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February 13, 2008

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Mitchell Hoffman

I will interpret this week’s question broadly, asking not only whether good government mattered in England before the Industrial Revolution, but asking whether good government in all countries before the Industrial Revolution.
Ostensibly, the two readings suggest opposite answers, and thus no clear answer to the question. Greif argues that governmental institutions were unnecessary in promoting risk-taking and enterprise among the Maghribi traders in the medieval Mediterranean. Rather, cheating and bad behavior was prevented because commercial relationships were often repeated ones, and because an untrustworthy action would likely be communicated to other traders within the Maghribi coalition. Instead of using governmental institutions, the Maghribi used punishments and profit-sharing incentives to regulate themselves. North and Weingast describe how institutions created after the English Glorious Revolution, such as the King having to get Parliament’s approval before levying additional taxes, encouraged growth and financial stability. They discuss several examples of financial development, such as the growth of banks, growth of private capital markets, and increased trading in private securities.
There is really, though, no contradiction between the two articles. Besides the obvious fact that the two articles discuss particular countries in particular time periods, it is very possible that good governmental institutions were important for relationships between individuals and governments, but relatively unimportant for relationships among individuals. If an individual trader does something dishonest, he may be prevented from doing business both with the victim of his dishonesty and with other traders, and additionally he may be socially ostracized (particularly, as was the case for Maghribi Jews, if they are from the same ethnic group). The same cannot be said about countries. If the English government, or the King of England, does something dishonest, it is not easy to socially ostracize him or to stop doing business with him (i.e. stop paying taxes and stop receiving his military protection). The fact that it is not easy to ostracize or stop doing business with governments is of likely important bearing for some of the articles cited by North and Weingast, for example, the Bulow and Rogoff article on forgiveness of third world debt. If Russia or Argentina defaults on debt, countries cannot credibly eliminate future trade with those countries or throw them out of the United Nations.
I find the particular evidence offered in both articles interesting, and on the whole, convincing. I would like to have seen more numbers in the Greif article, such as the number of Maghribi traders (even a rough sense would be helpful, i.e. 500 traders of 50,000 traders) and some sense of the commercial value of their activities. But on the whole, both articles supported their arguments well, particularly the claims about the development of financial markets in North and Weingast.
Instead of answering the question with a definitive yes or no, the article suggest that good government was important for encouraging commercial relations between individuals and governments, but were unimportant for governing commercial relations among individuals.

Mauricio Larrain

Markets are commonplace in all types of societies, including the poorest. Nevertheless, some markets that are essential for economic development are less common and more easily repressed. These are markets in which economic actors make exchanges requiring significant commitments in the present, in the expectation of payment or a stream of returns in the future.

The gains from trade in these markets cannot be realized unless the parties expect that the contracts they make will be carried out. These markets are less likely to exist when institutions for the protection of property rights and contract enforcement are absent and thus are more likely to need third-party enforcement. One important question that arises from this is whether third-party resolution of disputes is solely the province of government or could it be achieved by the private sector without intervention of the government.

Greif (1989) gives an interesting historical example of a society that achieved third-party enforcement without governmental institutions. The market institution that enabled eleventh century Mediterranean merchants to deal with these contractual problems was the so called “coalition.” It reflects a reputation mechanism among economic self-interested individuals. By establishing ex-ante a linkage between past conduct and a future utility stream, an agent could acquire a reputation as honest, that is, he could credibly commit himself ex-ante not to breach a contract ex-post.

Nevertheless, there are several reasons that lead us to think that the private sector has clear limits in enforcing contracts. Reputation is of more limited utility for transactions in which the actors involved deal with each other infrequently. Reputation is not useful when transactions are exceptionally large or performance can be verified only over a long period of time. Private institutions that disseminate information on contract violations are less useful when the reasons for breach of contract cannot be conveyed; when firms that receive the information fail to impose the appropriate punishment strategy; when firms that breach contracts are able to mask their identities; and when the contractual arrangements that undergird the existence of the organization that collects and disseminates information about breaches of contract are themselves unenforceable (see Clague, Keefer, Knack and Olson (1999) for more details).

The article by North and Weingast (1989), on the other hand, argues that third-party enforcement by the government played a central role in the market development in early modern England. The evolution of the constitutional arrangements in seventeenth-century England was a reflection of an explicit attempt to make credible the government's ability to honor its commitments. According to the authors, the sharp change in the willingness of lenders to supply funds reflected a substantial increase in the perceived commitment by the government to honor its agreements. Moreover, the institutions leading to the growth of a stable market for public debt provided a large and positive externality for the parallel development of a market for private debt.

In conclusion, I think that North and Weingast provide solid evidence that a “good government”, one that provides third-party enforcement, appeared to have made an important difference in the centuries before the industrial revolution in Britain. However, for the reasons outlined above, I believe that Grief does not provide evidence that a “good government” is not important for the development of an economy.

Edson R Severnini

During the centuries before the Industrial Revolution, several institutional changes occurred in England. The redesign of the fiscal and governmental institutions limiting the intervention of governors in the economic environment following the Glorious Revolution of 1688, however, were fundamental to support the Industrial Revolution. That is true that other institutions gave important contributions in that period, like the “coalition” studied by Greif (1989), which facilitated complex trade characterized by asymmetric information and limited legal contract enforceability among economic agents, but I think they were not sufficient to provide the economic incentives for the industrial era, since, as North and Weingast (1989) argues, “successful long-run economic performance requires appropriate incentives not only for economic actors but for political actors as well”.

Using a very rich source of information on agency relations during the eleventh century (geniza documents), Greif (1989) provided very interesting evidence about how the Maghribi traders overcame the organizational problem associated with the exchange relations between merchants and their overseas agents through the “coalition”. He shows that this economic institution based on a reputation mechanism enabled the traders to reduce the transaction cost associated with agency relationships, and thus motivated each coalition member to follow the contractual arrangements. This nonmarket institution was indeed successful in deal with contractual problems among individuals and firms, but would it be enough to provide the conditions to a vigorous economic performance within a country such as England during Industrial Revolution? I think the answer is no, because it is possible that the “small agents” and the government have misaligned interests: individuals and firms can act toward productive entrepreneurship, and the government toward unproductive entrepreneurship. In fact, North and Weingast (1989) mention two confiscation episodes that occurred during the Medieval period, when the coalition was working: Edward I confiscated the wealth of Jews in the late thirteenth century once the Italian merchants began operating on a larger scale, and Phillip IV confiscated the wealth of the Templars under similar circumstances. Under such a governmental situation, it is probable that individuals and firms do not have incentives to accumulate resources and/or to invest.

In this regard, I think that the fundamental institutional changes that prepared the economic environment to the Industrial Revolution in England were those constraining the fiscal conditions of the government and restricting the governmental ability of creating rent-seeking opportunities, in the Glorious Revolution of 1688. In fact, the triumph of parliamentary interests in the Glorious Revolution led to five significant institutional changes (remotion of source of expediency, limit of Crown's legislative and judicial powers, dominance of parliamentary interests in taxation issues, possibility of parliament allocates funds and monitors governmental expenditure, and balance of power between Parliament and the monarchy) that greatly improved the predictability of governmental decisions. That is, the Parliament got a fundamental power of veto that protected it against political assault and consequently reduced the possibility of opportunistic behavior by the government. As the evidence provided by North and Weingast (1989) on the development of capital markets suggests, this fact strengthened the England's institutional commitment to secure rights, enhanced the ability of economic agents to engage in secure contracting across time and space, and, as a consequence, reduced the transaction costs per exchange. The result was more investment from that period onwards since the entrepreneurs could invest their wealth (maybe the wealth accumulated thanks to success of “coalition”) with more guarantee.

Gabriel Chodorow-Reich

Government

The readings for this week discuss two distinct roles for government in the economy. The North and Weingast reading treats the role of government vis a vis the individual; that is, the extent to which government expropriates private property. The implications of the Greif article, in contrast, concern how government (or lack thereof) affects the potential for private parties to contract with each other.

North and Weingast make clear the extent to which an intrusive and confiscatory government can impede financial development. Following the Glorious Revolution in England, new Parliamentary checks on crown expenditure and the weakening of the crown’s influence on the legal system greatly reduced the crown’s ability to obtain forced loans from the citizenry. The effective strengthening of property rights for private financial wealth benefited the crown by allowing it to borrow at a lower market rate of interest (since expropriation risk was reduced). Perhaps more importantly, protection from crown confiscation allowed financial markets to flourish (see their Table 5). In their conclusion, North and Weingast go so far as to suggest that relatively mature capital markets may partly explain why England was the birthplace of the industrial revolution.

In the very different context of medieval trade, Greif studies a coalition of traders that allowed its members to overcome the absence of property right enforcement by the sovereign. In particular, the coalition used collective punishment as a means to deter agents from cheating a coalition member. Coalition members also shared information, allowing traders to monitor whether contractors had acted honestly. Thus, private institutions allowed actors to overcome the absence of an effective government enforcer.

Taken together, the readings suggest that governance should be measured on a scale from harmful to helpful. Greif examines a government that is neutral; North and Weingast chronicle a transition from harmful to neutral. Neither observes a government with pro-active policies designed to help its citizenry.

With this distinction, some conclusions are possible. Harmful governmental institutions can have deleterious effects on the economy, and their removal can ease aspects of commerce and promote the development of functioning markets. In some cases private actors can create private institutions that substitute for government action. At a deeper level, whether good governance causes economic growth or growth induces good governance remains an empirically open question, to which we might add contemporary China as an interesting data point. At minimum, it is clear that British governmental institutions were vastly improved at the time of the industrial revolution relative to earlier epochs.

I Romem

I don't think the question is phrased right. You see, if I lived in fear that the despot would confiscate what I owned if it suited him, I would think twice about accumulating any capital whatsoever. Moreover, if I ever did put together a bundle I would bury it deep and dark - not build a factory with it out where the red-coats wander. Had it not been for the sequence of events that took place on the British Isles in the seventeenth century, culminating in property-securing, despot-checking institutions, the industrial revolution would hardly have taken place. Hence, asking whether "good government" made a difference in pre-industrial Britain is like asking whether turning up the thermostat affects room temperature before the heat rises.

In pre-industrial Britain, the security of property rights that developed institutionally as per North and Weingast's article seems mostly to have affected public finance. As such, it granted Britain an advantage in its contemporary military pursuits – an important development in its own right, but not of the kind that interests us as economists. Nonetheless, they proceed to describe the birth of modern banking and private finance in their narrative. Now that is a big deal. Arguably, the financial backbone that crystallized then was later a necessary condition for the onset of the industrial revolution.

Furthermore, had it not been for property-owners' calm that their capital would remain theirs, it is doubtful whether any individual – rich as he may have been – would have mustered the courage to risk his assets in any type of large-scale industry, ripe for confiscation. This, too, is a big deal. As North and Weingast explain, it is not sufficient to have a temporarily benevolent regime, such as that of Louis XIV in France. Rather, an institutional structure is required that grants government's benevolence with credibility by restricting its capacity for arbitrary action. Despots no more.

As for Avner Greif's article about the Jewish Maghribi traders, I believe it may be perceived as a counter argument to the necessity of good-government, because it demonstrates how trade relations can be sustained without government, based on a community reputation mechanism. Not so. The Jewish Maghribi traders' network was a wonderful phenomenon while it lasted, but as Greif reports it ceased to function as soon as Muslim rulers in the twelfth century forced the Maghribis to abandon trade. Clearly, this was an example of the destructive power of arbitrary government. Had it not been for the Maghribi's rare communal mechanism it is likely their trade would never have developed to begin with, given the peril of arbitrary despotic confiscation. The Maghribi traders were the exception that shed light on the norm, but even their light was dimmed all too soon by an arbitrary despot.


Alexandre Poirier

We are presented two articles that, despite offering different takes on the effect of government, have reconcilable views. The first one, by Greif, presents an account of Jewish Maghribi traders in the 11th century, and the way they organized their trade. They hired agents in different countries to help with the delivery and purchase of goods, but these agents were the beneficiary of asymmetric information and could potentially steal from their employers. The Greif article shows how these traders organized themselves in a coalition to exclude agents who were found to have cheated.

The second one, by North and Weingast, shows that an improvement in good governance, such as the one that resulted from the Glorious Revolution of 1688, improves capital markets and is overall a good thing for the economy. A despot ruler who could bend the rules and always get what he wants faced a dynamic inconsistency problem when issuing bonds: the borrowers knew that the government could choose to not repay them, so they were less likely to purchase these bonds. If the government faces a check when trying to confiscate property, the population is more likely to accumulate more capital, and buy more bonds.

Overall, the second article shows that governance that faces the rule of law (independent judiciary branch) makes individuals more prone to cooperate with it, so the government also benefits from having less power. North and Weingast show that the British government managed to raise unprecedented amounts through the issuing of bonds after the Glorious Revolution, and this increase in borrowing ability gave them the upper hand in the following conflict with the French Government, setting the stage for British world dominance.

On the other hand, the Greif article shows that the impact of bad governance on private markets with informational asymmetries does not always result in market breakdown. For example, the Maghribi traders faced a slow and corrupt judicial system, but they managed to establish a private organization that also managed to reduce inefficiencies. However, the example of the Maghribi traders is hardly generalizable to all other markets with inefficiencies: the Maghribi traders were a closed group that shared a religion. If we look at the market for all Mediterranean traders, including Christian and Muslim ones, we can assume that the absence of an efficient judicial system has resulted in an inefficient trade market. I think we should view Maghribi traders more like an example of how individuals can organize themselves efficiently under very specific conditions. But, overall, good government is indeed important for government finances, and capital markets.

Wayne Feng

The role of “good-government” can be interpreted as questioning on the role of government as an institution with importance of advancing economic progress. Greif tells us a story of overcoming contractual problems with a solution developed independently (versus an exogenous influences such as the government). With this example there is a demonstration of trade and enforcement of contracts without government. North and Weingast argued for the governmental influence in Britain being essential for developing an appropriate environment for the Industrial Revolution. For them government enforcement of “good” policies such as property rights led to developed capital markets which can explain why Britain was the home of the Industrial Revolution (versus other competitors such as France). The main question for us should be whether or not the environment which promoted the Industrial Revolution would have existed without government enforcement. While Greif does demonstrate that private individuals can develop systems to support a market, it can be best assumed that for an event as large and pervasive as the Industrial Revolution, governmental intervention was necessary. We see with the analysis and story posed by North and Weingast that France within a same time period faced a different picture which can be attributed to the governmental process and choices. While it may be idealistic to suppose that proper markets could adapt even without governmental influence, history and modern examples tell us otherwise (third world countries, Russia, China). For a lasting result you need there to be support from greater powers, the government. In some senses we confirm the ideas proposed by Gerschenkron in the role of institutions in countries seeking to improve their living standards (industrialize). One other interesting question in the imperfect nature of markets and contracts even with government influences. While this may be a more modern exercise, what about comparing the system developed by the Maghribi traders with systems such as Ebay. How does the modern system of enforcing reputation and contracts advance the market, does it work as well? Would it be better if there was a stronger outside force enforcing these markets? But back to the main question, it would seem to make a world of difference when the government is a “good” government that cares about trade. At the same time it is a government in a certain situation that will result in an industrial revolution. Prior to Britain there were certainly civilizations which promoted trade and contracts, but were not in a position to utilize this to advance what would be the industrial revolution.

Lemin Wu

Commerce can thrive without special care from governments. So are contracts enforceable. The first thing that people ask of a good government is to restrain from grabbing the private sector. The British government, with “King in parliament” as the style of sovereignty, became a better government after the Glorious Revolution exactly in the sense of abstinence from grabbing and it was achieved with significant institutional changes.
Before the Glorious Revolution, Parliament played a limited a role in fiscal decision, while budgetary problem was so severe under the Stuarts that to make up shortfalls, the Crown imposed new customs, forced loans without honoring the terms, granted patents of monopolies for money, sold hereditary titles and even simply seized the property of citizens. The unpredictability of governmental action and the insecurity of private property distorted the incentives of investment and production, hindering the accumulation of wealth.
The Crown might grab the private sector due to several institutional features. It had quasi-legislative powers with the royal prerogative courts and the notorious Star Chamber had come to have final say concerning prerogative. The judges could be fired for ruling against the Crown. All these implied limited external check to the monarch’s authority.
Following the Glorious Revolution, a number of institutions were established to check the government’s grabbing behavior. The supremacy of parliament posed as a direct check as Parliament was now responsible for on-going management of the government. Parliament also gained exclusive authority to raise new taxes and the right to audit and veto the expenditure of governmental funds. Prerogative courts were abolished and the Crown could no longer remove judges at discretion. Meanwhile the threat towards the Crown behind the check and balance was real and felt given the successful dethroning of Charles I and James II. With these institutional characteristics taking over, the once abused tax power of the government was constrained and the political freedom was assured as well as economic freedom.
Some researchers also noted that the shift of power from the monarch to Parliament reduced the level of rent-seeking activities because Parliamentary decision naturally involved diversity of view which pushed the cost of rent-seeking to forbidding level. Besides, the survival of the Crown in the new political order partly kept a balance against potential abuse of power from Parliament.
The above institutional changes raised the predictability of the government and the security of private properties as well. A subsequent consequence was the soaring willingness of the people to lend money to the government, which financed the war of England against France. Established confidence of the investors also fostered a mature capital market which laid foundations for the industrial revolution a century later.

James Zuberi

Judging from the readings, good government appears to have made a large difference to Britain in the years before the industrial revolution. But this statement needs to be qualified in a number of ways. For the difference in generating revenue and spurring confidence in government notes to occur – it was necessary that there was stock of wealth existing in the country and the inefficiency was in confidence in government bonds. Also the definition of good government should be widened to include a government that does not appropriate property. Finally, the difference that good government made may well have occurred through channels that were not directly related to a government which tries to enforce contracts and care about commerce.

The case of supporting institutions should be made forcefully here so that a reader does not take away from this reading that a good government will lead to an industrial revolution. England already had a common law system which was able to bear the burden of contract enforcement. England already had wealthy individuals who, if made confident in government bonds, would give their money to the government. England already had a governing body in the Parliament which could bear the responsibilities of taxation and better governance. England was lucky enough that the forces which called for a reduction in the powers of monarchy won twice; if these forces had not prevailed then the monarchy may have resorted to more rent seeking behavior.

The ability of a government to raise large amounts of capital is absolutely not an end in itself, especially if the aim of the government is to use the wealth to fight a war with France. This ability is measure of confidence and so individuals with wealth may now venture out with their checkbook and be open minded in where to put their wealth. The authors mention that in the span of the next century after the glorious revolution, the number of banks dramatically increased. Such a development allowed for the institutions of banks to learn to profitably allocate money across the country. To put it another way, money going from individuals to the government, willingly, does not increase economic growth or stabilize economic production – rather the reallocation of funds from less productive to more productive projects increases the prospects for economic growth. Thus, the changing of government from an entity which appropriates to a more benign entity opened space for financial institutions to develop and thus to better the prospects for the economy as a whole.

Eva Vivalt

Judging by the readings, good governance seems to have made a good deal of difference before the Industrial Revolution. In the readings, we are presented with a few cases: that of successful Maghribi traders who were able to proceed with their work without much fear of confiscation, albeit with no formal avenues to enforce contracts; the case of Britain after the Glorious Revolution, when the rulers were more bound to respect their contracts; and the example of what may happen when the government is not so bound, the case of Britain before the Glorious Revolutions, to name the main ones.

In the case of the Maghribi traders, we find both positive and negative aspects to the level of good governance present. On the one hand, if the governance had been poor enough that shipments were sometimes seized, the trust-based system of the traders may have fallen apart and in this respect the fact that governance was not bad is critical. In such a bad governance scenario, people may have distrusted each other more, not knowing whether an agent was the problem with a missing shipment or whether the government had truly stepped in. Presumably the same system could have found a new equilibrium with certain expected rates of default based upon expected levels of government confiscation, beyond which any agent would be suspected; alternatively, then agents might have the motivation to cheat a tiny bit, in the hopes that it would be masked as within the bounds of innocent variation, and thus drive that equilibrium expected rate of default down until the market crashed. While what the ultimate consequences of any shipment seizing would have been are unknown, the governance not being bad can likely be counted as a positive. On the other hand, while the Maghribi traders had set up a well-functioning system based on trust to stand in for the absent enforceable contracts, there were costs to this system. It is noted that shorter and per-venture trips were preferable, and yet they sometimes must have been inefficient, and thus gains could have been made had better contracting been possible.

The case of Britain pre and post the Glorious Revolution is more explicit about the impacts of good governance. We are told that before the Glorious Revolution, when the government was not so constrained in taking money or reneging on its contracts, it became at one point hard to borrow, and “forced” lending resulted which caused many bankruptcies. Afterwards, the government was able to borrow incredibly large sums, such as around the turn of the 18th century during the war with France. It is even suggested that the bad governance contributed to the instability of the era. Certainly, then, at least judging by these readings, having good governance seems to have been important before the Industrial Revolution.

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