Sunday, April 27, 2008

Is rule of law an esoteric concept?

A recent article in “The Economist” about economics and the rule of law (‘Briefing’, March 15, 2008) begins with a confession by a prominent economist that he does not know what rule of law really means and ends with an enigmatic pronouncement to the effect that the more economists find out about the rule of law the more desirable it seems and the more problematic the concept seems to become. The article makes rule of law seem like an esoteric concept.

The main problem that economists have in explaining the economic importance of rule of law seems to stem from the observation that some countries, most notably China, have high rates of economic growth without strong adherence to rule of law. Could this be explained in terms that everyone can understand?

In my view the best place to start thinking about the relevance of rule of law to economic growth is by considering the difference between the incentives facing roving bandits and stationary bandits. It seems to me that Mancur Olson’s crime metaphor is apt because, like governments, bandits use muscle (coercive power) to pursue their objectives (“Power and Prosperity”, 2000). Olson pointed out that a Mafia family with a continuing monopoly on crime in a particular neighbourhood can obtain greater revenue by selling protection than by committing robberies. By preventing others from robbing their ‘clients’ and leaving ‘clients’ with some incentive to earn more wealth, the ‘family’ can obtain the benefits of more revenue through a larger tax base.

This helps us explain the problem of failed states. In such countries competing war-lords tend to behave like roving bandits and bandits behave like roving war-lords. Whenever anyone tries to do something productive, someone else takes the wealth that they have created. Once a war-lord gains control of his territory, however, he then has an incentive to act like a stationary bandit by protecting his subjects from marauders and leaving them with an incentive to earn more wealth.

An autocrat might be motivated to some extent by a desire to improve the well-being of his subjects, but even if his motives are entirely selfish it can still be in his interests to enter into a mutually beneficial partnership with them. In exchange for taxes he may begin to use his power to give them the incentive to attempt to accumulate wealth, for example by recognising property rights and enforcing contracts. Even when this happens in a limited way it can still have potential to unleash a lot of economic growth in countries where people have previously had little incentive to accumulate wealth.

It should be recognised, however, that some autocrats behave more like roving bandits than stationary bandits even though their control of their territory is secure. This may occur for a variety of reasons. Some autocrats may have problems in converting their followers from a culture of pillage to one of fostering the growth of a tax base. They may have problems in determining the point on the Laffer curve where tax revenue is maximized. Most importantly, in my view, it could be rational for an autocrat to impose a tax rate higher than the revenue maximizing rate in order to keep his subjects in a state of poverty if he is concerned that they would depose him, or limit his power, if they were permitted to accumulate wealth and the power that goes with it.

Even when autocratic rulers unleash a lot of economic growth by providing their subjects with incentives for wealth accumulation, the institutional environment still falls a long way short of the rule of law. There is always the possibility that even the most benevolent autocratic rule can revert to predatory rule and become a threat to people and their property. Rights cannot be secure when they can be restricted at the whim of autocratic rulers. This means that under autocratic rule economic growth is inherently fragile.

The rule of law is not a mystery. It is the principle that no-one is above the law. Where rule of law exists, governments can be dismissed if they fail to act lawfully.

How does the transition from autocratic government to rule of law occur? Unless autocratic governments decide to surrender powers voluntarily, the transition is only possible if people acquire sufficient power to bargain with their rulers. Autocratic rulers may allow their subjects to acquire such power as a result of accidents of history. For example, autocratic rulers sometimes need to ask people for support against foreigners who threaten to depose them and that support may come with strings attached. Sometimes autocratic rulers lose the support of their armed forces. Foreign powers can also help the transition to occur, as in England in 1688, but only if there is a domestic political movement strong enough and enlightened enough to require future governments to act lawfully.

My conclusion is that it is not difficult to understand how some countries have been able to experience high rates of economic growth without adherence to rule of law. The difficult question is how long such economic growth can be sustained.

Since writing this I have been trying to remember a paper that provides a clear expanation of the rule of law. This paper  by Richard Epstein is the one I was trying to remember.

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