A problem that any stock exchange must deal with is enforcement of contracts. Imagine, for example, that someone sells a stock short, but contrary to his expectations the stock price rises, and he must satisfy his contract by buying the shares come settlement time. What if the short seller balks and doesn’t stick to his agreement? This did not happen often, writes Stringham, because traders had to worry about their reputations.
But couldn’t those who were cheated by short sellers have gone to the government to make the short sellers keep their word? They could not, and the reason is simple. Stringham points out that short selling was illegal and, therefore, going to the government was futile. If anything, those who had wanted to renege on their short-selling contracts could have gone to the government to get it to support their reneging. But Stringham quotes an analyst of the time pointing out that this didn’t happen much. People were expected to keep their commitments and largely did.
This is strong evidence against the claim that complex market transactions between strangers need some form of external government enforcement.
Some remarks.
I am not claiming that private governance in the absence of government support is impossible. I am claiming that it is costly. In this example, my claim would be that short selling is more costly when it is illegal than when it is legal, because short-sale contracts are perceived to be more difficult to enforce when they are illegal. That claim may be incorrect, of course. But I would bet that if you compare markets where short-selling is legal with markets where short-selling is illegal, the transaction costs will be lower in the former.
Also, consider alcohol and drug prohibition. Both of these almost surely raised the costs of transactions, and in both cases violence plays a role in market governance.
Having said that, I would point out that examples of markets that the government treats as illegal are not good examples to prove my point. When government makes something illegal, it artificially raises transaction costs in those markets, because people fear prosecution. So even if costs turn out to be higher in illegal markets, I cannot argue that this is due to absence of government. It may be due to the hostile presence of government.
As far as I can tell, we are left with purely hypothetical thought experiments. Take an example of a complex economic activity that involves a lot of specialization and trade. The famous pencil, or a toaster, or an I-phone. The parties involves in the process of assembling such goods involves do not know one another. They cannot gauge reputations, nor can they even know whether other parties care about their reputations. Now, remove all government enforcement of contracts, and imagine what happens.
What I imagine is that the parties have to come up with multi-layered contractual arrangements and enforcement mechanisms that are incentive compatible and fully state-contingent, so that everyone can be sure that disputes won’t erupt into violence. I am not arguing that this cannot be done. What I am claiming is that these transaction costs will be lower when in the back of everyone’s mind there is the understanding that there are government courts that have coercive powers to enforce decisions.
Government does not provide optimally or costlessly the legal infrastructure that facilitates complex trade among strangers. However, my intuition is that in the absence of government such infrastructure would cost much more to put in place.
Historically in Britain, gambling debts were legal but unenforceable, meaning that gambling wasn’t illegal, but the winner couldn’t go to court to enforce payment from the loser. Consequently all parties had to rely on private enforcement mechanisms. This is therefore a rare example of a situation where government was not artificially raising transaction costs, but nor was it providing a legal infrastructure to enforce agreements.
So this could serve as a test case of the Kling/Henderson disagreement.
Sadly for the anarcho-capitalists, the “private enforcement mechanisms” meant heavy involvement from criminal gangs, which have receded now that the government has got much more involved. Indeed, if you take seriously the anarcho-capitalist claim that government is really a criminal enterprise, then this is hardly surprising – one business forswearing an area simply means that its competitors will step in.
“heavy involvement from criminal gangs, which have receded now that the government has got much more involved.”
Anarcho-Capitalist humor is very droll.
Arnold Kling states:
I am not claiming that private governance in the absence of government support is impossible. I am claiming that it is costly.
Does anyone claim that private governance in the absence of government support costs nothing? Governance is a function and all functions have some costs. The problem with government by a State is that it is a coercive monopoly, which usually implies high costs and risks, low quality and much corruption.
Kling then gives a poor hypothetical example:
Take an example of a complex economic activity that involves a lot of specialization and trade. The famous pencil, or a toaster, or an I-phone. The parties involves in the process of assembling such goods involves do not know one another. They cannot gauge reputations, nor can they even know whether other parties care about their reputations.
Maybe Kling means that parties do not know all other parties involved in these complex processes: this is true because it would be very difficult; but it is completely unnecessary. Parties know (as well as is efficient and possible) the parties they directly interact with: their providers and their clients. They need to trust the quality of the products and services bought, and that they will be delivered in time, and if they extend credit to customers they need to know their solvency. This knowledge is always imperfect, but it is not zero.
(Seconding Francisco Capella:)
“They cannot gauge reputations . . . .” Manufacturers don’t gauge the reputations of their subcontractors? That’s obviously false.
Arnold, your position on this issue is supported by the extensive historical evidence in Ogilvie and Carus’s survey of the role of private and public institutions in economic growth.
http://www.econ.cam.ac.uk/people/faculty/sco2/full-texts/Ogilvie-Carus-2014-Handbook%20of%20Economic%20Growth.pdf
If you view this explanation of what Paulie and the Organization brought to the wise guys in ‘Goodfellas’ you can see that the Organization has taken over the governmental functions for the criminals, i.e., they enforced contracts and provided protections against bad actors.
https://www.youtube.com/watch?v=dNW-HMonRoU
In the absence of a trustworthy government, others will rise up to provide the enforcement mechanisms needed to enforce contracts and avoid violence. Even Wise Guys know that war is costly to the conduct of profitable business.
“What I imagine is that the parties have to come up with multi-layered contractual arrangements and enforcement mechanisms that are incentive compatible and fully state-contingent, so that everyone can be sure that disputes won’t erupt into violence.”
You really think there is a risk of my bad transaction erupting into violence? Here’s a different way of looking at it – life is a game of prisoner’s dilemma, and the best strategy we know of is some variation tit-for-tat. So there are two main social functions to be performed – enabling co-operation, and punishing defectors. The way I see it, the ecosystem of reputation systems and payment processors are all about enabling cooperation. The gains from cooperation scale geometrically (or at least not linearly). It is really really easy to find honest people who are not interested in ripping me off. Government these has absolutely no role in finding people who want to cooperate. People do that, and invent their own frameworks for doing it – whether it be to find financial transaction partners, or to find people to play chess with. That is, I am willing to make an appointment to spend time to meet my friend in the park without without the background belief that the government will compel him to meet me there.
Instead, government is about punishing defectors. My intuition is that the gains from cooperation are so enormous these days that exclusion from the system is punishment enough to induce people to cooperate. Do people pay their credit card bills because more because they fear jail, or more because they want to maintain a good credit rating? Given that we abolished debtor’s prison already, I’d say the latter. This also explains why crime is worse in less economically developed areas – defection becomes more profitable relative to cooperation, so people defect