This chapter from Hurst's book follows the logic of Callender's paper by emphasizing the potential for positive intervention by the government in the economy. What's the 64 dollar question here? We want to investigate how the law creates an environment where people can take on more risks. Remember from Callender, the reason state intervention was necessary in large transportation and banking projects was because private individuals did not have the reputation required to raise millions of dollars of capital; investors could not trust private individuals enough to give them that kind of money. Hurst presents a different angle on this issue of the government reducing risks in business transactions:
But what astonishes me in the United States is not so much the marvelous grandeur of some undertakings as the innumerable multitude of small ones. . ." - Alexis de Tocqueville, Democracy in America, p.156-157 (cited in Hurst on p.18)
Hurst wants to examine how the law, especially corporate and contract law, evolved in America to make these multitudes of small business transactions possible. Again, as in Callender, the influence of the government is crucial to making the economy work.
What's Hurst's punch line? "Only within some minimum framework of reasonably predictable consequences were men likely to cultivate boldness and energy in action." (p. 22) The "energy" being released is the drive to find profitable opportunities. First we must consider why gains from trade might not occur without the rule of law.
Many students have complained that we don't do any economics and are just talking about historical fact after historical fact. If you have taken Econ306, Econ414 or even Dr. Schwab's Econ200 class, you ought to have seen some game theory before. This is exactly the stuff that Dr. Wallis was talking about in class.
We have talked about debtors and creditors and the problems of loaning money in the early republic. Recall how debtor stay laws and paper money policies made lending money a very risky proposition. Indeed, Beard's hypothesis about voting along economic interests was initially about paying back the public debt. With Callender, we talked about states defaulting on loans and the riskiness of private ventures being an obstacle to raising capital for firms. Let's use a loan contract to see where government can help.
Suppose we have two agents, a saver and a borrower. The borrower knows of a profitable opportunity that can turn $100 into $110. Unfortunately, borrower does not have $100 to invest in this opportunity and can't take advantage of it. However, he knows saver, who in fact does have $100 lying around. Borrower would like to go to saver and offer him the following proposition:
"If you lend me $100 now, i'll pay you back $105 in a week. You don't have to do anything and you get $5 for free. How does that sound?"
In this loan contract, the borrower takes 100, invests it and gets back 110, then pays back 105 to saver. Saver makes a 5 dollar profit (105 repayment instead of 100 initial) and borrower makes a 5 dollar profit (110 investment payoff - 105 repayment). If we are a benevolent social planner, we want this transaction to occur because it increases social welfare - everyone is better off!
What's the catch? The problem is that saver can't trust borrower. Borrower could take saver's money and run off with the 110 and not repay the loan. This is in a world with no laws - so the only way for saver to get his money back is to get himself a posse and go hunt this guy down. In the Nineteenth Century, this is very difficult to do... if borrower breaches the contract and runs, chances are he'll never be caught. Let's set up a game tree:
We would like to solve this game. Note that in these diagrams I have listed payoffs as the ordered pair (Saver, Borrower). As we've done in other classes, we use backwards induction. Suppose the game ever reached the node where Borrower has to decide whether to repay or not repay. What will he choose to do? He looks at the 110 and the 5 and thinks to himself "Ah, I want the 110. I will not repay." Now work backwards to Saver's decision. Saver knows if he signs the loan that Borrower will not repay him. So his decision is between not loaning (0 payoff for Saver) or sign the loan and not get repaid (-100 payoff for Saver). Saver thinks to himself, "Ah, I want the 0 and not the -100. I will not sign the loan." Here, the Nash Equilibrium is (Don't Loan, Don't Repay) and the outcome is (0,0).
But from a social welfare standpoint, we want the loan to go through because (5,5) is preferable to (0,0). The thing screwing us up is that Borrower's incentives are leading him to run off with money rather than repay the loan. Here is where government can step in and adjust the incentives to make this loan work.
Now suppose government tells Saver and Borrower that if Borrower does not repay the loan, the government will send guys with guns after Borrower and drag him back to repay the loan. In fact, not only will Borrower have to repay the loan, but Borrower will also have to pay for Saver's legal fees. This is a typical provision, where the loser in court pays the winner's legal fees. Assume legal fees are $10.
How does this change our picture? Well, everything stays the same except the case where government has to step in. When Borrower defaults now, he takes the $100 to make $110, but is dragged back to pay back the $105 plus he loses $10 for the legal fees. So he comes out with $110 - $105 - $10 = -$5. Saver will now get his promised payment of $105 and comes out +$5. This will totally change the outcome of the game:
And thus we see that the introduction of government to enforce contracts gets us to the desirable outcome. This is why Hurst believes that the rule of law makes men more free. He quotes an English judge: "If there is one thing more than any other which public policy requires, it is that men of full age and competent understanding shall have the utmost liberty of contracting, and that contracts, when entered into freely and voluntarily, shall be held good and shall be enforced by courts of justice." (p.12, emphasis added)
The major difference with the way Americans approached property was that "what we did in the name of vested rights had less to do with protecting holdings than it had to do with protecting ventures." (p.24) In old European societies, property rights like in the Magna Carta or the British Declaration of Rights had to do with preventing the crown from confiscating what people already had. This is a very defensive notion of property rights in which people want to merely keep what they believe is rightfully theirs. Instead, Americans wanted to form laws that reduced the risk of doing business so that people who wanted to use their property for profit could do so without worrying as much.
Risk in transacting can come in many forms. One simple example is the loan defaulting we used earlier. Everything will boil down to trust: "Of course, all social living puts a premium on reasonable expectation and safe reliance on others' conduct; but the development of the market steadily increased the interlocking character of operations in this society and thus tended to raise men's need to be able to rely on one another's performance." (p.14)
We have presented economic growth in the North-Callender framework as resulting from the expansion of markets. As larger and larger markets are brought together, gains from trade via regional specialization and division of labor can be realized. But when you expand the size of the market, transactions become less and less personal. How do you know the goods you paid for will be delivered? How do you know the service you have contracted for will be of good quality?
In ancient tribal societies, the way people overcome this problem is by simply dealing with only people they trust implicitly - their family members. Tribal units are family based because people tend to trust their blood relatives the most, and therefore can rely on blood relatives easiest. Even when you look at banking and manufacturing in the early republic, we see this pattern. Recall the early United States is a place with all kinds of risk so people don't want to loan each other money. When someone forms a bank or a business in the northeast, guess who all their business partners are? You guessed it - they invite their relatives to be partners and relatives loan money to each other.
If people are limited to dealing with only their relatives, that severely limits the kinds of profitable transactions that can occur - we only have so many relatives! If you want to "give men more liberty by increasing the practical range of choices open to them," (p.6) then you need to set up mechanisms that can substitute for the trust felt for relatives. In an impersonal, modern market economy, what you need are secure property rights and enforcement of contracts.
While discussing the role of the corporation, Hurst explicitly makes a link to Callender's dismissal of the notion of lasseiz faire: ". . . it is characteristic of the nineteenth century that there was here also a demand for positive help from the law. Merely to be let alone to combine capital was not the substance of the entrepreneurs' desire. Here, as so often, a lively and persuasive sense of capital scarcity, relative to our opportunities, supplied the dynamic of public policy. One did not mobilize and discipline scattered resources merely by exhorting government to keep its hands off. Entrepreneurs wanted the positive prestige of the sanction of the state implicit in the charter grant. They wanted the aid of an orderly capital subscription procedure under which capital could be fed into the enterprise on a defined installment plan, with provisions for periodic assessments of stockholders and forfeitures to enforce assessments." (p.17)
This is exactly what Callender was talking about - government helping mobilize capital for entrepreneurs. So much for lasseiz faire. When you think about the title of Hurst's book, consider the role of laws. Typically we think of laws as preventing us from doing something or restricting us. But like Dr. Wallis said, unbridled freedom for every individual means imposing on each others' rights. Do we really want unbridled freedom? I know I don't want people to have the right to go around beating up whoever they want to. That's why assault and battery is illegal. Do I feel more secure with a law that (hopefully) prevents people from beating me up? You bet. Society can't function without some commonly agreed upon rules of conduct - Hurst's "minimum framework of reasonably predictable consequences."
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© 2002 Andrew N. Kato (04/09/02)