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October 19, 2016

Donald Trump and America's Incomplete Contract with Itself

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Last week's Economist has three articles that struck me by their connections. One of them looks at how US presidential candidate Donald Trump is undermining the unwritten rules of American democracy. Another deals with the business of outrage -- the money being made by political entrepreneurs selling racism and conspiracy theories. And a third examines the work of the 2016 Economics Nobel winners. That's where I'll start.

This year’s Economics Nobel was shared between Oliver Hart and Bengt Holmström. (At Warwick we’re proud of this because Hart has two Warwick degrees, an MSc from many years ago, and more recently an honorary degree.) It turns out that the field of research that Hart has pioneered can throw light on the disturbing state of American politics.

Hart’s central contribution has been the idea of an incomplete contract. A complete contract writes down how the parties are to share the gains and losses arising under all circumstances. When the possible contingencies are too many and too varied to foresee them all, the contract is incomplete. When unforeseeable contingencies arise, there are unexpected gains and losses, and these have to be allocated among the parties. Who should gain and who should lose? Re-reading the contract does not help. Instead, the parties have to take responsibility for renegotiating their partnership. Hart pointed out that the possible outcomes depends on the relative bargaining power of the parties. In turn, telative power depends on many things, including resources, information, customs, beliefs, values, and incentives.

In that setting, how do unwritten rules arise? When the parties bargain with each other in mutually predictable ways, it is because they are following unwritten rules. If the rules they follow are consistent and agreeable, the partnership underlying the contract can persist in a state of harmony. An everyday example of a partnership based on unwritten rules is marriage. The marriage contract is always incomplete. On marriage, you promise to love and cherish each other for better and for worse, in sickness and in health, till death you depart. But exactly how you should do that under all circumstances cannot be written down in advance. There will be many unexpected blessings and tragedies that must be shared or shouldererd. To deal with these situations, marriages that last generally evolve unwritten, even unspoken rules that the parties follow to maintain harmony.

Another example is democracy. It turns out that democracy too is an incomplete contract. That’s generally the case, even for a country like the United States that has an apparently robust written constitution. The constitution has the written rules. These state who can play the game of democracy, how to tell who has won and who has lost, and the limits on what the winner can do. But it does not dictate the spirit in which the players should play the game. Just as a bad but not technically unfaithful spouse can undermine a marriage by violating its unwritten rules, a bad politician can undermine democracy without breaking the letter of the law.

What are the unwritten rules of democracy? The written rules are clear enough. In a democracy, when society is divided, victory goes to the side that can muster a majority (or a plurality). In a democracy, victory is always temporary. The majority party governs for a term. These are the written rules, but they are only the start. They imply, but do not requre, the spirit in which the competing parties should play the game. The spirit of the game is that it is never played for keeps. The ruling party should not aim to limit the rights of the minority or entrench itself at their expense. Between elections, the minority must be free to oppose, to criticize, to try again to mobilize a majority and so win the next time. When this works, it has an interesting result, one on which we place too little value. This is that every election has low stakes. It is the opposite of winner-takes-all. The election decides who rules for a few years, not for a thousand years. The winners do not take all and the losers do not lose everything.

In the outcome, democracy is based on a conjuring trick of self-fulfiling expectations. When politicians and their followers expect an electoral contest to be low-stakes, they becoming willing to accept defeat. Because defeat is temporary, and not too costly, they do not try too hard to win, for example, using threats and bribes. And so they become willing to keep within the unwritten rules of democracy, and these in turn sustain the written rules -- the constitution.

You can see this clearly if you think for a moment about politics without democracy. Without democracy, the stakes are always terrifyingly high, because politics is deadly. We won? Be afraid. You lost? Go to jail, or go to hell. In contrast, democracy has this magic property that it makes politics polite: We won? During our brief term we will seek to govern for everyone. You lost? Thank you for the contest. The low stakes might be the single most important reason to prefer a democracy.

For democracy to work, most people have to subscribe to the unwritten rules. But developing those unwritten rules was historically a long and difficult process; embedding them in the societies of western Europe and north America took centuries. Although the rules took so long to create, they can be torn up relatively easily. Today the US constitution may look robust, but the shared beliefs underlying it are threatened. In the election campaigning, the threat is expressed in the high stakes that the parties attach to victory over defeat. Donald Trump has said that, if elected, he will seek the prosecution and imprisonment of the loser. If not elected, he will not accept the result or postpone his hopes until the next election. Rather, he will reject the outcome, claiming that it is “rigged,” leaving his angry followers to take the law into their own hands.

Now it goes without saying that corrupt politicians should go to jail, and ballot-rigging should be exposed, especially in a democracy. But it undermines the unwritten rules when a candidate for executive office campaigns as prosecutor, judge, and jury. In turn, to allege corruption and ballot-rigging, whether for electoral advantage or to make money, breaks the same unwritten rules. It does this by raising the stakes. The stakes can hardly be higher when one of the campaigns threatens to take all in the case of victory, or to take up arms in the case of defeat.

American politics is becoming high-stakes in a way that has not been the case since the Civil War. The atmosphere is eating away at the incomplete contract of American democracy. Free speech, even lying speech, is a core value of democracy, meaning that no law can make politicians tell the truth, or protect voters from their lies. There is no solution other than the self-restraint of politicians and the good sense of the electorate.

But this is no time for European self-congratulation, for the same has been happening across Europe. In the best outcome, it will take many years for the West to recover.

October 13, 2009

The 2009 Economics Nobels versus Big Government

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Elinor Ostrom and Oliver Williamson have just shared the 2009 Nobel prize for economics. Unsurprisingly, the first ever award to a woman is attracting much of the media interest. Many journalists are likely to find that an easier topic than the content of their contribution.

Anyway, we'll focus on what Paul Krugman would call the wonkish stuff. What do these two share? According to the prize committee, it is their contribution to "the economic organization of cooperation."

What does that mean? On the BBC news website BBC economics editor Stephanie Flanders is quoted as saying that the judges had rewarded work in areas of economics whose practitioners' "hands were clean" of involvement in the global financial crisis. This is true, sort of. As far as I can see, neither Ostrom nor Williamson have contributed anything to recent asset price bubbles, correlated risk taking by banks, or the psychology of "It's different this time."

But it's more interesting than this. In a year when big government is all the rage, the prize committee has chosen to honour two scholars whose work cautions against big government solutions to economic problems.

I've never read anything by Ostrom; in fact, I'd never heard of her before yesterday. I feel bad about that, but I would feel worse if much more knowledgeable people like Paul Krugman (last year's Nobel laureate) and Steven Levitt (of Freakonomics fame) did not also admit to never having read her work. In order to say anything about it, I am relying partly on the Nobel citation, partly on a short interview she gave to BBC Radio 4 News last night.

Anyway, this is what I have picked up. Ostrom works on the management of common property such as land, water, and fish stocks. Economics 101 tells us that private exploitation will destroy the commons in the absence of government regulation. Ostrom's research is reported to show that there are alternatives in between private exploitation and government regulation. User communities often come up with cooperative management solutions that are less costly or more efficient than either, on their own initiative. It sounds like I should find out more.

In contrast to Ostrom's, I know of Williamson's work. I use it in my research papers, and also in my teaching. In fact, I'll be telling my final year undergraduate students about it next Monday in a lecture on the topic of "Government Failure." (The course is called The Making of Economic Policy, and I give two introductory lectures, one on how markets fail and one on how governments fail.) Williamson comes into the lecture because of his work on what he calls "the impossibility of selective intervention."

The starting point is to imagine the best of all possible worlds. We live in a market economy, and sometimes markets fail. Williamson's work shows, for example, that the very existence of firms is a response to markets not doing everything well. For some purposes it's cheaper to organize exchange within an integrated organization than through markets. Firms are these integrated organizations.

Can an integrated organization fix everything that markets can't fix? The key here is that government intervention is conceptually similar to just having bigger and bigger firms. In fact, twentieth century socialists often thought of the socialist economy as "one big firm." When markets fail, I suppose we'd all like to think the government could step in selectively, just when required and only then, and fix the failure. Then, we could always have the best of everything: market allocation, unless it fails; if the market fails, intervene to correct or replace it. That's selective intervention. Over the last century social democrats and democratic socialists have put forward many different ideas about what exactly needs fixing, but all would have agreed, I think, that selective intervention is the key. Williamson's work suggests, however, that this best of all worlds is out of reach.

Of course, Williamson is a scholar, not an ideologue, so he doesn't reach this conclusion directly. In The Economic Institutions of Capitalism (1985), for example, he asks a related question: what are the true limits on firm size? (Or, why don't we run the economy like one big firm?) He argues that replacing the market with an integrated organization always has unanticipated costs. The market, for example, provides high-powered rewards for success and penalties for failure. Intervention always impairs these incentives. We can define the benefits of intervention in advance, but not the costs. If politicians are allowed to intervention selectively, some interventions will inevitably make things worse.

Why? There are several reasons. One is the cost of good intentions: "Decision makers," Williamson writes, "project a capacity to manage complexity that is repeatedly refuted by events." Another reason is the propensity to micro-manage: Intervention always involves the exercise of power, including the power to divert resources to private goals. A third reason is the effect of "forgiveness" on effort: If a firm is losing out to market competition, there is no appeal against the verdict of customers. Managers and workers know this, so they make inordinate efforts to avoid losses. In a politicized environment, in contrast, sharing and horse-trading are much more important, so loss makers can buy political insurance against failure, or forgiveness. As a result, efforts to avoid failure are less. Finally, loss making activities are more likely to go on making losses. That's because politicization creates scope for lasting alliances based on reciprocity; loss making activities can win subsidies from profits made elsewhere and are not closed down. So, losses persist. 

In short, Ostrom and Williamson point in the same direction. Ostrom is saying that big government may be less necessary than we think. Williamson is saying that, even when necessary, the results of big government will always disappoint.

This is not the same as to say that politicians should never act. If there are always unanticipated costs, there may still be benefits, and the benefits may still outweigh the total costs -- both expected and unexpected. An example is the big-government bail-outs that saved the world economy over the past year. We will be paying the bill for a long time, and the bill will be bigger than anyone thought. The fact is, it had to be done and was worth doing.

The message of the 2009 economics Nobels is not to make a virtue out of what was done from necessity. The return of big government is not a cause for celebration.

I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).

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