the efficient allocation of resources and risk rather than simply a facilitator of private transactions, do many environmental, public health, safety, or consumer protection regulations make any sense.

A defender of EDA might try to square the circle here by arguing that it also allows for “normative commitments” aside from avoiding economy-wide disasters, such as promoting “a healthy environment.”  [p.51] But we get very little here on where these (non-welfarist?) normative commitments come from. Perhaps the answer might be that they are delivered exogenously from a political process that culminates in lawmaking. But then EDA would give us no guidance on how a legislator might select those commitments. More troubling, when the shape of those commitments (as instantiated in statutes) is unclear, which is to say all the time, EDA seems to either default to a kind of libertarian minimalism focused only on the most extreme negative outcomes, or regulatory maximalism that requires unjustified sacrifices for the sake of minor benefits.

Let’s return to the water-cooling rule as an example. In the Clean Water Act, Congress established a requirement that firms employ the “best technology available for minimizing adverse environmental impact,” from water pollution. Does this reflect a normative commitment to reducing pollution simpliciter, or a normative commitment to achieve a reasonable balance between technological costs and benefits? It is hard to say; the Supreme Court found the questions sufficiently unsettled to defer to the agency’s judgment. Under an EDA framework, how should the agency proceed? If avoiding economy-wide catastrophes is the priority, perhaps EDA means that the agency should interpret the statute conservatively, require readily available off-the-shelf technologies that raise few prospects of economic disruption, and move on to more important questions. Or perhaps EDA means that the agency should regulate to the hilt, subject only to the constraint of shutting down whole industries. If maximizing welfare isn’t the goal, in what normative direction does EDA point when agencies are called on to regulate in the face of congressional ambiguity? The only place that EDA seems to avoid in these cases is the reasonable middle, where benefits and costs are weighed against each other to maximize people’s well-being.

But it is in this reasonable middle that Driesen’s most important contribution is offered. As an alternative to cost-benefit analysis, EDA is problematic. But Driesen’s exposition of EDA points to many ways in which cost-benefit analysis can and should be improved. Despite an ostensible commitment to the exercise of qualitative judgment, too often analysts focus on the raw numbers rather than the broader context. Scenario analysis and other “softer” analytic tools may indeed be helpful when information is low and stakes are high. The endogeneity of preferences to policy, adaptive preferences (which reduce the long-run welfare benefits of increasing average consumption), and the importance of positional goods are typically under-examined in practice. While behavioral economics has become important in many regulatory contexts, its consequences for cost-benefit analysis have not been fully explored. Path dependencies, and especially the public choice consequences of policy, are often accounted for behind the scenes rather than through explicit analysis and normative debate.

Ultimately, Driesen’s book serves best as a set of recommendations from a perspective that is not altogether friendly to the project of cost-benefit analysis, but is not altogether hostile either. Viewing an imperfect three-decade experience with cost-benefit analysis in the American regulatory state, Driesen focuses on the shortcomings and failures and looks for another way. But the gravitational pull of cost-benefit analysis is hard to avoid, and EDA often ends up too close to cost-benefit analysis to serve as an alternative. Where it strays from the logic of law and economics, EDA runs the risk of floating away into unattractive territory. But The Economic Dynamic of Law is nonetheless a useful reminder that the practice of cost-benefit analysis on the ground often fails to meet the highest aspirations of its proponents and the reasonable expectations of its critics.

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2 Responses

  1. A FEW CLARIFYING RESPONSES TO MICHAEL LIVERMORE

    I want to thank Michael Livermore for a thoughtful post. I confine myself for the moment to making a few clarifications.

    My argument that the neoclassical law and economic framework contributed to our failure to adequately address key policy problems does not not rely on a claim that cost-benefit analysis (CBA) always suggests that we should do little about systemic risk. With respect to the financial crisis, we never carried out formal CBA of the deregulatory measures (nor could we have) that led to the crisis. Instead, proponents assumed that the prior regulation was not needed because rational market actors would protect themselves, and thus the rest of us, from harm. (pp. 36-37, 39). Of course, we have carried out CBA of climate disruption. Although proponents of CBA imagine that such a clear and rigorous method yields an answer, I show that that CBA has been all over the map on this issue. (pp. 206, 225). A commitment to avoiding systemic risk would have taken us in the direction of aggressive action even in the days when Nordhaus’ CBA suggested rejecting the Kyoto Protocol.

    My argument about the neoclassical framework’s contribution to policy failure is subtle. I blame neoclassical law and economics for contributing to an overall deregulatory climate, by tending to glorify markets as a model. (pp. 22-32, 211-12, 234). I won’t belabor the point, but it seems that Livermore has focused on one or two mentions of Nordhaus’ earlier work and paid less attention to the broader argument. (p. 212).

    My book does not argue that avoiding systemic risk and providing economic opportunity should constitute our sole normative commitments, any more than serious proponents of conventional law and economics argue that efficiency should be our only normative commitment. Like Richard Posner, I accept that the political process may legitimately make normative commitments not explained or justified by economic theory. I merely argue that economic theory should focus on more important goals than mere efficiency, and specify systemic risk avoidance and keeping open a robust set of economic opportunities as the two key goals for a better law and economics.

    The book argues that economic dynamic analysis is not only useful for pursuing the normative goals my theory highlights, but for pursuing other normative goals (e.g. justice) as well. (p. 227). Livermore argues that economic dynamic analysis defaults to either minimum or maximum regulation. Economic dynamic analysis is simply a means of appreciating the tendencies of society and the consequences of proposed legal reforms. By itself, it says nothing about normative values. Of course, the economic dynamic theory as a whole does say something about values, arguing that avoiding systemic risk and keeping open a reasonably robust set of opportunities is more important than economic efficiency.

  2. In the world of law and economics it is difficult to offer any reasonable alternative to the “mainstream”; and the typical response to alternative works is that to the extent the alternative comes close to the norms of standard economic analysis it makes a constructive contribution (or more typically, adds nothing new), and to the extent it strays, it runs into “unattractive territory”, as Livermore states. The problem with mainstream economic analysis of law, and a critical point raised by David’s work is that one can use market tools in evaluating law without having to be committed to a particular “school” of economics.

    Economic dynamics is in some respects a search for what I have described as the difference between understanding markets and understanding economics. Economics is simply one way of interpreting observations about market interactions and dynamics; and neoclassical economics is simply one subset within economics. Market theory is not the same as economics. Market theory is focused on dynamic exchange over time, and the legal frameworks that best facilitate creativity, entrepreneurship, and innovation; not simply cost effective decision making based on static assumptions. While there is overlap between market theory and economics, and while economic concepts are used in thinking about market implications, the two cannot simply be conflated into one.

    David’s work offers an alternative framework for thinking about the market context of law. His focus on precaution and on the interplay of micro and macro forces over time assists us in asking new and important questions, and guides us in thinking about potentially new approaches. In so doing, he also points out important problems that arise in the application of standard neoclassical economic tools to law.

    In his example of the financial crisis, for instance, he not only speaks to systemic risk but to the problems of dealing with the changing scale of socio-economic activity. Today we have globally integrated financial markets, for example, and this large scale integration can lead to equally large scale financial disruptions when problems arise. The inability to isolate and contain these disruptions can turn small problems into catastrophic problems in a very short time. While markets might be able to process the consequences of these problems quickly in terms of rapid adjustments in relative prices, people are not able to adjust their lives and relationships so easily. Consequently, it is important to address both micro and macro level activities and implications simultaneously, and to take a precautionary approach to risk that might be deeply disruptive in human terms.

    David’s approach to the economic dynamics of law offers us an additional way of understanding the market context of law; and where he strays from standard neoclassical economic assumptions he often takes us to more interesting territory.