North D. and Weingast B. (1989) The economic impact of institutions

North, Douglass C. and Barry Weingast (1989) “Constitution and Commitment: The Evolution of Institutional Governing Public Choice in Seventeenth-Century England”, The Journal of Economic History, 49/4: 803-832.

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Disclaimer: this summary is written by the contributors of the blog and not by the author of the article. Any mistake is Manuel’s fault (and he shall be punished).

“Put simply, successful long-run economic performance requires appropriate incentives not only for economic actors but for political actors as well. Because the state has a comparative advantage in coercion, what prevents it from using violence to extract all the surplus?”

Game theory

The key for a successful bargain (as the one broke between the various stakeholders in the case of a constitution) is ex post compliance. Worries about opportunism after the agreement is what prevent many contracts from being signed. So a bargain has to be self-enforcing to last; i.e. it has to preserve the incentive for each party to fulfill its share (p.806). However often useful, the reputation-based systems are too weak to be really effective. Any major issue may suddenly induce one of the parties to heavily discount the future and default (p.807).

“Our view also implies that the development of free markets must be accompanied by some credible restriction on the state’s ability to manipulate economic rules to [its] advantage” (p.808).

Background

As late as the 16th century, the king was expected to fund his government through the management of his estate. Only in case of war did he call the parliament to ask for the exceptional levy of taxes. Otherwise he was free of any monitoring. However, after the arrival of the Stuarts on the throne, spending increased so much that the sovereign started to deficits. He had to alienate the Crown lands to cover expenditure. But it was only a transitory and Pyrrhic measure (p.809).

Desperate for funds, the kings had to raise custom duties and imposed wealth owner to subscribe to the hated “forced loans” whose repayment took decades and interests were seldom paid. There were other indicators of the sovereign’s “readiness to alter the rights of private parties” without regard for his reputation nor economic consequences: the sale of monopolies (p.810), of peerages and the reliance on purveyance (p.811). Eventually, in 1640, the government seized the bullion merchants had stocked in the Tower.

As retaliation the Parliament repeatedly refused to vote extra funding for the king, thus forcing to rely more heavily on predatory expedients. The parliament “thereby exacerbated the problem they were attempting to eliminate” (p.812). Correspondingly the king strived to centralize all powers by rarely calling parliament, ruling via royal proclamations and trying to bypass the common law thanks to the Star Chamber (p.813).

And 1688 came

The Civil War finally broke out but Parliament simply eliminated all restrains upon his own power, so no self-enforcing equilibrium could be reached (p.814). The Restoration did little but repeat the dead end that had prevailed under the early Stuart and royal encroachment resumed. Finally, in 1688, the king was granted a sufficient income but under supervision of the Parliament. The key component of the famed Glorious Revolution is thus a somewhat unglamorous fiscal reform (p.815).

“The successful dethroning of Charles I and, later, James II […] established a credible threat […] regarding future irresponsible behaviour” (p.816). In effect this “increased dramatically the control of wealth holders over the government” (p.817). As a collegial body with divergent interest, Parliament was less likely to distort the market. Moreover, the King and the Lords had their say in the decision process thus diminishing the Commons’ ability act opportunistically. Finally as the representatives of the business community, the Whig majority had no intention of infringe upon the mercantile sphere (p.818). The courts were also important in limiting the king’s ability to renege and in securing property rights (p.819).

Fiscal Revolution

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Based on tab 3 p.822.

Before the 1672 “stop of the exchequer”, the Stuarts’ credit had been pretty sound and by that time they had accumulate a £1 million debt (p.820). After 1688, however the new fiscal agility of the government allowed it to borrow sums unseen before. This financial activity led the government to put forward numerous innovations, in particular the incorporation of the Bank of England, which quickly became a new check on the king’s spending in the hands of wealth owners. A safety fund was set up in case of the failure of a tax a loan was earmarked upon; thus further diminishing risk.

Investors were extremely eager to purchase the government’s bonds (p.821). Consequently the government’s debt increased fourfold in just nine years (1688-1697; p.822). By 1720, public debt relative to GNP had increased by a factor 50. This system virtually eliminated temporary tax hikes designed to fund wars. However, despite the increase governmental increase, interest rates collapsed from 14% in the 1690s to 3% in 1730 (p.823). These market responses directly reflected the change in expectation (p.824).

The market responds

The impact on the private sector was maybe even more positive. A market for private debt quickly developed in relation with the market for public securities. Those highly salable assets lubricated capital markets, helped private rates of interest to fall and made a larger range of projects economically feasible (p.825). Testimony of the economy’s good health, the number of private banks jumped from zero in 1688 to 70 in London alone in 1800 (p.826). Financial modernity allowed to increase the integration of the national capital market. The BoE – a direct consequence of 1688 – developed new means of payment and clearing: notes, discounted bills and drawing accounts (p.828).

One Response to North D. and Weingast B. (1989) The economic impact of institutions

  1. […] what has often been advanced (cf. North and Weingast), the government failed to honour his commitment in 1696-8.  The situation was made worse by the […]

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