Modes of Economic Governance

Princeton University, Princeton NJ

Investigators

Abstract

This research examines the sources of relative advantages and disadvantages of different systems of economic governance, and interactions among them. The focus is on questions such as: Which system will be better under what circumstances? When can different systems coexist, and when will one supplant the others? Will each society select the mode that is optimal for its circumstances? Will new systems be adopted when appropriate, or can groups remain locked into old modes even though these may be outdated or dysfunctional? The methodology of the research combines theoretical analysis, and testing this analysis against case studies that are available or emerging. In advanced western economies, economic contracts are enforced by an impartial and effective legal system. This enables strangers to deal with each other. In most other countries, and historically in all countries, such a legal system may be missing, or corrupt, or too slow. Other systems of governance then evolve. One alternative comprises social norms and sanctions. Small close-knit groups can use these effectively since they are well-informed about each other and in an ongoing relationship. This system is common among businesses in many East-Asian countries and among communities of traders linked by ethnic or similar ties. Other methods of unofficial governance include private profit-motivated third parties who collect and convey information about previous violations of contractual obligations; credit-rating agencies perform such functions even in advanced economies. Finally, they include private third parties who will enforce contracts by punishing any breaches; organized crime groups have played this role when the official state has broken down, for example in late 19th century Sicily, just after World War II in Japan, and just after the collapse of the communist regimes in the Soviet Union and Eastern Europe. These third-party alternatives have performed acceptably in some circumstances and have proved dysfunctional in others. Improving our conceptual understanding of the mechanisms of enforcement of economic contracts is of obvious basic importance in the theories of law and economics. The research also has practical uses. For example, U.S. firms trading with, or investing in, countries with different governance practices can better foresee any problems they are likely to face in getting their local partners and governments to keep promises, and can devise methods to protect themselves against breaches of contract. Multilateral organizations like the World Bank and IMF that advise less-developed countries on structural reforms can design their recommendations better if they understand the governance structures under which the reformed enterprises must operate; where necessary, they can recommend simultaneous reforms of the methods of governance in these countries.