Institutions, property rights and goods and factor markets

Markus Lampemlampe@clio.uc3m.es

office 7.0.09 Contact hours: Tuesday 10.45-12.45h or

on appointment

Contents

(1) Growth and institutions: the neo-institutionalist view

(2) Constraining the Leviathan (a panacea?)(2) Constraining the Leviathan (a panacea?)

(3) A micro-look at the Manor as an example of pre-modern(seemingly) inefficient institutions

(4) An alternative explanation of pre-modern growth: Adam Smith and the division of labour.

2

Persson’s synthesis

Population growth +

+Diminishing marginal

returns(Malthusian mechanism)

Divison of labour(Smithian mechanism)

Learning-by-doing based methodological change which might be linked to

population size (for examplein the Boserup way)

+

(Malthusian mechanism)

Income per capita/Real wages

+

+

-

3

Until now

• Stilized facts of a “race” between population, ressourcesand (slow) technological progress

• If population grows faster than labour productivity (orTFP, both have the same growth rates if capital and education per person is the same), all technologicaleducation per person is the same), all technologicalchange leads to higher populations only and living standards are low

• (∆Y/Y- ∆L/L) ≈ αK (∆K/K- ∆L/L) + αHK (∆HK/HK- ∆L/L) + ∆TFP/TFP

• So, an important question is why technological progresswas so low in preindustrial economies

• For Malthus, population was the problem4

But there was some growth(in NL and UK at least)

5

Black=Italy, Red=United Kingdom, Blue=Netherlands, Green=USA

Or if we look at real wagesSilver equivalents of real wages of workers around the world

per

day

6

Gra

ms

of s

ilver

per

Source: Robert C. Allen: The High Wage Economy of Pre-industrial Britainhttp://www.helsinki.fi/iehc2006/papers2/Allen77.pdf

Or agricultural productivity (England 1500=1)

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• Why did Amsterdam and London (and with them Hollandand England) grow, while others did not?

• Today we will look at two kinds of explanations:– Institutionalists (or New Institutional Economics):

Main question

– Institutionalists (or New Institutional Economics): Douglass North and others argue that institutions are very important, since they are human-designed(social choices) and in part the outcome of geography, culture, politics and economic factors

– Smithian growth (division of labour through trade and market integration)

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North and Thomas (1973), pp. 2-3

• “Efficient economic organization is the key to growth, the development of an efficient economicorganization in Western Europe accounts for the riseof the West. Efficient organization entails the

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of the West. Efficient organization entails theestablishment of institutional arrangements and property rights that create the incentive to channelindividual economic effort into activities that bring theprivate rate of return close to the social rate of return… if a society does not grow it is because no incentives are provided for economic inititative.”

• …are the rules, regulations, laws and policies – written and informal – that effect economic incentives and hence theincentives to invest in capital, human capital and technology

• That is, they define and influence the opportunities and choicesof individuals

Institutions

• Individuals will only take actions that are economicallyrewarded; whether this is the case or not depends on theinstitutional framework

• Hence, if institutions and therefore incentives are not workingcorrectly, the expansion of productive potential (necessary toovercome diminishing returns from current factor endowmentsand technologies) can be slowed down

• This is “inefficient organisation” of the economy, that hinders itsfunctioning and therefore growth 10

North and Weingast (1989, p. 808)• “Our view also implies that the development of free

markets must be accompanied by some crediblerestrictions on the state’s ability to manipulate economicrules to the advantage of itself or its constituents. Successful economic performance, therefore, must beSuccessful economic performance, therefore, must beaccompanied by institutions that limit economicintervention and allow private rights and markets toprevail in large segments of the economy. […]

• Absolutist states which faced no such constraint, suchas early modern Spain, created economic conditions thatretarded long-run economic growth.”

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• Institutions : any form of organization and regulation of individual and collective behavior (a set of rules )

• Incentive : any factor that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives.

A set of definitions

to the alternatives.• Property rights : the ability to exercise legal control over a

resource (an item of value, incl. the person’s labour supply) including the right to attach a price to it, or profit from its use.

• Markets : institutions that allow economic agents to set pricesand transfer property rights through contracts .

• Transaction costs : the costs that parties incur in the process of agreeing and following through a bargain � informationasymmetries � negotiation, intermediation, monitoring, enforcement costs 12

Institutional change and (in)efficiency• Since they are social choices, institutions can be changed• Theory suggests that, under conditions of competition, more efficient

institutions will replace inefficient ones• North (1990, p. 84) argues that changes in relative prices (due to

changes in the relative scarcity) and changes in tastes (preferences) changes in the relative scarcity) and changes in tastes (preferences) are the most important sources of institutional change

• Nevertheless, change has costs: winners from a new situation haveto be able to “overrule” potential losers that benefit (extract “rents”) from current arrangments (“vested interests”) in a political process(“political economy”). Also, the political process does not alwaysfollow the economic logic of competition and efficiency.

• Therefore, inefficient institutions can exist and persist (e.g. arbitraryexpropriation, forced taxation by a strong government, privileges forminorities with strong influence)

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• There exists an endemic conflictbetween the own interest of thegovernment and economic efficiency� a strong state is necessary toguarantee social order (prevent free

Did preindustrial economies grow so slowbecause of bad institutions?

guarantee social order (prevent free riding by citizens and and providepublic goods)� but it can also appropriate a largeshare of the surplus generated by theeconomy (for example by not repayingdebts) for its own consumption, thuslimiting growth potential

• How to constrain the Leviathan?The frontispiece of the “Leviathan”by Thomas Hobbes (1651)

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England• Institutional set-up : after the death of Elisabeth I Tudor,

permanent conflict between the Crown and representative bodies(Parliament, common law courts) on taxation and allocation of property rights (chartered monopolies)

• Absolutism with high concentration of power in the Crown:– quasi-legislative powers (Royal Prerogative superior to

Parliamentary acts)– quasi-legislative powers (Royal Prerogative superior to

Parliamentary acts)– full control of the government acts (no need for Parliament’s

approval or authorization for issuing or renegotiating debt)– judges salaried by the Crown; King could remove disloyal

judges.• Events: Civil War and execution of Charles I Tudor (1649) �

Commonwealth (Republic based on military rule in the name of Parliamentary supremacy) under Oliver Cromwell � Royal restoration under Stuarts (1660) � political conflict (Whigs vs. Tories) � William III Orange (a Dutch stadtholder) invited by the Parliament to become King: the ‘Glorious Revolution’ (1688).

Constitutional monarchy under the Bill of Rights of 1689

1. Parliamentary supremacy established � sovereignty shared.

2. The Crown cannot disband Parliament at discretion

6. Prerogative power curtailed and subordinated to Common Law � prerogative courts were abolished

7. Judges independent from Parliament at discretion3. Parliament gains central role in

financial matters (taxation)4. The Crown´s independent

sources of income limited by Parliament.

5. Parliamentary power to oversee how government spends � veto power over expenditures voted in Parliament

7. Judges independent from Crown � they could only be removed if convicted of criminal offence or by the two chambers of Parliament

8. Political rights were regarded as a key element in the protection against arbitrary violations of economic rights

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• The new institutional balance made the government’scommitment to secure property rights more credible, by rulingout expropriation by a predatory state and increasing the cost of rent-seeking���� a constrained government is also a more predictable

Consequences

���� a constrained government is also a more predictablegovernment .

• How did this contribute to prepare the ground for the transition tohigher growth?

• By reducing the cost of capital : after the Revolution, rise in thevolume and decline in the cost of borrowing by the Englishgovernment = reduced risk premium� reduced also the cost of capital raised in private capital markets.

17

Government finance before the Revolution: forced loans with systematic default

���� high risk = high interest rate

18Source: North and Weingast (1989), p. 820.

After the Revolution: increased public expenditure,

access to credit and price stability

19

Credible commitment���� falling interest rate on government debt

20Source: North and Weingast (1989), p. 824.

In international perspective• North and others suggest that in all countries that did not grow

(Spain, France, etc.) the problem was the same, and England (or theNetherlands) was the first country to escape it.

• However, authors like Epstein (2000) have argued that also theNorthern Italian city states were republics that went into decline at thesame timesame time

• Greg Clark (2007, ch. 9) argues that actually the problem of highinterest rates was only one of the English state, not of privateindividuals in England. For them interest rates (on land) had beenfalling since about 1300, because the risk of expropiation was far lessproblematic than North claims

• Epstein additionally argues that what made interest rates for theEnglish Crown high before 1688 was not so much the uncontrolledgovernment, but the backward way of organizing governmentfinances 21

(Private) rate of return on farmland and rent charges in England, 1170-2003

Interest rates on public debt, 1300-1750,all over Europe

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Epstein (2000), Figure 2.1: the English Crown inthe 15th and 16th Century paid higher interest ratesthan other European Monarchies because of itsbackward system of managing public debt (whichwas in part a result of not having to fight many warsafter 1066)

Rate of return on farmland and rent charges, Clark (2007), Figure 9.1.(Because of ursury laws interest rates on privateloans are difficult to assess, land could be rentedout because it literally brought fruits and therefore“interest” payments were justified; muchland was held by the church itself)

So there were other problems• Interest rates for the Crown in England were high because they did not

develop regular “financing instruments” (a consolidated debt), becausethey did not need much revenue (since only few wars had to be foughtsince 1066)

• England could solve the problem quickly, because the national marketand national politics were actually integrated and united (as a consequence of absence of wars and good natural infrastructure)consequence of absence of wars and good natural infrastructure)

• In other countries, like France or Spain, the government was actuallyweaker than absolutism makes us believe (because there were manytraditional “freedoms” for regions or people of status that limited taxrevenues), similar problems ocurred (for different reasons in many cityrepublics and in Poland, that additionally were very small), which madeit difficult for them to survive wars or protect their commercial routes

• That is, a strong state can be a problem if not controlled, but a weakstate and one that is too controlled (so it cannot actually act) is alsoproblematic, since sometimes markets and private institutions need thestate

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Limitation to taxation

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Source: Bogart et al. (2000), pp. 78, 79

Overall fiscal (state) revenue is the product of revenue (or tax pressure) per capita and the size of thepopulation. High overall revenue means, among other things, that a government can sustain large armies and navies. Tax pressure per capita means how much a government (local, regional or national) was able to raiseper capita. While taxes per capita were highest in the Netherlands, overall income from taxes was highest inFrance in the 18th Century, since it had the highest population. However, the capacity to increase taxes in France seems to have been limited (tax pressure per capita is about 1/3 that of the Dutch and less than halfthat of England in the second half of the 18th Century.

• The lord was given a conditional grant of land tenure in return formilitary services to overlords and the king (so the king sharedgovernment with the Lords since he could not effectivelysubordinate them and/or control the territory himself)

A micro-look at the problem: Serfdom and Manorialism

• Peasants were given a conditional grant of tenure (land rights) in return for compulsory labor services (corvée) on the demesne(the portion of land held directly by the lord); they had also to payfines and taxes both in kind and money.

• Peasants were serfs (villeins) � serfdom entailed a personal bondage to the land and the landlord, constraining peasants’ freedom and mobility (no leave or marriage without permission)

• Serfdom is an inefficient contract in terms of productivity (lack of incentives). Why lords did not choose to rent land to peasants?

Manor houseVillage

Source:

W.Sheperd,

Historical

Atlas,

1923

26

• Serfdom emerged in the high Middle Age (after 1000 AD) to “capture” scarce labor as lords could not lease land to peasants when therewas fertile and abundant free land in the frontier, where, however, security was lacking

• So serfdom can be viewed as a contractual relationship : peasantsprovided labor services in return for protection and justice

Insecurity and risk in a non-integrated world

provided labor services in return for protection and justice• In this closed system without labor and commodity markets, the Lords

and the peasants could short-cut insecure markets, live in peace(peasants) and obtain the product-mix they required (lords) � not as inefficient (statically)

• Serfdom was gradually replaced by land rent contracts whenincreased demographic density on land reduced the incomeopportunity of landless peasants --- and the emergence of labor markets (and of markets for other goods) eliminated the efficiencyadvantage of compulsory labor services

A second explanation: Smithian growth

• As already heard, if surplus of production can be exchanged on themarket, it is useful to specialize according to individual comparativeadvantage to assign ressources more efficiently

• Via this, we can actually have increase in incomes without muchtechnological advance (although remember the learning-by-doing idea technological advance (although remember the learning-by-doing idea by Persson)

• This exchange might happen at the level of a village (farmers, weavers, carpenters, smith, etc.), at the level of a country (rural regions and citiesproviding “overhead services” such as markets, financial institutions, etc.) and at an international level (different countries specializingrelatively in the production of different goods)

• However, the essential problems in a world with small surplus and thinmarkets are (a) transport is costly and insecure, (b) finding transactionpartners is difficult, (c) property rights might not be respected and difficultto ensure 28

Adam Smith and economic history• In the 16th to 18th Century domestic markets in the Netherlands

and in England were integrating into a “national economy”, largeparts of the population lived in and moved to cities likeAmsterdam and London

• Their international trade in all kinds of goods (first only veryvaluable ones, later also wood, wheat, etc.) was also increasingvaluable ones, later also wood, wheat, etc.) was also increasing

• This went together with institutional advances (fairs, banking, accounting, trading companies, VOC/EIC, etc.)

• Incomes were rising, although it is not clear if Smithian forcesactually led to sustained growth (in the Netherlands in the 18th Century income levels stagnate at a high level, in England theindustrial revolution happens, which might or might not have to do with division of labour)

• More on that next week!29

Summing up• Non-defined and insecure property rights and inefficient institutions are

a problem for economic growth, because they work against allincentives for individual action in favour of productivity growth

• The state can provide security of property rights and thereby increaseefficiency (lower transaction costs) and give incentives to innovation, but it needs to be controlled itself (North)but it needs to be controlled itself (North)

• But in the first place the state needs to be able to act in a uniform wayfor all regions and people he is ruling over (political integration, Epstein)

• Market integration also makes division of labour possible (Smith) and lowers the risks associated with specialization, but requiresinstitutitions and infrastructure

• In view of that preindustrial or premodern institutions (like the Manor) might be inefficient in welfare terms, but they might have served theneeds of the time (which made them efficient for contemporaries)

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Sources• North and Thomas, The Rise of the Western World, Cambridge UP, 1973, ch.

1+2. • Douglass C. North, Institutions, Institutional Change and Economic Performance,

Cambridge UP, 1990, cap. 1-11.• North and Barry Weingast, “Constitutions and Commitment”, Journal of Economic

History 49 (1989), pp. 803-832.• S.R. Epstein, Freedom and Growth. The Rise of States and Markets, 1300-1750, • S.R. Epstein, Freedom and Growth. The Rise of States and Markets, 1300-1750,

London 2000, chs. 1+2.• Karl-Gunnar Persson: An Economic History of Europe, Cambridge UP 2010, ch.

5.• Dan Bogart et al, “State and private institutions”; ch 3 in The Cambridge

Economic History of Modern Europe, Vol. 1, Cambridge 2010.• Daron Acemoglu, Introduction to Modern Economic Growth, Princeton University

Press, 2008, ch. 4.• Gregory Clark, A Farewell to Alms, chs. 8 and 9.• Presentations by professors Stefano Battilossi and Jordi Domènech

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Some background information

• Not used in class and for exam• Land use in the manor: why efficiency advances

were slow (peasants were risk-averse becauseof thin markets)of thin markets)

• Institutions for a market economy

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• No market for land, common land use• Open fields. Villeins received a number of land strips to cultivate for

their own use � hundreds of scattered small strips of land, privatelyheld, grouped into three great fields (wheat-barley-fallow rotation) around the village; communal management; common pasturing onwaste (grazing land) .

Land use in the Manor: Open fields

waste (grazing land) .• High inefficiency in terms of productivity and total output � time-

consuming; high transport costs; negative externalities (‘neighborhoodeffects’); over-exploitation of arable land for pasturing (“tragedy of thecommons”) ; lack of incentives for more intensive use of land �

squandered factors of production + low marginal labor productivity.• Puzzle: why did open fields survived so long (even after the abolition of

serfdom, until the ‘enclosures’ of the 1700s—aggregation of land stripsunified under capitalistic management and producing for urbanmarkets)?

• Were peasant villagers indifferent to improvements in efficiency?34

Field 1

Field 3

Fallow

Field 1

Wheat

RyeField 2

Oats

Barley +

Legumes

ManorVillage

Source:

W.Sheperd,

Historical

Atlas,

1923

35

• Explanation 1: “collective farm” .• Scattering equalised quantity and quality of land among

households; allowed villagers to form teams to maximize thedistribution of scarce resources—e.g. oxen (joint plowing) and labor (joint planting and harvesting)—thus increasing efficiency in theabsence of labor markets; minimized peer monitoring costs.

Explanations

absence of labor markets; minimized peer monitoring costs.• Objection: historical evidence?; in fact land and labor markets did

exist!• Explanation 2: risk aversion � “the prudent peasant”• Scattering was a strategy of self-insurance against risk.� A diversified portfolio of locations reduced the risk of crop failure

and stabilized the variation of income from year to year against therisk of natural or human disaster.

• In a very risky environment, peasants rationally opted in favour of maximizing safety, not productivity.

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Low average, low variability:scattered (open fields)

Reducing the probability of disaster by reducing va riabilityof income at a cost of reduced average income

frequency

High average, high variability:consolidated (enclosures)

incomeµCµS

average with consolidated landaverage with scattered strips

Source: McCloskey 1976

Disasterzone

37

• Open field disappeared when technological advances (selectionof weather-resistant seeds, drainage and water control) reducedrisk, more efficient insurance emerged (public storage, deepsupra-regional grain markets), and food demand by urbanpopulation required and gave incentives for higher agricultural

Enclosures and mixed husbandry

population required and gave incentives for higher agriculturalproductivity

• � ‘enclosures’ based on innovative, more efficient crop rotationsand “mixed husbandry”, that is growing rops and raising livestockin the same farm

• For the increase in animal husbandry there were also marketincentives from urban demand for animal proteins (dairyproducts), etc., and from woollen textile trade with Flandres and the Ottoman Empire)

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• In the Middle Age, risk represented a binding constraint on tradeopportunities (unreliable coinage, seizure of trade goods, frauds)

• Institutional innovation: trade fairs (periodic markets geographicallylocated and specialized by products)

• Origin?• Demand -side � Economic-functionalist interpretation: merchant networks

Institutions for a market economy

• Demand -side � Economic-functionalist interpretation: merchant networkscreated fairs to lower transaction costs, promote dissemination of information, improve contracts enforcement, in order to capture gains fromregional specialization and inter-regional trade in marketable commodities(clothes, livestock, high-quality foodstuff such as dairy, wine, oil)

• Or was it supply-side ? Political interpretation: with emerging territorial and national states, governments established fairs to assert their legal and fiscal prerogatives and to capture revenues from trade� the state granted towns to organize fairs and gave legal support tocommercial claims in tribunals, in return for taxes.

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• Long-distance trade under conditions of high informationasymmetries creates an agency (principal-agent) problem

• Italian “sedentary merchants” created transnational businessorganizations with branches in all major trading centres of Northern Europe and the Mediterranean basin.

Trading companies

� how could merchants or companies (the principals) be surethat the business decisions taken by their travelling orsedentary partners, ship captains or sale agents (the agents) were aligned with the principal’s, not their own interests?

• New techniques of monitoring : double-entry accounting• Appointment of relatives as agents � family (extended) as a

business unit based on trust.

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• In the age of mercantilism and global expansion of European business, similar agency problems were faced by monopolistic Trade Companies (eg. the East India Company)

• Trade Companies evolved as early cases of Multidivisional Multinational Corporations, based on shares (like the Dutch East

Trading companies (II)

Multinational Corporations, based on shares (like the Dutch East India Company VOC (1602) and the British East India Company EIC (1600) and many others) � functional separation betweenthe centre (advisory, auditing, strategic decisions such as planning, allocation of resources, control and evaluation) and decentralised operating divisions (with large autonomy in decision making and performance-based incentives, e.g. profit-sharing)

� reduction in transaction costs (information, monitoring) and agency-problem addressed . 41