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Do Markets Need Government?

“The person who says it can’t be done should not interrupt the person doing it.” This saying, which I often read for inspiration, could well summarize Private Governance, the inspired book by Edward Peter Stringham. Many economists, and others, have argued that government is needed to enforce contracts and settle disputes. They say that the market—private actors—can’t do that. Stringham would say that these skeptics should not get in the way of private actors who are doing just that: enforcing contracts and protecting people from predators.

Stringham, who holds a chair in the economics department of Trinity College in Hartford, Connecticut, shows how well private governance has worked in areas ranging from stock markets to gated communities to credit-card markets. He argues that private governance often works better than governance by governments. Along the way, he gently challenges some of his economist heroes, including James Buchanan—who taught him in the Ph.D. program at George Mason University—Ludwig von Mises, and Friedrich Hayek. I find his case persuasive. (Disclosure: Stringham is a friend whose work I have studied and learned from since about 2003, when he was a young assistant professor at San Jose State University.)

Stringham contrasts private governance with legal centralism, which, he writes, is “the idea that order in the world depends on and is attributable to government law.” The belief in legal centralism, he shows, has been widespread, even among free-market economists. He highlights, for example, the thinking of the recently deceased Nobel Prize winner Douglass North, who maintained that cooperation among market participants without external enforcement by a government can occur only in very limited settings. Stringham points out that North and others that he challenges have simply claimed a priori, based on their view of humans and their application of game theory, that external government enforcement is necessary. But why settle for a priori reasoning? He suggests that “rather than using game theory to debate whether cooperation is or is not possible in relatively large advanced markets without enforcement, a more fruitful approach is to study actual markets to see how they work.” And that is what he proceeds to do.

One of the markets he examines is the world’s first stock market, the Amsterdam Bourse, which began early in the 17th century. A problem that any stock exchange must deal with is enforcement of contracts. Imagine, for example, that someone sells a stock short but, contrary to his expectations the stock price rises, and he must satisfy his contract by buying the shares come settlement time. What if the short seller balks and doesn’t stick to his agreement? This did not happen often, writes Stringham, because traders had to worry about their reputations.

But couldn’t those who were cheated by short sellers have gone to the government to make the short sellers keep their word? They could not, and the reason is simple. Stringham points out that short selling was illegal and therefore going to the government was futile. If anything, those who had wanted to renege on their short-selling contracts could have gone to the government to get it to support their reneging. But Stringham quotes an analyst of the time pointing out that this didn’t happen much. People were expected to keep their commitments and largely did.

This is strong evidence against the claim that complex market transactions between strangers need some form of external government enforcement. One might think that the participants behaved well because they knew that lurking in the background was a government with enforcement powers. But that couldn’thavebeen the case for short sales because short sales were illegal: market participants would have known that they couldn’t rely on government because they were engaging in illegal activity.

Consider, by contrast, the performance of the Securities and Exchange Commission. A case in point is Bernie Madoff’s infamous Ponzi scheme. Stringham notes that the SEC conducted eight investigations—eight!—of Madoff, yet failed to follow incriminating evidence that, according to New York Times reporter David Stout, was “in plain sight.” Yet as far back as 1999, a private analyst named Harry Markopolos concluded, after studying the issue for five minutes, that Madoff’s stated strategy for guaranteeing high steady returns “could not exist.” Writes Stringham: “Within four hours he demonstrated this mathematically.” Markopolos sent a report to the SEC in 2000 that stated, “the entire fund is nothing more than a Ponzi scheme.” The SEC did nothing. Madoff was finally caught in 2008, and it wasn’t the SEC that caught him. Rather, the Ponzi scheme had the problem that all Ponzi schemes eventually face—running out of money—and Madoff, realizing that he couldn’t continue, confessed.

Interestingly, even the SEC’s own inspector general claimed that the SEC is incompetent. In a report on the SEC’s disgraceful performance in failing to catch Madoff, the IG wrote: “Because of the Enforcement staff’s inexperience and lack of understanding of equity and options trading, they did not appreciate that Madoff was unable to provide a logical explanation for his incredibly high returns.”

The SEC, like other government agencies, is in Stringham’s view a deus ex machina, a “god from the machine.” Stringham explains that the deus ex machina plot device “is named for Greek plays that used gods played by actors suspended on cranes to suddenly solve characters’ problems.” In many social science and policy debates, he writes, “theorists think of potential problems and assume government can solve them.” Those who advocate government enforcement rarely explain why they think that governments will have the incentives or the information to do their job well. In my view, this deus ex machina problem is the unjoined debate in economics. 

How about police? Surely they couldn’t be provided privately, could they? Stringham shows that in San Francisco in the middle of the 19th century they were provided privately. Gangs were terrorizing people and, up until 1850,  government police were absent. Rather than wait for government to solve their problems, San Franciscans took matters into their own hands and created a system of private policing. The city government started hiring police in 1850, but Stringham quotes observers at the time noting that the government police were both expensive and dishonest—police officers themselves engaged in theft. In 1851 and 1856, prominent businessmen formed vigilance committees that rounded up many criminals, private and public, and banished them from San Francisco. The result: San Francisco became a much safer place to live.

One of the most interesting parts of the book is Stringham’s discussion of individual self-governance. If we restrain ourselves from bad behavior, then, argues Stringham, external constraints on our behavior, government or private, are not as important as they would be if we were all characters in Lord of the Flies. So, do we restrain ourselves? Stringham discusses interesting research showing that we do. One experiment with MIT students, for example, found that students who did not act honestly in a baseline experiment acted honestly “after being asked to list the Ten Commandments.” Stringham writes: “The first lesson (which everybody already knows) is to start with a distrust of anyone from Cambridge. But the second and more interesting lesson is that thinking about morality matters.”

Parenthetically, let me say that the first sentence in the above quote is evidence of Stringham’s droll sense of humor, which pops up again and again in the book.  For example, in that same chapter, Stringham asks, “Would you murder an innocent person if you could get away with it?” He adds, “I sincerely hope that most readers answered no. If you answered yes, please unfriend me on Facebook.”

Stringham points to research showing that “certain parts of the brain light up when subjects cooperate with people but not when they interact with computers.” In short, many of us get psychic gains from cooperating.

How far can private governance go? Stringham discusses this in one of his most interesting and profound chapters, titled “Applying Hayek’s Insights about Discovery and Spontaneous Order to Governance.” Stringham lays out the tension in the late Friedrich Hayek’s work between Hayek’s theory of markets and his theory of law and legislation. Whereas Hayek understood that markets develop organically and are not imposed by central planners, he had a different view of law. In Hayek’s early writing on law—The Road to Serfdom in 1944 and The Constitution of Liberty in 1960—he took as given that law is centrally planned. But Stringham traces the evolution in Hayek’s thought from that view to one more consistent with his thinking on markets—a view that law is not invented but discovered.

Stringham points out that Hayek was not completely consistent. While he thought that law did develop organically, Hayek wanted a legislature that would intervene to, in Stringham’s words, “remove the bad precedent and prospectively set the legal system onto a new and better track.” Stringham convincingly lays out the problems with that solution. Legislators, and even judges, do not have good feedback mechanisms that will lead to better law. Stringham argues that what is needed is competing legal systems—competing systems of governance.

In his final chapter, titled “The Unseen Beauty that Underpins Markets,” Stringham ends with a ringing panegyric to private governance. That ending is a suitable way to end this review. Stringham writes: “Private governance makes markets work. Private governance replaces threats of coercion with numerous noncoercive mechanisms that expand the scope of trade, and it should be seen as one of the most successful peace projects in the history of the world.”

David R. Henderson is a research fellow with the Hoover Institution and professor of economics in the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, Calif. He blogs at www.econlog.econlib.org.

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