Tuesday, April 28, 2009

Separation of powers and credible commitment

Douglass North and Niall Ferguson, among other historians, have observed the dramatic lowering of English government bond rates after the Glorious Revolution in 1688 (alternatively seen as a Dutch invasion aided and abetted by Parliamentary and City of London traitors to the House of Stuart, and a subsequent "political merger" of the former enemy nations, as Ferguson puts it). North and Ferguson have imputed these lower rates to the superiority of modern democracy which they see as having been given birth by that Revolution.

Aside from the very uncommon but verbose Jacobite, and aside from that sad majority of historians who are shallow parrots of yesterday's tabloid headlines and fail to see the importance of anything so abstract as government bond rates, there is general agreement by the remaining historians about the effect of the Revolution on the great lowering of England's bond rates. But, while the identification of the Glorious Revolution as a great improvement in the financial condition of the English government (and subsequent world dominance of the British Empire, spread of free trade, abolition of slavery, etc. -- as well as to modern evils such as historically unprecedented rates of deficit spending, taxation, and inflation) is accurate, the attribution by North and Ferguson of these lower rates to the supposed "democratic" nature of the Revolution is quite wrong.

A more accurate if rather vague view of the situation is given by Nicholas Gruen:

Be that as it may, one of the huge things that powered us into the modern world was the idea of subjecting monarchs to the rule of law - particularly in Holland and the UK (after the Glorious Revolution of 1688). Because debtors for the first time had an expectation of being repaid when the monarch borrowed money off them, bond rates went right down and the government could borrow money. ‘A free nation deep in debt’ I think was the contemporary expression as Britain and Holland’s stars rose.
We can be far more specific about how the Dutch Invasion of 1688 caused England's bond rates to decrease. There are rather three specific events, quite related to the rule of law but not at all related to voting of the masses (which was not a feature of England for more than a century following that Revolution), but far more pertinent to the English government's immediately subsequent ability to finance itself at low rates. The first was the Bank of England. Whatever the advantages or faults of central banking to the general economy, the Bank of England was the financial engine behind the Royal Navy's subsequent boast, factual until the 20th century, that "Britania Rules the Waves", and specifically its ability to enforce free trade and destroy slavery. The two other events are quite related. The second event was a now-obscure lawsuit against King William and Queen Mary resulting in a crucial legal opinion written by one of England's greatest Chief Justices, Lord Holt, in 1701. The third was a now-obscure provision of the 1701 Act of Settlement which reasserted the independence of Holt and the other English justices from both Crown and Parliament. The Bank of England is well known, but these latter two events are at least as important and deserve to be yanked from their obscurity and put into every History 101 lesson.

Justice Iredell gives a good description of The Banker's Case in the later U.S. case Chisholm v. Georgia. Briefly, in the case brought by banker creditors of the Crown in 1701 to collect in what was owed them under debts contracted by the Stuart kings, the House of Lords (the ultimate court of appeal), led by Lord Chief Justice Holt, held that that the Court of the Exchequer had the power to decide and remedy a case of debt brought against the Crown, and that their decision holding the debts valid and remedying them with payment from the Exchequer was proper. In this particular case, William had no power to renege, not only on debts incurred under his reign, but on the debts incurred by his Stuart predecessors Charles II and James II.

This would not have meant too much of the Crown had retained a unilateral ability to fire the justices of the Court of the Exchequer for deciding against the Crown. In the Act of Settlement Parliament determined that the Crown's justices held their posts for life "on good behavior": it would take a vote of the House of Commons, the House of Lords, and the concurrence of the Crown itself to impeach a justice.

The combination of The Banker's Case and judicial tenure for life created what economists call a credible commitment for the government to abide by its contracts. This is a comitment that neither a single person as sovereign operating under Ulpian's principle of Roman law that "the prince's will is law", nor a democratic legisulature acting under Rosseau's principle that "the general will" supposedly reflected in the enactments of this legislature are unreviewable law, can make. Such a sovereign can simply declare it to be the law that they need not abide by their contracts or by the property rights of their subjects. It is the separation of powers -- and especially an judiciary with power of final decision over contracts involving the government treasury that is as independent as possible of those tax collectors, borrowers, and repayers -- not democratic voting that makes the credible commitment of a government to repay its debts and otherwise honor its contracts possible.

Tuesday, April 14, 2009

Polynesians vs. Adam Smith

Adam Smith observed how even the most basic of products in 1776, at the dawn of the industrial revolution in Britain, depended, directly and indirectly, on the work of thousands of people:

Observe the accommodation of the most common artificer or day-laborer in a civilized and thriving country, and you will perceive that the number of people of whose industry a part, though but a small part, has been employed in procuring him this accommodation, exceeds all computation. The woollen coat, for example, which covers the day laborer, as coarse and rough as it may appear, is the produce of the joint labor of a great multitude of workmen. The shepherd, the sorter of the wool, the wool-comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production. How many merchants and carriers, besides, must have been employed in transporting the materials from some of those workmen to others who often live in a very distant part of the country! How much commerce and navigation in particular, how many shipbuilders, sailors, sailmakers, ropemakers, must have been employed in order to bring together the different drugs made use of by the dyer, which often come from the remotest corners of the world! What a variety of labor, too, is necessary in order to produce the tools of the meanest of those workmen! To say nothing of such complicated machines as the ship of the sailor, the mill of the fuller, or even the loom of the weaver, let us consider only what a variety of labor is requisite in order to form that very simple machine, the shears with which the shepherd clips the wool. The miner, the builder of the furnace for smelting the ore, the feller of the timber, the burner of the charcoal to be made use of in the smelting-house, the brickmaker, the bricklayer, the workmen who attend the furnace, the millwright, the forger, the smith, must all of them join their different arts in order to produce them. Were we to examine, in the same manner, all the different parts of his dress and household furniture, the coarse linen shirt which he wears nest his skin, the shoes which cover his feet, the bed which he lies on, and all the different parts which compose it, the kitchen grate at which be prepares his victuals, the coals which he makes use of for that purpose, dug from the bowels of the earth, and brought to him perhaps by a long sea and a long land carriage, all the other utensils of his kitchen, all the furniture of his table, the knives and forks, the earthen or pewter plates upon which he serves up and divides his victuals, the different hands employed in preparing his bread and his beer, the glass window which lets in the heat and the light, and keeps out the wind and the rain, with all the knowledge and art requisite for preparing that beautiful and happy invention, without which these northern parts of the world could scarce have afforded a very comfortable habitation, together with the tools of all the different workmen employed in producing those different conveniences; if we examine, I say, all these things, and consider what a variety of labor is employed about each of them, we shall be sensible that without the assistance and co-operation of many thousands, the very meanest person in a civilized country could not be provided [emphasis added], even according to what we may falsely imagine the easy and simple manner in which he is commonly accommodated.
Leonard Read used the pencil as an even more startling example of how a simple 20th century product depended on a vast global network of economic relations. The number of people required, directly and indirectly, to manufacture a high-technology device, such as a cellphone or laptop computer, is probably in the millions. Friedrich Hayek explained the fine-grained division of labor that makes modern technology and wealth possible as a division of knowledge in "The Use of Knowledge in Society":

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate "given" resources—if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data." It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know.
Yet there existed a culture, the pre-European Polynesians, which established self-sufficient economies sometimes not totalling more than a few hundred people on dozens of small islands int the Pacific. Due to the small number of people that made up a self-sufficient economy, they did it using technology and institutions radically different from the agricultural civilizations of the Eurasian continent where they had come from. The Polynesians did not work metal: metalworking (for example the mining, smelting, smithing, etc. required to extract and work iron) requires too much of a division of labor. They used only the materials readily available on a South Seas island: their houses, ovens, boats, weapons, etc. were all made out of plants, stones, and animal parts. Since they lived at a Malthusian equilibrium (which almost every culture lived under until northwest Europe in the 17th century started a long climb out of it), their standard of living was on average the same as the world average -- dirt poor by our standards. This was enough, however, to produce catamarans that could navigate the South Pacific long before Magellan and Cook.

Small island economies greatly increased the premium and resulting emphasis on trade between islands in Polynesia and Melanesia (the Melanesians were an earlier group of island settlers). When inter-island trade was feasible, large proportions of resources and attention went into it. The kula ring was a splendid example of a sophisticated trade institution that developed among some of the Melanesians.

What's more, the Polynesians could do something that we moderns cannot -- replicate their entire economy from one island to another by packing up their families, along with a variety of plants and a handful of animals, onto a handful of catamarans. Could we similarly replicate our entire modern global economy, or a set of tools that could produce an equivalent result, to, say, another planet on a handful of rockets? That was the ambition of K. Eric Drexler's nanotechnology: pack a rocket full of "assemblers": self-replicating robots that can make almost anything. In the mid-20th century, mathematician and computer scientist John Von Neumann sketched a theoretical model of a self-replicating machine -- a self-replicating pattern in the 2-dimensional world of "cellular automata" (where, among other simplifications, copy operations come for free). I have long been skeptical of the idea that physical self-replication can be done with a simple design:

While going from macroscopic industrial parts proposed by von Neumann, or the nucleic acids, amino acids and myriad of tertiary biochemicals in bacteria, to atomic-scale diamondoid parts reduces the search space, and thus complexity, but this also reduces the degrees of design freedom. It could be that the search space of diamondoid replicators is so small that there is no possible configuration of, say, 10 million carbon atoms can copy itself in practice, when we get down to the details of atomic placement in each operation. A particularly difficult task in atomic placement for one small segement of a Stewart platform (eg assembling the ratchet complex) may necessitate a blowup in the complexity of the platform itself or in the machinery that brings molecules to and places them for the platform. To be truly self-replicating we need to close all the loops in the graph of operations. Attempts to close the last 1% ("vitamins") might introduce even more open loops than we close. The minimum complexity might easily exceed the degrees of freedom in the search space, in which case a solution does not exist.
The seeming simplicity of the the small-island Polynesian economy, lacking a sophisticated division of production and distribution operations and thus lacking a highly complex division of knowledge, is in one sense an illusion. This simplicity was made possible by making intensive use of very high evolved plant life. The complexity of life is extremely high. The self-sufficiency of the pre-European Polynesian economy is only possible if agriculture can be productively accomplished with tools made by the farmer or his friends. There is no simple design of a pan-assembler or self-replicating device -- the simplest ones we know of, life, are of extremely high complexity, and it will be a long time before we create new versions of life, much less artificial self-replicating machinery, in a lab.

Partially self-replicating machines are, of course, quite possible. The actual direct and indirect labor required for these machines, like those required for laptops and cell phones, is in the millions of people, and for many of the same reasons -- these machines are based on sophisticated microchips and plastics, among other parts of complex origin. Even if we radically redesigned every tool and machine we have for our hypothetical self-sufficient extraterrestrial economy -- and such radical redesign would be utterly necessary -- it would still likely require hundreds of thousands of people and gigatonnes of machinery, at least, to have a wealthy yet self-sufficient economy beyond earth.

Take Smith's coat and Read's pencil, elaborate the required network still further for today's complex products, and multiply by many thousands of products -- that is what is required to fill the shelves of your hardware super-store (in the U.S., Home Depot and Lowe's). Do this again for your drugstore, your clothing store, etc. You'd have no such super-stores in our space colony. It would in many ways be quite poor by earth standards.

The Polynesians relied on the ready availability of high-evolved life that could readily be grown in the native environment (no complex artificial creations like Plexiglass domes or grow-lights needed), and yet were dirt-poor by our standards. Modern products generally require elaborate divisions of labor necessarily involving millions of people. Such an economy cannot be planned, as numerous attempts to do so demonstrated in the 20th century. A modern economy requires a decentralized information-transmitting mechanism such as a market to work. In sharp contrast to the Polynesian small-island economy, our global economy cannot be easily replicated. We have to make it work here, or nowhere.

Monday, April 06, 2009

Money and the efficiency of plunder

(Note to readers -- after several months of posting reruns, I am back to doing original posts until further notice).

Arnold Kling describes his militaristic theory of the origins of money, and kindly also quotes and refers readers to my theory (or set of theories, as I posit that shell proto-money played a crucial role in several different kinds of hunter-gatherer transactions). Here is the gist of Kling's theory:

Imagine that you're a warlord leading a band of soldiers. Your business model is that your soliders prey on farmers, taking plunder and tribute. To help motivate your soldiers, you promise them a share of the booty. When the band of warriors is small, the promises can be verbal and informal. However, in order to organize a large army, you need formal, written contracts. Lacking lawyers and xerox machines, you make little carvings on metal, hand them out to soldiers, and say, "After the battle, turn this in to the clerk and we'll give you a share of captured slaves and grain and stuff."

There may not be as much contrast between our theories as Kling suggests. We both seem to agree that the traditional economists' explanation of money emerging from a barter market that otherwise obeyed the principles of efficient modern markets is not historically sound (although I do believe it is theoretically and empirically sound as a theory of the way things can happen -- money-like intermediate commodities can and have been observed to emerge from barter markets). Where we may differ, and perhaps not by much, is on the role of coercion. I believe that both coercive and voluntary transactions (and transactions that partook of both components) were important, and that the voluntary transactions were not efficient market exchanges:

Voluntary spot trades are not the only kinds of transactions that benefit from lower transaction costs. This is the key to understanding the origin and evolution of money. Family heirlooms could be used as collateral to remove the credit risk from delayed exchanges. [As explained elswhere in the article, these were typically exchanges that involved very high transaction costs. I'd add in clarification now that the closest modern economic model of them would be bilateral monopoly, not spot exchange on an efficient market]. The ability of a victorious tribe to extract tribute from the vanquished was of great benefit to the victor . The victor's ability to collect tribute benefited from some of the same kinds of transaction cost techniques as did trade. So did the plaintiff in assessment of damages for offenses against custom or law [emphasis added], and kin groups arranging a marriage. Kin also benefited from timely and peaceful gifts of wealth by inheritance. The major human life events that modern cultures segregate from the world of trade benefited no less than trade, and sometimes more so, from techniques that lowered transaction costs. None of these techniques was more effective, important, or early than primitive money -- collectibles.
Warfare involved, among other things, killing, maiming, torture, kidnapping, rape, and the extortion of tribute in exchange for avoiding such fates. When two neighbor tribes were not at war, one was usually paying tribute to the other. Tribute could also serve to bind alliances, achieving economies of scale in warfare. Mostly, it was a form of exploitation more lucrative to the victor than further violence against the defeated.

Victory in war was sometimes followed by an immediate payment from the losers to the victims. Often this just took the form of looting by the enthusiastic victors, while the losers desperately hid their collectibles. More often, tribute was demanded on a regular basis. In this case, the triple coincidence could and sometimes was avoided by a sophisticated schedule of payments in kind that matched the losing tribe's ability to supply a good or service with the victor's demand for it. However, even with this solution primitive money could provide a better way -- a common medium of value that greatly simplified the terms of payment – very important in an era when terms of the treaty could not be recorded but had to be memorized. In some cases, as with the wampum as used in the Iriquois Confederacy, the collectibles doubled as a primitive mnemonic device that, while not verbatim, could be used as an aid to recall the terms of the treaty. For the winners, collectibles provided a way to collect tribute at closer to the Laffer optimum. For the losers, collectibles buried in caches provided a way to “under-report”, leading the victors to believe the losers were less wealthy and thus demand less than they might. Caches of collectibles also provided insurance against over-zealous tribute collectors. Much of the wealth in primitive societies escaped the notice of the missionaries and anthropologists due to its highly secretive nature. Only archeology can reveal the existence of this hidden wealth.

Hiding and other strategies presented a problem that tribute collectors share with modern tax collectors – how to estimate the amount of wealth they can extract. Value measurement is a thorny problem in many kinds of transactions, but never more so than in the antagonistic collection of tax or tribute. In making these very difficult and nonintuitive trade-offs, and then executing them in a series of queries, audits, and collection actions, tribute collectors efficiently optimized their revenue, even if the results seemed quite wasteful to the tribute payer.

Imagine a tribe collecting tribute from several neighbor tribes it previously defeated in war. It must estimate how much it can extract from each tribe. Bad estimates leave the wealth of some tribes understated, while forcing others to pay tribute based on estimates of wealth they don't actually have. The result: the tribes that are hurt tend to shrink. The tribes that benefit pay less tribute than could be extracted. In both cases, less revenue is generated for the victors than they might be able to get with better rules. This is an application of the Laffer curve to the fortunes of specific tribes. On this curve, applied to income taxes by the brilliant economist Arthur Laffer, as the tax rate increases, the amount of revenue increases, but at an increasingly slower rate than the tax rate, due to increased avoidance, evasion, and most of all disincentive to engage in the taxed activity. At a certain rate due to these reasons tax revenues are optimized. Hiking the tax rate beyond the Laffer optimum results in lower rather than higher revenues for the government.

We do seem to differ in that Kling's account is basically an account of the origins of coinage in the agricultural era, and mine is an account of the origins of shell proto-money in the hunter-gatherer era. As indicated above, I believe both coercion and voluntary transactions (and admixtures of same) played an important role in the hunter-gatherer era, and as a general matter that's also true of the agricultural era.

I have very little disagreement with Kling's account of the importance of coercion in the origin of coinage. Indeed, here's what I had to say about the origins of coinage:
Given what we have seen about the benefits of proto-money to tribute and tax collectors, as well as the critical nature of the value measurement problem in optimally coercing such payments, it is not surprising that tax collectors, specifically the kings of Lydia, were the first major issuers of coinage. The king, deriving his revenue from tax collection, had a strong incentive to measure to value of wealth held and exchanged by his subjects more accurately. That the exchange also benefited from cheaper measurement by traders of the medium of exchange, creating something closer to efficient markets, and allowing individuals to enter into the marketplace on a larger scale for the first time, was for the king a fortuitous side effect.
My account of coinage differs from Kling only in that I'm looking at the measurement problem that occurs when collecting the plunder; he is looking at the measurement problem that occurs when distributing the plunder out to the soldiers. Both are important. Indeed I have also discussed the latter before on this blog (I don't recall the origins of the idea -- I may have read it somewhere -- a bleg to my kind readers, if you know of a reference, please post it in the comments):

Markets will tend to standardize on whatever the dominant transactor, the party that controls the largest plurality of cash flow, standardizes on, and in most historical societies the dominant transactions were tax collection and the payment of those taxes to soldiers.
By "dominant" here I just mean constituting the plurality (the largest player), not the majority of the value of all transactions, whether coercive or voluntary or some admixture of same. Coinage made measuring the value of both plunder and the distribution of plunder more accurate: both were important in increasing the efficiency of plunder and giving rise to coinage. More efficient exchanges, resembling more spot exchanges than bilateral monopoliies, and thus a larger tax base, were a fortuitous consequence for the Lydian kings (and later for the Greeks who eventually conquered the relatively coinless Persians).

The issue of coercion is also deeply implicated in the origins of agriculture itself. After all, hunter-gatherers were expert botanists compared to the modern layman. They were perfectly well aware that one could plant seeds (and shoots, for asexual reproduction) and have them grow, and could have easily learned the basic techniques associated with early agriculture once they had experimented with this knowledge. Yet these expert botanists with brains the same size as ours existed for 100,000 years before the agricultural breakthrough occured. The problem was not one of farming technique, it was one of securing this capital investment from fellow tribe members and foreign tribes. Only once this problem in coercion and transaction costs was solved could agricultural society appear. More here and here.