Economic reasoning

Want to End Poverty? Legalize Freedom

THE AMERICAN’s editor-in-chief Nick Schulz recently sat down with Robert D. Cooter, a law professor at the University of California, Berkeley, and one of the leading lights in the academic field of law and economics. Professor Cooter is the co-author of an important new book, Solomon’s Knot: How Law Can End the Poverty of Nations, an excerpt of which follows the interview below.

Nick Schulz: Your book offers a framework for thinking about how it is that some nations are rich, some are poor, and others are in between. You stress the importance of changes in laws and legal structure as the catalyst for growth. Why are legal institutions so important?

Robert Cooter: Ineffective law inhibits growth by forcing too much dealing with relatives. Effective law gives unrelated people enough trust to launch innovative business ventures. The law of property, contracts, and business organizations is most fundamental for business dealings among strangers. State authorities cannot create these laws merely by declaring them. Instead, the law must evolve into institutions that keep hands off venture profits.

NS: You discuss something called “the double trust dilemma of development.” What is it and why is it so crucial to understanding economic growth?

RC: Combining new ideas and capital causes sustained growth. This is true of technical innovations in Silicon Valley, and it is true for adaptations of technology and organizations in developing countries. To develop an innovation, the innovator must trust the financier with his idea and the financier must trust the innovator with her capital. When the double trust dilemma is solved, an innovator and financier can launch a business venture. “Solomon’s Knot” joins two rings on a ship securely, like a business venture joins a new idea and capital.

NS: What role does culture play in enabling or prohibiting necessary legal reforms?

RC: Innovative business ventures are the proximate cause of sustained growth. To launch an innovative business venture in Canada or Sri Lanka, the innovator and financier must solve the double trust dilemma. Furthermore, the legal reforms that facilitate business ventures are most likely to occur when everyone believes correctly that they will share in the gains.

Such economic reasoning invokes universal principles, not cultural differences. Japanese and Californian innovators face universal problems, even though the Japanese industrialist has a different relationship with his main bank than a Silicon Valley entrepreneur has with venture capitalists. Our book is like economics textbooks that easily cross international boundaries by omitting cultural particularities.

NS: You write: “Redistribution often increases growth and it should be pursued, especially redistribution that increases the education and health of workers and poor people. Redistribution that slows growth should be abandoned.” How can we determine if and in what ways redistribution slows growth?

RC: People launch risky ventures to pursue wealth. Redistribution that reduces the profitability of innovating causes fewer ventures to launch. Excessive redistribution stifled growth in China during the Cultural Revolution.

However, developing new ideas presupposes having them. New ideas with economic value come mostly from people who are educated and healthy. Unhealthy, uneducated sheep herders are unlikely to drive innovation and growth. The state and nonprofit organizations should fund education and healthcare, especially for poorer people, by collecting taxes and soliciting gifts from relatively rich people.

NS: You have an interesting discussion in the book about how to think about inequality. You argue that it’s useful to think about inequality the way we think about the role played by patents in an economy. Explain.

RC: Monopoly mostly benefits the monopolist and harms everyone else. Patents are an exception. The social justification of patents is that temporary monopoly for innovators causes more innovation, and more innovation benefits everyone. Similarly, the social justification for permitting innovators to keep much of what they make is that it causes more innovation that benefits everyone. In a well-organized economy, the richest people are the most successful innovators and the wealth of innovators is socially justifiable for the same reason as patents for inventions.

NS: You conclude by saying that we need to “legalize freedom.” What exactly do you mean?

RC: Freedom is the presence of good law, not the absence of all law. Innovative business ventures need effective laws of property, contracts, and business organizations. Legalizing business freedom allows innovation to carry us on an unpredictable journey to a richer world.

Excerpt from Solomon’s Knot: How Law Can End the Poverty of Nations:

The Double Trust Dilemma of Development

Economies grow when business ventures develop innovations, which requires combining new ideas and capital. Combining them confronts a dilemma illustrated by this letter sent to a Boston investment bank: “I know how your bank can make $10 million. If you give me $1 million, I will tell you.” The bank does not want to pay for information without first determining its worth, and the innovator fears to disclose information to the bank without first getting paid. The obstacle to financ- ing innovation is that an investor cannot evaluate an idea until after he knows what it is, and after its disclosure he has little reason to pay for it. To give another example, a Berkeley mathematician named Richard Niles invented bibliographic software called endNote that many profes- sors use on their computers. In the early stage of development, he hoped and feared receiving a call from Microsoft. Microsoft would ask for an explanation of endNote. Once Microsoft understood endNote, it might buy the company and make him rich, or it might develop its own version of his program and bankrupt him. Niles eventually got a call from Micro- soft, which he answered with trembling, but Microsoft was merely trying to sell him its office software. Niles did get his reward later when a large publisher, Thompson, bought endNote.

To develop an innovation, the innovator must trust the investor not to steal his idea, and the investor must trust the innovator not to steal his capital. This is the double trust dilemma of innovation—a new name for an underdeveloped idea that draws from a rich economics literature.

Distrust obstructs innovation regardless of whether it involves a new market such as insurance in Swaziland, a new organization such as an assembly line in Sichuan, or a new technology such as a faster computer chip in Silicon Valley. Like courting lovers, an innovator and an investor approach each other warily because the stakes are high.

The double trust dilemma has some workable solutions for binding the two parties together, as depicted by Solomon’s knot. To secure peace in the past between two rival kings, each one gave a valuable hostage to the other. Thus in the fifth century, King Geiserich of the Vandals gave his son as hostage to King Theoderich of the Visigoths, who reciprocated by giving his daughter as hostage. Hostage exchange works best when each side values cooperation more than its hostage. For example, King Geiserich presumably valued getting his own son back alive more than he valued killing the daughter of King Theoderich, and vice versa for King Theoderich.

Establishing trust between parties in a modern business transaction sometimes resembles exchanging hostages. When a buyer in Argentina contracts to purchase machine tools from a seller in Germany, the buyer fears that the seller will keep the money without delivering the machines, and the seller fears that the buyer will keep the machines without paying the money. Contract law and banking institutions offer a solution to this problem: the buyer deposits the purchase price at an international bank (“letter of credit”), and the bank releases the money to the seller on presentation of documents proving that the seller delivered the goods to the designated place. The system works because the Argentine buyer values the machine tools more than their purchase price, the German seller values the purchase price more than the machine tools, and each one can get what he wants only by doing what the contract says.

Like the exchange of hostages between King Theoderich and King Geiserich, or international trade between the German seller and the Argentine buyer, developing an innovation involves reciprocal risks between innovator and financier. In effect, the financier’s money and the innovator’s ideas are a double bond to guarantee their cooperation. The double bond is effective as long as each side believes that collaborating to develop the innovation is more profitable than any alternative use of the secrets and the money. This is true regardless of whether the innovation concerns a new market, organization, or technology.

Three stages in an innovation’s life cycle illustrate three ways that the innovator and financier can establish trust. First, someone has a new idea and obtains capital to develop it. The innovator may form a new firm or work inside an established firm. In the first stage, only a few people in the innovator’s inner circle understand the innovation. At this point, the innovation’s economic value has not been established. The innovator often has to persuade the investor of its value. Second, the innovator develops the innovation sufficiently to prove its value in the market. When the innovation succeeds economically, the innovator’s organization enjoys exceptional profits, and it expands faster than its competitors. Third, competitors observe the innovator’s success and try to learn what the innovator knows. As competitors emulate the innovator, the innovator’s profits fall and its growth slows. (Economic evolution emulates the most fit through profit detection, whereas biological evolution eliminates the least fit through natural selection.)
The three stages in an innovation’s life cycle correspond to three phases of finance in Silicon Valley. Each stage secures trust between innovator and financier in a different way. According to a popular quip, initial funding for start-up firms comes from “the 3 Fs”: family, friends, and fools. Family and friends have confidence in the innovator, not the innovation. This confidence inspires family and friends to invest without understanding the innovation’s market value. The first stage is relational finance—investment motivated by personal relationships. In addition, a few fools may invest who think that they can evaluate an innovation with- out understanding it.

Most innovators have too few personal relationships with wealthy people to finance an innovation’s full development, so they must eventually turn to strangers. The second stage of funding comes from “venture capitalists” who are not family, friends, or fools. Unlike relational finance, venture capital is a form of private finance. Finance is private because it comes from a small group of investors with expertise in evaluating undeveloped innovations.

The creative people who found a company often manage it badly. When the founders prove to be bad managers, the venture capitalists must replace them with good managers. In these circumstances, the venture capitalists seize the firm to increase its profitability. Alternatively, where the founders prove to be competent managers, venture capitalists may seize the firm to avoid sharing profits with the founders. Venture capitalists sometimes want to remove good managers who have large claims to the firm’s future profits. Founders and venture capitalists have good reasons for distrusting each other. The initials “v.c.” stand for “venture capitalists” and also “vulture capitalists.”

Conversely, Silicon Valley innovators sometimes expropriate the investments of their financiers. Thus John P. Rogers convinced some prominent California investors to give him $340 million for a high-tech start-up named Pay By Touch that would “transform how America pays its bills” by using “biometric authentication technology” (e.g., finger- prints). In 2008 the company went bankrupt, and investors contend in lawsuits that Rogers burned through $8 million per month without producing anything of value.

Innovators and venture capitalists use various legal devices to overcome their mutual distrust. The founders often commit to performance goals in exchange for financing from venture capitalists. If the founders fail to meet the stated goals, they lose their investment and their jobs. Specifically, the venture capitalists hold preferred shares of stock and the founders hold common shares. The financing contract may say that preferred shareholders can demand repayment of their investment after three years. Such a contract reassures the venture capitalists that the founders will do their utmost to perform as promised. The contract also reassures the founders that the venture capitalists will keep the firm’s secrets.

Corporate governance provides another device to solve the double trust problem in Silicon Valley. The firm’s bylaws may stipulate that common shareholders (founders) and preferred shareholders (venture capitalists) appoint an equal number of directors to the company’s board, plus an independent director accepted by both sides. If the founders and venture capitalists disagree, the independent director holds the decisive vote. Thus the independent director will decide whether or not the venture capitalists can replace the founders with new management.

In the third stage, a successful start-up sells itself to the public. The start-up may sell directly to the public through an initial public offering of its stock, or it may sell indirectly when a publicly traded company acquires it. In order to sell stock to the public in the United States, a firm must comply with disclosure rules of the Securities Exchange Commission. Brokers disseminate the firm’s disclosed information to potential investors. Many people understand the innovation sufficiently to decide whether or not to invest in its further development. Because investors in stock markets are a large group of people, we describe the third stage as public finance.

When finance becomes public, the innovator has fewer secrets and less scope to appropriate the investor’s money, so the double trust dilemma ameliorates. As the double trust dilemma disappears, public finance approaches the economist’s ideal of a “competitive equilibrium.” In a competitive equilibrium, no one has valuable private information and everyone earns the same profit rate (“ordinary rate of return”). Like pure contentment, a perfectly competitive equilibrium is approached and never quite reached.

Each stage of finance—relational, private, public—requires different bodies of law to solve the double trust dilemma. Any business venture requires the protection of the firm’s property from predators. Without effective property protection, people fear the theft of their wealth, so they hoard instead of investing. Resources flow from makers of wealth to its protectors. Hoodlums, mafias, cheating accountants, Ponzi artists, conniving state regulators, and thieving politicians steal wealth. Families, clans, and gangs can protect property, but an effective state is much more reliable. State protection of property is the legal foundation for investment in the future.

All forms of business ventures require protection of the firm’s property from outside predators, but relational finance can get by without much more legal support from the state. When law makes their property secure against outsiders, the firm’s members can work together by relying on relationships, not formal contracts. In the first stage, many new firms rely heavily on personal relationships for finance. Effective property protection and strong relationships make participants in a start-up firm believe that they will enjoy future rewards from current investments of money and time.

As development proceeds, the start-up firm enters its second stage where further development requires finance by strangers, not relatives or close friends. Relationships among strangers are too thin for informal mechanisms to carry the burden of enforcing promises. To cooperate in high-stakes ventures, strangers need formal contracts with effective enforcement. As with property rights, the state can enforce contracts much more reliably than clans or gangs. In the second stage, the business venture relies mostly on formal contracts with state enforcement. Enforceable contracts enable investors to retain substantial control over how firms use their money. Contract law underpins markets for loans, bonds, and direct foreign investment.

Some firms in all countries, and all firms in some countries, never go beyond private finance. (We say more about this in our book.) In Silicon Valley, however, many firms go to the third stage, in which the business venture raises capital from public markets. The business venture may raise money directly by selling its own stock to the public (“initial public offering”), or the company may proceed indirectly by selling itself to a larger firm that sells stock and bonds to the public (“acquisition by a public company”).

Members of the general public who buy stocks or bonds have no control over how the firm uses their money. Instead, their money comes under the control of the firm’s managers and board of directors. These insiders have many opportunities to appropriate outsiders’ investments. For example, insiders use accounting tricks to convert profits into sala- ries, thus depriving stockholders of their dividends. If public investors don’t like the firm’s policies, their recourse is to sell their securities (“exit”). Protecting outsiders from insiders in public companies requires more than securing property and enforcing contracts. For public finance, the additional protection comes from the law of securities, corporations, and bankruptcy, which we call “business law.”

In sum, establishing trust between innovators and investors requires law, especially the law of property, contracts, and business organizations.

Relational finance requires property protection, private finance requires contract enforcement, and public finance requires business law to protect outside investors, as depicted above. The progression requires more intensive use of law. The law’s effectiveness determines the firm’s ability to expand from relational to private to public finance. (Figure 3.1 is a useful simplification, although it does not show how bodies of law complement each other, which we discuss in our book.)

Biologists sometimes say, “ontogeny recapitulates phylogeny,” which means that the development of a single organism from birth to maturity somehow resembles the evolution of the entire species. Similarly, the three stages of finance for a start-up in Silicon Valley resemble three stages of historical evolution in capital markets for countries. The industrial revolution in England, which was the world’s first, went through these stages. In the early 18th century, inventors mostly relied on their personal assets and loans from family and friends (relational finance). As industrialization proceeded, loans from wealthy investors and banks became available more readily to new industries. Finance of industrial companies by sales of stocks and bonds to the general public came later. Public financing of industrial companies originally concerned infrastructure like canals, docks, and railways, where private business and the state intertwine. As the law became more reliable, public finance spread to manufacturing firms. Figure 3.2 depicts the evolution of finance in these three stages.

Today, the poorest countries have weak capital markets, so businessmen mostly borrow from family and friends. Starting from a condition of lawlessness, imposition of secure property rights can cause a spurt of growth based mostly on relational finance, as in China’s new industries after the 1980s. Some peoples, notably the Chinese and the Jews, have family networks that extend business relationships beyond the usual boundaries. However, the conditions of trust among relatives do not reach the scale of modern businesses. Relational finance keeps business small and local. No modern country became wealthy by relying exclusively on relational finance.

To increase the scale of business, an economy must augment relational finance with private finance, especially bank loans. In countries where banks dominate, an elite of wealthy insiders often lend to business ventures based on private information. Thus bank finance in some developing countries performs a similar role to venture finance in Silicon Valley.

As countries become affluent, they increasingly augment private finance with public finance, which means selling stocks and bonds to the general public. Stocks and bonds compete with banks and wealthy individuals to finance economic growth.

The expansion of finance supplements earlier forms without replacing them. All three forms of finance—relational, private, and public— remain important in the richest countries. The extent of public finance varies significantly among countries, including rich countries. Japan and northern Italy have achieved affluence mostly through relational and private finance, with relatively little public finance, whereas the United States and Great Britain rely mostly on public finance for mature industries. Germany appears to be shifting from the former to the latter.

Expanding the basis of finance requires effective law that controls behavior, not aspirational law that expresses lofty ideals. What makes a law effective? Not just writing it down. Written law in a poor country often resembles written law in a rich country. Property and contract law- on-the-books in India and Nigeria resemble English common law, and property and contract law-on-the-books in Peru resemble the Spanish civil code. Writing down a law, however, does not make it effective. The written laws are less effective in India, Nigeria, and Peru than in England or Spain.

A law’s effectiveness comes from society and the state. Many laws are obligations backed by sanctions. These obligations are as effective as the sanctions that support them. When potential injurers foresee a legal sanction, they usually obey the law. The sanction can come from society, as when people threaten to shun their relatives or damage reputations, or it can come from the state, as when one person threatens to sue the other for breach of contract.

Are social sanctions sufficient to make laws effective without state enforcement? Instead of speculating about the “state of nature” from his room in London, Bronislaw Malinowski traveled to the Trobriand islands in 1914 and observed how people resolve their disputes. He found that when one person harmed another, Trobriand islanders used social pressure to force the injurer’s family to compensate the victim’s family. Facts like these persuaded anthropologists that law is much older than the state.

As in the Trobriand Islands in 1914, social sanctions remain important in modern societies. Social sanctions are flexible and cheap, so the victims of wrongdoing in business rely on them first. When a businessman breaches a contract, for example, the victim may stop trading with the injurer (refusal to deal), break promises owed to the injurer (retaliatory breach), sully the injurer’s reputation (reputational sanctions), and ask others not to deal with the injurer (boycott).

Non-state organizations can improve the efficiency of social sanctions. Thus, most uncut diamonds are traded without written contracts in a small number of exchanges in cities like Manhattan and Antwerp. The diamond exchanges have merchant courts to resolve disputes without relying on state sanctions. Banishment from the exchange, which ruins a diamond dealer’s livelihood, is the ultimate punishment. By making information easier to obtain, the internet has increased the effectiveness of reputational sanctions, especially by posting buyers’ evaluations of sellers’ goods. Reputational sanctions on the internet are so efficient that strangers buy antiques online without examining them. The Internet suggests that, instead of decreasing over time, people may rely more on social sanctions in the future.

The effectiveness of social sanctions depends on the stakes. Social sanctions suffice to prevent wrongdoing in repeated transactions with low stakes, but not in one-time transactions with high stakes. For big deals, social sanctions are insufficient to secure trust, except within tight families. In big deals, people need the state behind contracts, much like diplomats need an army behind foreign policy. When buying a car or selling a house, ordinarily moral people can be ruthless, and professional car dealers and real estate agents are notoriously sleazy. Business ventures often resemble buying a house—a big deal with high stakes. Without judges or bureaucrats to threaten wrongdoers, many business ventures never launch.

The victim of a broken contract may file a civil complaint against the injurer and threaten to sue for compensatory damages. Like the head lion’s roar, a credible threat of litigation usually resolves conflict. To be credible, the plaintiff must stand to gain more in damages from the court than his costs of litigating. Keeping litigation costs down thus increases the credibility of threats to litigate. When courts resolve routine business disputes efficiently, the parties usually settle out of court on terms favoring the party who would win in court. In contrast, inefficient or corrupt courts decrease the credibility of threats to sue and prevent the party who should win in court from extracting a favorable settlement out of court.

Besides social and court sanctions, civil servants in the state bureaucracy apply administrative sanctions, such as revoking permits, applying regulations, investigating violations, or imposing fines. Autocratic states especially rely on administrative sanctions to protect citizens. Thus the state bureaucracy in contemporary China, and the Communist Party that stands behind it, protect the sources of economic growth by guaranteeing most property rights and enforcing many contracts. Imagine a land dispute involving an industrial enterprise in Guangzhou that wants to expand by taking land from a farm. To mediate the dispute, the parties first appeal to powerful private persons. If private mediation fails, they might turn next to a local official in the city government. If one of them rejects the local official’s decision, the next appeal might go to a Communist Party official in Beijing. Many observers believe that the threat of social and state sanctions in such a chain of events deters much wrongdoing. Protection of property rights and enforcement of contracts in China is much better than in the past. However, most observers believe that China’s bureaucracy performs these tasks far worse than courts in its richer neighbors like Japan or Singapore.

In developed and developing countries, new business ventures begin with secrecy, risk, and high profit expectations, and all three decrease as the venture matures. Sea routes from Europe to Asia were eventually mapped and secured, trade between them became commonplace, and middle-class Europeans could buy spices. In Silicon Valley, competitors work around patents and ferret out secrets, thus converting today’s technological breakthroughs into tomorrow’s commodities. However, an innovative economy never settles into a permanent condition without secrecy, risk, or extraordinary profits. Combining new ideas with capital is the immediate cause of economic innovation,
not remote causes like demography, geography, education, factor mobilization, health, culture, religion, world prices, interest rates, inflation, regulations, and tariffs. Uniting ideas and capital in a business venture requires the law of property, contracts, and business. To prosper where law is weak, businesses must deal through relationships and self-enforcing private contracts. When laws, courts, and state bureaucracies improve, finance expands from relational to private, and from private to public, so more ideas combine with more capital to grow the economy faster.

Robert D. Cooter is a law professor at the University of California, Berkeley.