As global capitalism goes through its greatest crisis in seven decades, a robust new debate on the role of the market versus the state has begun. Much of it focuses on perceived failures of markets, and the need to reassert state action through regulation of markets. Certainly, in an economic crisis, effective governnance is a crucial guarantor against total systemic meltdown. Market fundamentalists in the US seem to be having a difficult time accepting this fact. At the same time, I would argue that the right way to think of the long-run solution to the problem is to frame it in terms of redesigning and modernizing market institutions, not just regulating or constraining them.
The shortcoming of much of the market versus state debate is that it deals in abstractions rather than the institutions that underlie each concept. Going deeper, it is people and their relationships that underlie or precede the institutions, and relationships may be the starting point for thinking about market design. Relationships, and the trust embedded in and supported by them, allowed international trade to span continents centuries ago in the absence of government regulation and effective legal remedies. Avner Greif, an economic historian at Stanford, is famous for having argued that the Maghribi traders of the 12th century succeeded in international trade without relying on governments or formal legal systems. More recently, the concept of Guanxi, describing complex personalized networks of influence and social relationships, has been used to explain the success of China in international trade and investment early in its economic reform process and before developing anything like standard property rights and other legal protections for contracts.
Yet markets that rely on relationships and trust have limits; “trust but verify” might be a good rule instead. Greif also points out that the Genoese traders ultimately outdid the Maghribis, using more formal, legalistic institutions for governing transactions. Indeed, Jeremy Edwards and Sheilagh Ogilvie of the University of Cambridge re-examine the historical evidence and find that for their trading success, the Maghribis relied on legal backup more than Greif admits. Arguably, China is also struggling with the constraints placed by its lack of legal frameworks and property rights. Very recently, Sankar De and Manpreet Singh of the Indian School of Business have empirically tested the benefits of informal relationships among small and medium enterprises in India, and found that these benefits are weak or nonexistent. There is no getting away from the fact that complex market economies need formal legal institutions and governments to back them up: This point is well recognized. Less well understood is the importance of the market institutions themselves.
In many cases, market institutions are chiefly shaped by the underlying legal institutions. Retail stores must post prices clearly for customers, for example. In some cases, maximum and minimum prices may be legally mandated or enforceable. But in other cases, stores may go below posted prices if they choose. The products themselves must satisfy certain disclosure requirements, which can affect how buyers search and choose among sellers and products. In formal retail markets, relationships start to recede to second-order importance: personalized discounts or credit arrangements, extra service and so on.
Financial markets are the most challenging to organize and maintain. The products that are bought and sold are abstract, they are assets whose returns are uncertain, and the choices are almost limitless. The best functioning financial markets rely on strong explicit rules to improve information flows and transparency of trading, and the nature of price agreement and trading itself, thereby allowing market participants to trust the rules rather than just individuals or individual firms. Modern electronic stock exchanges are relatively anonymous, but transactions and intentions are well documented and disclosed.
The failures we have seen have been failures of the old relationship model of trading, rather than a failure of modern markets. Investors who follow a Bernard Madoff or an Allen Stanford based on reputation and trust, do so in a misunderstanding of well-functioning markets, which strips away easy advantage from individuals, no matter how clever (that cleverness being distorted towards fraud instead). The US investment banking industry had also persisted as a relic of a pre-modern era of relationships and secrecy, ultimately bilking the entire world with its pretence of knowing something special. They were all too good to be true in a competitive market economy. There was too much trust, not enough verification, unlike other financial markets where verification is continuous and pervasive.
Relationships can substitute for weak market institutions. They can also subvert market institutions, as in the Satyam case, where Ramalinga Raju used relationships with those who should have been monitoring and verifying to undermine those necessary functions. Relationships can also be important where markets cannot work well, or where market transactions would be deemed to be ethically or morally indefensible. But the failings of markets based on relationships cannot be used as a justification for condemning, constricting or shutting down those markets—instead, better market design is the correct prescription.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org