Our caveman proto-economy demonstrates how economic exchange can be a mutually beneficial alternative.  If one caveman is clearly stronger than the other, the stronger can simply rob the weaker, leaving the weaker to starve.  But if the two cavemen are fairly equally matched in strength, economic exchange is far less risky to both of them.  Concepts of property can be observed in the behaviors of many animals, which suggests that the development of social institutions is fundamentally motivated by formalization of property rights.

The conflicts of uncivilized societies are resolved by war.  The conflicts of civilized societies (nuclear weapons make a society "civilized" by inhibiting it from all-out war ) are played out in the international marketplace, with the winner decided by the size and efficiency of its economy.

Here we apply some principles of political economy to analyze the relationship between government structure and economic prosperity.  What form of government facilitates economic development best?  What principles should a government follow in maximizing the economic welfare of its people?  

The 20th century tested three models of government--democracy, communism and fascism--against one another, and democracy prospered best.  One hundred years ago parliamentary democracies were gradually relegating the monarchies of western Europe to merely ceremonial status.  The technological transformations of western society between 1800 and World War 1 were far more dramatic than the technological transformations of the 20th century since World War I, and triggered much greater social turmoil than anything we have seen recently.   Gilded Age capitalism thrived as these new technologies flourished, although many industries took on a distinctly monopolistic character.

The rapid technological advances of the west brought a number of far-reaching social changes.  The importance of religion faded as science challenged traditional Western concepts of God, and 19th century theism was unable to respond to the changing world view.  As the west prospered in its atheism, reducing most of the rest of the world to colonial status, the latent anxiety in western culture was manifested as a rise in intolerance for other cultures.  The 1880's saw pogroms against European Jews and undisguised contempt by westerners for Islam, Hinduism and other traditional cultures.  World War I was in large part a conflict between between western Christian, Orthodox and Islamic cultures.  (Samuel Huntington's recent book The Clash of Civilizations argues that global politics today can be understood as a similar tension between seven opposing cultures.)

These conflicts destabilized many societies.  The Bolsheviks overthrew the czarist governmetn in Russia and evolved a Leninist communism, centralized and totalitarian, that gave way to Stalinism, even more centralized and totalitarian.  Italy, Argentina, Germany and Japan drifted into fascism.  At mid-centrury, after two world wars spanning a global depression, the triumph of democracy was hardly a foregone conclusion.  In fact, the sudden expansion of communism following World War II and the rapid industrial transformation of the Soviet Union had many people believing in a "domino theory" in which the nations of the world would topple into communism like a line of dominoes.

By the 1980's, however, the chronic weakness of Soviet economy was increasingly apparent.  The Soviet grip on the satellite nations of central Europe weakened, the "Iron Curtain" vanished, the Soviet government finally acceded to reformist pressures, and the Soviet Union disbanded into separate nations again.

Planning and Growth

The "anecdotal evidence" of 20th century history would seem to indicate that democracy promotes economic growth best, since the economic performances of the centrally-planned economies were unable to match the economic performances of the United States, western Europe, post-war Japan and the Asian rim countries.

The organizational challenges of a centrally-planned economy are enormous: the planning agency must determine production quotas for all final goods and services to be produced in the economy, then calculate all the intermediate goods that will be required to produce those final goods and services, then calculate the intermediate goods needed to supply those intermediate goods, etc.  The production quotas must ultimately be translated into factor allocations: the economy will need 25,000 electrical engineers,120,000 thousand machinists, 90,000 teachers, 25 million tons of steel, 60 million tons of iron, 100 million tons of coal, etc., all to be rationed among thousands of production activities.  As technologies increase the interdependencies between  industries, the vulnerability of the economy to planning errors increases.  The planning problem becomes increasingly complicated, and planning errors result in production bottlenecks and shortages in some sectors, surpluses in other sectors.

The theoretical appeal of central planning is that it yields the socially optimal mix of goods and services.  The presumption is that the "invisible hand" of the free market does not.  Indeed, central planning advocates can point to substantial income disparities in western democracies as evidence of the wrongness of laissez-faire capitalism: the US economy produces luxury yachts while homeless people shiver in the cold.  That central planning largely failed to match the economic efficiency of free markets actually says little about the fairness of income distributions in market economies.

One of the most eloquent criticisms of state planning is provided by F.A. Hayek in his book The Road to Serfdom (1944).  Hayek notes that the advocates of central planning generally argue for its necessity rather than its desirability.  Hayek warns "that the unforeseen but inevitable consequences of socialist planning create a state of affairs in which, if the policy is to be pursued, totalitarian forces will get the upper hand."

Mancur Olson's Power and Prosperity

The late economist Mancur Olson of the University of Maryland was one of the preeminent political economists of the 20th century.  His  book Power and Prosperity (published posthumously in 2000) presents an interesting alternative model of the evolution of government, analyzes the failures of Stalinism, and explains the critical role of "market facilitating" institutions in promoting economic growth in a democratic society.

In Olson's view, governments evolved from "stationary banditry" rather than from a social contract among more or less equally endowed cavemen.  Early agrarian societies were preyed upon by roving bandits who competed for "turf" and eventually settled on particular host communities.  Once a bandit organization established its control over a particular area and excluded rival bandits, it's main concern would be to maximize its wealth extraction from the host community.  In other words, the community becomes a sort of investment vehicle for the bandit.  A short-sighted bandit would pillage freely, ruin the economic productivity of the community, and impoverish himself.  A smart bandit would extract some tribute, but leave enough wealth in the community to foster continuing economic growth from which he could extract more tribute next year.  The stationary bandit sees it is in his own best interests to protect his community from invasion by others, to establish and enforce laws protecting person and property rights, etc.  After a while the bandit dignifies himself with the title "king" and the extraction of tribute becomes ordinary taxation.

Being king is a really fun job, but you have to take care of your kingdom.  Kings who abuse their subjects and bleed their economies too heavily are natural targets for stronger kings backed by happier subjects and bigger, healthier economies.  Over time, the king comes to rely more and more on an administrative bureaucracy, and gradually shares power with this bureaucracy.  The king must then focus on keeping the bureaucracy efficient and maintaining political balance between the rival factions within the bureaucracy.  This is where democratic decision-making processes become useful.  A principle of majority rule actually suits the king's purposes by maintaining stability!  Olson argues that democracy provides the strongest long-term guarantees of individual property rights.  Observed capital flight from totalitarian economies to free-market democracies supports this hypothesis.

Olson analyzes Stalinism as a highly innovative mechanism for maximizing wealth extraction from a society.  Stalin imposed state control over all industries, imposed production quotas on all industries, and put everyone to work in these industries at very low real wages.  Stalin was thus able to extract all industry profits as profit for the state.  In fact, "Stalin was able to obtain a larger proportion of the national output for his own purposes than any other government in history was able to extract."  The low wage rates meant people could't afford much leisure: they had to work their regular day in the state factory, and then work in their own vegetable plots or after-hours businesses to help make ends meet.  Olson notes the structure of the implicit tax on labor under Stalin: a very high lump-sum tax, no marginal tax on extra hours worked or extra pay for bonus work.  The highly regressive taxation implicit in Stalin's system of bonuses, progressive piece rates, etc. is the reverse of US progressive tax rates.  By compressing wage scales for differential skill levels, Stalin's policies actually got more work out of more skilled workers.  These policies stimulated very high savings and investment rates as well.

Olson applies a sort of reverse-Marxian analysis to the fall of Stalinism.  The system had the seeds of its own destruction built into it: the central planning bureaucracy simply couldn't manage the complexity of economy as well as the parallel private sector economy.  The central planners simply could not know the details of every production process as well as the local managers of those processes, so the state industry system was gradually bogged down in petty corruption and covert collusion between mid-level bureaucrats.  The government initially tolerated some private sector markets, although these often traded in goods pilfered from state industries.  Eventually the state industries gradually came to depend on these private markets to help correct some factor imbalances and supply problems.  Here is where the Soviet Union and China diverged: Mao engineered a huge purge of corrupt bureaucrats in China's Cultural Revolution, thus restoring a degree of efficiency to his state industry system.  Stalin's successors failed to conduct such purges, and the Soviet state industry system gradually sank in its own petty corruption and inefficiency.  Russia's poor development prospects today derive from the obsolete skill sets and attitudes of workers trained in the old state industries, its obsolete factories and technologies, its primitive and unreliable capital markets, its cronyism, and its inability to guarantee adequate security for its citizens and their property,   The Russian government turned over control of its decrepit state industries to powerful special interests that are unwilling and uanble to face market competition.

Olson concludes with a general discussion of the necessary pre-conditions for economic growth: (1) secure, well-defined property rights; and (2) absence of economic predation.  He notes that markets are pervasive in all societies, but that some economies thrive while others languish in part due to luck, and in part due to differences in market-facilitating institutions that permit efficient accumulation of wealth.  Stable social institutions such as contract law, uniform commericial codes, standards of weights and measures, as well as reliable, efficient capital, stock and bond markets, including additional markets for derivatives such as futures contracts and options contracts--all of these institutions facilitate efficient capital accumulation, equilibrate resource allocations between activities and time periods, and stimulate long-term investment.  Poor economies that lack these are typically restricted to exchanges that are self-enforcing.
 
 

The Coase Theorem and Transactions Costs Suppose that for each ton of paper it produces, a paper mill discharges one ton of waste into a river rather than paying $100/ton to dispose of it in some environmentally benign way.  Suppose that a fish hatchery downstream loses $60 in fish for each ton of waste the paper mill emits.  What will happen?   The Cambridge economist A.C. Pigou proposed taxing the paper mill's effluent so that the damages caused to the trout hatchery ($60/ton of effluent) are internalized, which presumes the hatchery has an entitlement to a clean river.  In this way, the paper mill bears the full social cost of its activities.  The paper mill keeps on polluting, since it's cheaper to pay $60/ton tax rather than pay the $100/ton treatment cost.  The government collects the tax revenue, but doesn't necessarily compensate the hatchery.  The hatchery still suffers the harm and has an incentive to relocate to a less polluted river if this is more profitable. Ronald Coase's famous 1960 article "The Problem of Social Cost" (Journal of Law and Economics 3:1-44) takes a different view of this problem.  If the hatchery sues the paper mill for damages, the court will merely clarify the parties' property rights to the river: either the paper mill has the right to dump waste into the river, or the hatchery has the right to a clean river.  But the court's decision will not determine whether or not the paper mill will continue dumping its waste into the river!  This is for the hatchery and paper mill to negotiate between themselves. If the court finds for the paper mill, the mill continues dumping and the hatchery continues suffering damages of $60/ton.  The hatchery would be willing to offer the mill up to $60/ton not to pollute, but since the alternative treatment costs $100/ton, the paper mill would decline.  But if the court finds for the hatchery, the paper mill would be willing to offer the hatchery compensation up to $100/ton for putting up with its waste, and since this exceeds the hatchery's damage costs, the hatchery would accept any compensation over $60/ton and the paper mill would continue polluting as before.  So the amount of pollution the mill dumps in the river is determined by the relative costs of the parties, not by the court's decision.  The court's decision merely determines who pays who. Coase's "theorem" is summarized as "In the absence of transactions costs, the generator of an externality and the victim will negotiate to the same externality level regardless of how the peoperty rights are assigned." The stipulation regarding transactions costs is important.  In fact, in our example, negotiations may still proceed as long as the transactions costs are less than the $40/ton potential gain from negotiation.  More specifically, negotiations will proceed as long as each party's share of the transactions costs is less that his or her expected share of the $40/ton total gain from the negotiation.   We can immediately see some logical correlaries of this theory.  Since transactions costs prevent Pareto-improving bargaining, any technology, institution or market mechanism that reduces transactions costs must be Pareto-improving.  The Coase theorem ought to apply to politics as well: rational political bargaining betwen interest groups should result in socially efficient policies.  If transactions costs remain high, it may be appropriate to inquire why: is there some third party that benefits from keeping the two parties apart?

Olson sees the social contract itself as a Coaseian bargain.  The proper role of government is to minimize transactions costs in the economy by providing market-facilitating institutions.