Fudan University Lecture 61 Government and Institutions 1.Did Britain take the lead in the...

Fudan University Lecture 6 1

Government and Institutions

1. Did Britain take the lead in the Industrial Revolution because it had a “better government” or more broadly “better institutions”?

2. Has been a central argument of the “North School” which points to the 1688 Glorious Revolution as the triggering event.

3. Yet things are more complex than that.


Institutional analysis is about a number of things:

1. Enforcement of contracts and the protection of property rights.

2. Setting up the “right” incentives for individuals to minimize rent seeking through exclusionary arrangements and other rent-generating legislation.

3. Recognizing market failure and providing public goods.

Will deal with all three.


Good institutions: Law and Order

• Most economists think that Law and Order are essential for economic growth.

• We distinguish between formal institutions (legal and other formal arrangements) and informal ones such as customs, traditions, habits, etc.


Property Rights and Enforceable Contracts

Without them, markets really cannot function and no investment will take place.

Most economists think that these functions are public goods, that is, supplied by government through “Law and Order.”

But historically, and even today, “law” and “order” are often privately supplied and do not always require the state to do it all.


• But once that is agreed on, questions arise:

• How and when can we have order without law (private-order institutions that enforce contracts and prevent opportunistic behavior)?

• Can we have law without order (that is, all formal arrangements are to benefit a small predatory minority).

• What about institutions such as IPR’s and personal freedom of expression and access to information that are essential to technological progress?


For most societies, good property rights and enforceable contracts are a sine qua non

What are “good” property rights? Good here means:1. Unequivocal and uncontested, secure 2. Conveys full control of asset up to spillovers to

others’s assets.3. Full alienability: can sell, bequeath, mortgage,

and transfer at will. Efficient Contracts:1. High penalties to absconding and reneging2. Easy resolution of unspecified contingencies. 3. Easy and cheap to write and enforce.


1. Effective formal property rights seem to demand an effective, inexpensive, and fair police and court system.

2. But court systems were none of those in eighteenth century Britain.

3. Trials were slow, expensive, and outcomes were difficult to predict.


Property rights enforcement in the 18th c. :

1. Between classes: the state passed very draconic laws against crimes such as theft and burglary, and one could be hanged or deported for petty larceny.

2. Within the middle classes and above: property rights were respected and if contractual disagreements occurred they were settled, decline in reliance on courts.

3. The state does not do much to keep law and order: much of it depends on local administrators such as Justices of the Peace (JP’s) who are unpaid. There are royal courts that deal with certain cases, but justices are unpaid as well. No organized police force, some local constables.

4. In short, this was a nation of “law and order” but there was more order than law. Within limits, there was an “economic civil society”.


Private-order institutions

• Most important: reputation. Common knowledge issue, but runs against information and verifiability constraints in larger and more mobile environments.

• Reputation mechanisms tended to work in groups that knew one another and tended to care about reputations, such as people that belonged to the same church or associations;


Here the record is quite clear

1. In the eighteenth century, Britain became an “associational society” --- middle class people joined a variety of clubs, societies, and assorted other organizations to interact and do things together.


Source: Peter Clark, 2000, p. 132

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“Society of Dilettanti” 1777-79


These organizations supported informal institutions

1. By allowing an efficient exchange of information through “economic gossip.”

2. By making the penalty on opportunistic behavior contain not only the loss of future business but also the threat of losing one’s “social network.”


Moreover,

• But this does not help much against working class people, or members of a criminal underclass who do not belong to middle class associations.

• Hence, the upper and middle class passed extremely harsh and draconian laws against people who stole their property (“black laws”).


1. The other variable is “culture” --- some cultures believe that honesty and veracity are positive values and then parents and other educational agents pass that on to the next generation. Religion is one example. This often happens when equilibrium outcomes are “internalized”.

2. Settling disputes “in the shadow of the law” --- both sides know that they can go to the state (i.e., court) but that course is slow and costly.


In Britain in the eighteenth century

Most private property was protected through private means.


Property can be protected in two alternative ways.

1. One is for the class of property owners to build a real or metaphorical wall around themselves (by purchasing guns and locks, private alarm systems, hiring private security guards and so on).

2. The other is to build a wall around the criminals by hiring police to arrest them, courts to judge them, and ships to sail them to penal colonies, or prison guards to lock them up.


They are not equivalent

• Depending on technology, one might be a lot more expensive or efficient than another.

• In the wall-in system, externalities are more prominent, because once a thief is removed from society because of a crime against one victim, all his potential victims have less to fear.

• On the other hand, the wall-out system may become a “race to the bottom” kind of story.


While every society adopts a combination of the two systems, the weights of the components differ over time and across countries.

Britain in the period under discussion here shifted from a predominantly wall-in-the-property system to one of primarily wall-in-the-thief. Rise of modern prisons and exiling (“transporting”) criminals to colonies.

This is in part a result of modernization and growing power of the state after 1830.


In any case, most societies have courts and some kind of executive that “keeps order”. But that raises another problem.

To be an effective “third party”, the state needs to have a monopoly on violence so that it can enforce its decisions and collect the taxes it needs to pay for this system. But giving that monopoly involved a basic commitment problem.


The “fundamental problem” in economic institutions

“Et quia custodiet ipsos custodes” --- and who shall watch the watchman?

How can the state (king, emperor, count, ruler) ever credibly commit not to engage in confiscations himself if he has a monopoly on violence?

This issue turns out hard to solve. We need to have “checks and balances”, or what the economists call “constraints on the executive.”


It is this problem that Britain solved successfully in the seventeenth and eighteenth centuries

1. Parliament became the main source of power. It had to approve all taxation that the King imposed. It also had to approve all new rulers and as 1649 and 1688 showed, it could depose a King it did not like.

2. This does not mean that Britain was a low-tax nation, but rather that Parliament imposed the kind of taxes that it liked (mostly excise taxes on non-necessities).

3. Paradoxically, this meant that Britain was regarded as creditworthy and so had access to large amount of credit at relatively low interest rates. The state borrowed a lot to pay for wars. Government was deeply in debt.

4. Some economic historians believe that this debt was a good thing because it helped develop asset markets and financial institutions.


What explains the flexibility of British Institutions?Parliament’s role as a “meta-institution”

• If we think as “institutions” as the rules and laws by which the economic game is played, we have to ask who writes those rules. In Britain it became clear that Parliament could write and change these rules. What mattered most is that even those who lost from those accepted its legitimacy.

• This makes it into a meta-institution yet one that is not driven by the narrow interests of a dynasty and one that was receptive to the changing economic needs and changing ideologies of the country. It gave Britain something that was better than “good institutions” --- it gave it flexible (“adaptive”) institution.

• Most other countries did not have anything like this.


Do NOT confuse this arrangement with “democracy”

1. Very few people were enfranchised, perhaps 5% of population. Electoral districts often preposterous (“rotten boroughs”).

2. There was, as yet, little recognition of “human rights” although that slowly changes in the eighteenth century.

3. It was above all a government of, by, and for private property, mostly real estate but also increasingly government securities,


This system was changing quite dramatically over time

1. Indeed, what is remarkable about Britain is how adaptable and flexible its institutions are, and how they change smoothly when the needs change.

2. An examples many small claims between people could not be resolved peacefully. Led to the establishment of “courts of conscience” or “courts of requests” --- small-claims courts where, for example, innkeepers could take customers who did not pay for their drinks and so on.


Example: Bankruptcy

What Britain is also particularly good at is to reinvent institutions that are adapted to new circumstances. Bankruptcy law is set up in such a way that people who cannot meet their contractual obligations get off fairly easily.

1706 Bankruptcy act: recognized that some debtors could not pay because of events beyond their control, and that punishing such people would have neither a deterrence nor a signaling value. Bankruptcy discharged existing liabilities and thus gave the agent another fresh start — implicitly conceding that it was indeed misfortune and not intention that caused the insolvency.


Incentives and bankruptcies

Society was sufficiently networked that bankrupt businessmen could be handicapped for the rest of their career. Such a penalty alone would be a powerful incentive for most people to meet their contractual obligations and refrain from opportunistic behavior if they could. In that sense the formal institutions of this economy (bankruptcy proceedings) supported the social norms that created a self-enforcing equilibrium in which reliance on legal mechanisms was a last resort. Bankruptcies remained unusual events. Even in the turbulent decade of the 1790s, the annual rate of bankruptcy was one in 203 firms; in the more quiet decade of 1756–65, the rate was one in 605 businesses.


This kind of system works well if it is not abused. Reputations took care of that: someone who had been bankrupt carried a stigma and people would be much more reluctant to do business with him.

Moreover, to prevent abuse, the creditor had the option to have the debtor declared “insolvent” and demand that he be put in debtor’s jail. Britain has debtor’s jails till the 1870s, and they were quite controversial. Obviously mostly significant as an incentive (deterrent effect).


British institutions are thus flexible. Compare this with other countries:

1. In France, institutions could only change after a violent and costly revolution followed by a military dictatorship.

2. In Germany and Central Europe, most reforms were reversed by more reactionary regimes as they often depended on the decision of single rulers.

3. The US, taking its cue from Britain, specifies precisely how meta-institutions are supposed to work in the constitution.


1. Although British Parliament represents a small fraction of the population it was sensitive to commercial and industrial interests who lobby it.

2. The world’s first professional lobbyist was a Birmingham iron-manufacturer named Samuel Garbett (1717-1803).

3. Lobbying by itself was (and is) not a bad thing, since it sensitized the legislators to changing needs of business.


After 1750 Parliament makes some important changes possible

1. One example was the parliamentary enclosures

2. Another was the network of turnpikes and canals.

3. A third was the repeal of a long list of mercantilist and restrictive laws that benefited the few at the expense of the many.

4. More than anything else, Parliament came down on the side of innovators against vested interests who tried to block technological progress


Apart from this, what did the government do to foster industrialization?

In the case of Britain, because it was first and early: very little:• The Government did not provide any “modern” services such as education,

health, housing, hospitals, water supply.

• Nor did it invest in infrastructure such as roads, railroads, bridges --- these were mostly paid for by private “subscriptions”

• There was almost no consumer protection: caveat emptor.

• It did not regulate markets that were liable to fail such as insurance and financial institution.

• It did not pay for R&D

• Only by the mid nineteenth century is there any coherent notion of financial regulation and central banking (except for rent-seeking behavior of the B of E)


Government spent a lot of money

The proportion of Taxes/GDP reaches 15-20 % for a while.

But that money is almost entirely spent on military expenditures and interest on previous military spending.


Yet in Britain, it is often argued, government contributed

some “passive” elementsThree topics:

• IPR’s

• Incentives and rent-seeking

• Public goods.


Topic 1: Intellectual Property Rights


Intellectual Property

•Britain does have a patent system from 1624 (originally more of a rent-seeking institution than a policy designed to encourage technological progress) and it has been linked by some to its unprecedented economic success. (North, 1981).

•It also has a copyright law known as Queen Anne’s Law (1710) Copyright was awarded normally for fourteen years, with the possibility of renewing it to double this length. This Act was far from waterproof, as it did not cover Ireland and the American colonies, where British books were printed freely. Amended and adjusted repeatedly.


Deep controversy about IPR’s:

1. On the one hand, Enlightenment thinkers wanted market forces and free-enterprise (as opposed to government officials) to determine outcomes.

2. Moreover, they felt that IPR’s encouraged innovation and that innovation was the key element in economic growth, both by encouraging more R&D and by getting more investors to put “venture capital” into risky projects.

3. From a practical point of view, they felt that patents were the price society paid for disclosure. The full specification of the patent made the technical details accessible to others.

4. Finally, they were strongly committed to the sanctity of property rights (a natural right) and increasingly felt that the creation of knowledge conveyed “ownership rights” on the inventor or author. This was disputed by some.


On the other hand …

1. There was a general belief that monopolies of all types, even temporary ones, were bad.

2. There was an intuitive sense that knowledge should be free-access because anything that limited access to useful knowledge was bad.

3. Some writers pointed out that patents were used as false quality signals and lured investors and consumers into fraudulent schemes (e.g., “patent medicine”).

4. It was realized that patents could block research by non-patentees and actually slow down innovation (classic example of James Watt).

5. There was also a moral sense that inventors, like scientists, were serving the public good, and should be rewarded by honors, not necessarily financial rewards.


Another issue is what proportion of all inventions were actually patented.

1. The traditional answer has been: we don’t know, because the denominator is not well defined and hard to quantify.

2. There is a consensus, however, that in some areas of economic activity patenting was practiced, while in others it was not.

3. This was presumably correlated with the ease of reverse engineering, but that story seems too simple.


How many important inventions were ever patented?

We now have an answer, thanks to the pathbreaking work of Moser (2005, 2007).

Her idea was to define the population of “important inventions” as all the inventions exhibited at the famous Crystal Palace exposition (1851).

She found: less than 16% of all top-notch British exhibits were patented.


Overall assessment of the role of the patent system in generating the Industrial Revolution

There are two debates here: •Was a patent system of any kind desirable?

•Was the British system as it actually existed until 1852 a major factor in the Industrial Revolution?

•Was it on balance even a favorable factor?


Two historical facts:

1. The American system was far more accessible and user-friendly than the British system (Khan, 2005), yet Britain was the world’s technological leader and Americans did not patent much more than the British per invention (by Moser’s data).

2. The Dutch United Provinces actually had a patent system much like the British, yet their overall number of patents declines throughout the

eighteenth century.


However:

What may have mattered is the ex ante beliefs of British inventors. Many believed that they could beat the odds.

[cf. Adam Smith, 1776, p. 120: “The over-weening conceit which the greater part of men have of their own abilities is an ancient evil… their absurd presumption in their own good fortunes is … if possible, still more universal… The chance of gain is by every man more or less over-valued, and the chance of loss...undervalued”]

A “somewhat imperfect system” may have been optimal (Dutton, 1984) because it struck a balance between inventors and imitators, while leaving the hope with many inventors that they too would hit the jackpot like James Watt and Charles Tennant.


What this seems to indicate

1. Patent was a bit like a lottery, as some people claimed.

2. For a lottery to be successful, a few big winners need to be salient and widely known, so that others would get a strong signal.


But a patent system is not quite like a lottery

1. In a lottery, outcomes are purely random so the conditional prior probability is equal to the unconditional one for a rational individual.

2. But in invention, by definition, each outcome is a sui generis and has an irreducible idiosyncratic component.

3. Hence, each inventor may “fool himself” to think that he can outsmart the system.

4. Thus the patent system may have goaded potential inventors to allocate more resources to research than would be consistent with unconditional odds.


1. This is suboptimal for individuals in expectation (unless risk-loving).

2. But because of spillover effects, it may have been socially beneficial. That is, the invention is more useful to society at large than for the inventors.

3. Hence the patent system may have cheated the few to benefit the many.


Bottom line on IPR’s :

There is no convincing evidence that Britain’s early start with a patent system gave it an overwhelming technological advantage in the eighteenth century.

It is far from clear that a different (i.e., more accessible) patent system would have made much of a difference for Britain. There would have been more patents, but would there have been more technological change?

All the same there is reason to believe that it had on balance a positive effect on invention, even if the impact was not very large, largely by creating low-probability high-value gains, whose expected values were overestimated by would-be inventors.


Other institutional aspects of the Industrial Revolution

But there are acts of omission as well as commission.

Most important: the state could not and did not tax away the profits of successful entrepreneurs, it respected their property right, and did not let bandits or corrupt officials expropriate them.

Moreover, the institutional structure allowed for those who had

been successful in business to become part of the ruling class. Many nineteenth century politicians came from families that had made their money through and in the Industrial Revolution.


Topic 2: Incentives and rent-seeking

Another issue in every society is what incentives there are for the most resourceful, talented and ambitious young people to do. In Britain, where there was a small army and small government, there were few options except business.

Moreover, because of its exclusion of non-Anglicans from the civil service and the military, these people had nowhere else to go.

Unlike France or Prussia with large armies and bureaucracies, where many careers were made in the service of the King or Emperor.

In Britain, talent flowed into civil (instead of military) engineering and business (rather than government) administration.


The decline of rent-seeking

1. British government provided fewer and fewer options to make money by rent-seeking. While early in the eighteenth century corruption and “patronage” were still part and parcel of government, this is beginning to disappear in the 1760s, and by 1840 or so, there are few opportunities left to make money through “connections.”

2. This is a remarkable phenomenon in which corruption essentially disappears in 50 years between 1775 and 1825.


The pivotal figure was this:


William Pitt “the Younger”, 1759-1806

PM between 1783 and 1806.

Yes, that makes him PM at age 24…

Most famous today for being Napoleon’s implacable foe.

But in Britain, a major reformer. Typical product of the Enlightenment in Britain.


Between Pitt and Peel, “Old Corruption” declined.

• This had started under Pitt, and gathered steam under the “liberal Tories” and then Whigs.

• By 1815, a consensus had emerged that had no room in it for patronage, sweetheart deals, and other forms of rent-seeking.

• By the mid-1830s, the cost of all unreformed sinecures was estimated at under £17,000, down from £200,000 two decades earlier (Harling, 1995, p. 136).

• What used to be a parasitic class of drones had become, in Linda Colley’s terms, a “service elite.”


The decline of corruption was only a part of the overall decline in rent-seeking.

Between 1800-1830, most monopolies and exclusionary arrangements were repealed or modified. There were fewer and fewer opportunities to find “rents”. Among the mercantilist restrictions that were abolished were the East India Company, the restrictions on banking, the statute of apprentices, the Bubble Act, and the laws prohibiting the exports of machinery and emigration of artisans. Especially striking: prohibition of the slave trade, 1809.

What is astonishing is that these all took place without a revolution, without the Bastille or bloodshed.


Topic 3: Public Goods and Market Failures


So, what did the government precisely do in this age?

One “public good” it provided was peace and security, preventing invasion of foreign forces (by maintaining a large navy) and by having enough military strength to quell organized protests and riots.

It also maintained and protected colonies, but not clear how productive that was to country (see week 8).

It also provided local law enforcement and administration, although in the eighteenth century this was only “auxiliary”. After 1825 or so this role becomes increasingly important.

One further unique feature was the British Poor Law


The British Poor Law

A unique institution: no other society has a nationally coordinated and mandated set of legal provisions in support of the poor.

Yet in Britain much of this was left to local authorities (poor law guardians) who could decide most question of “who was entitled to how much for how long” etc.


Any kind of welfare system at this time had to make decisions:

1. Outdoor vs. indoor relief? Advantages of each

2. Real or nominal support? Matters in times of inflation

3. Able-bodied or deserving poor?

Historically they repeatedly went back and forth on these issues. By the end of the eighteenth century much of England had committed to a system called “Speenhamland” set up in 1795.


1. Speenhamland was:a. Cash payments (outdoor)

b. In real rather than nominal terms (linked to the price of bread)

c. Proportional to the number of family members.

d. For able bodied as well as deserving poor.

2. It served its purpose: during the hard years of 1799-1816, there was no starvation and few riots.


The British Poor Law

1. At its peak, the Poor Law system may have served 10-14% of the population of a cost of perhaps 2% of GDP.

2. In some regions it was particularly effective in helping people during off-seasons and years of high food prices.

3. Poor Law officials were quite involved in the life of the poor and people marginal to society, looking after orphans, widows, cripples, and so on.

One conclusion: if its purpose was to preserve domestic peace and prevent large scale rioting it was on the whole successful.


But like all such schemes it raised problems of moral hazard

1. Did it encourage laziness (“indolence”), imprudence, and large families?

2. Moreover, there was a debate the poor laws discouraged internal mobility because of settlement laws (one could only be supported in the parish of one’s birth). Adam Smith thought so, but modern research has shown that labor mobility was but little affected by these “settlement laws” (meaning that you could only receive support in the parish of your birth).

3. It was not equally effective in all of Britain, more important in the agrarian South and rural districts in the West and North, not so much in the new industrial urban regions.


Poor Law Reform

1. After 1815 there seemed less need for the system of poor relief, and political economists were increasingly opposed to it.

2. This led to the great Poor Law reform of 1834 which was supposed to place all the poor in poorhouses, so as discourage people from free-riding. Those poorhouses were extremely unpleasant places where people were fed and housed, but otherwise lived highly regimented and unpleasant lives.

3. The idea behind the new system was in the words of one historian that “the bread of charity should be made so bitter that only the most desperate would be tempted by it” --- in other words to make poor houses so unappealing that it would create no incentives to shirk.

4. Yet in fact the new system continued to support people on an outdoor basis, using loopholes in the new poor law.


The state also supplies a means of exchange

1. The British mint minted coins, but it overvalued silver, so silver disappeared largely from circulation. There were never enough small-change coins, and many firms issued tokens or used book-credit. Serious complaints about the “big problem of small change.”

2. Only when Matthew Boulton (Watt’s partner) applied steam engines to the minting of coins and new copper supplies in Wales were brought on line, was the “big problem of small change” brought under control.

3. The British state did a poor job at that. Inland bills of exchange and bank notes were “inside” money that circulated like money.


Apart from that, what role did the government play?

1. Until quite late in the nineteenth century, the government had little to do with education, insurance (including social security), health, overhead investment (roads, bridges), or science policy. As proportion of GDP, government spending fell through much of the period after 1815, excepting the Crimean War.

2. All the same there were growing signs of market failures in the British economy, and a sense that markets could not always be relied upon to produce the best solution.


1. One example was what was happening in the new cities. Great poverty, terrible sanitary conditions, congestion, bad water and bad food led to high mortality, epidemics, and a weakened population.

2. It became clear that this was a social problem since sick people infected others, and because it weakened workers.

3. The government spent a lot of efforts on investigating the “sanitary condition of the working class”.


Modern research has shown that the problem was that cities grew to fast and that capital accumulation was insufficient to “cope with city growth” so that infrastructures could not be expanded at a rate proportional to population growth. [same problem today in many large third-world cities].

This led to the Public Health Act of 1848 and a bunch of other acts, which gave cities a bunch of options but had little mandatory powers. The situation improved very slowly after 1860.


1. Debate between various experts on how to combat urban blight. Some more radical people wanted to eradicate poverty altogether. In Victorian Britain, this was not popular.

2. Most specialists wanted to fix the engineering problems but not the social problems of inequality and unemployment.


The other area of government meddling was labor

1. Policy makers got very concerned with Child Labor, and repeatedly passed laws against it (1821, 1833, 1849) although enforcement was difficult and it is not clear what net effect they had.

2. Why would this be a source of concern? Clearly child labor was increasingly incompatible with a Victorian sense of moral propriety.

3. But, much as in education there was a sense that the state should act in loco parentis.

4. In addition, there may have been other ways in which child labor may have been socially costly.


Child Labor

1. Some disagreement about how serious the problem was and whether the Industrial Revolution made it worse. What did children do before the Industrial Revolution? Answer: often worked in their parents’ farm or workshop.

2. There were cases of blatant exploitation of children in coalmines, cotton mills and as chimney sweeps, but on the whole it was not all that common: In 1851, about a third of all males aged 10-14 and twenty percent of all females of that age were “economically active.”

3. That does not mean necessarily that they worked year-round and clearly it undercounts those helping at home.

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