Does Contract Enforcement Require Government as a Backstop?
By David Henderson
Recently, Arnold Kling has been arguing that even when contract enforcement is totally private, it requires government as a backstop. He wrote:
Taking existing institutions as an existence proof for the feasibility of an-cap is not a valid argument. The fact is that eBay exists in a world with government. People who use eBay probably assume in the background that if a situation comes up where they think that they are getting shafted they can take the other party, or eBay itself, to a government court. That court will resolve the dispute, and everyone understands going in what that process will consist of.
His view is plausible a priori and, indeed, it used to be my view.
That is, until I read and reviewed Edward Peter Stringham’s new book, Private Governance: Creating Order in Social and Economic Life. My review is published in the Jan/Feb 2016 issue of The American Conservative and, unfortunately, does not appear to be available on line.
Why did Stringham’s work change my mind? Here’s the relevant passage from my review:
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’t have been 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.