The Third Pillar: How Markets and the State are Leaving Communities Behind

… AND MERCANTILISM

The alliance of town and Crown was not without other vulnerabilities. Foreign producers could compete with domestic ones and push prices down. Monarchs, however, had a very short-term view of economic might, perhaps influenced by the multiple reign-ending military threats they faced. They essentially believed that economic prowess depended on what was produced in the country in the short run, and thus sought to discourage imports and encourage exports – a practice which was called mercantilism. It was thought this would create more domestic jobs and income, exactly the argument that today’s populist politicians put forward. A collateral benefit would be that as a country sold more abroad than it imported, it would accumulate gold and silver, allowing it to reduce its dependence on foreign loans. So over and above the domestic restraints on competition, nations imposed tariffs on imports, and encouraged exports by offering subsidies. Not only did all this subject domestic consumers to yet higher prices, it gave domestic producers yet another layer of protection from the need to compete and innovate. Indeed, that was the purpose of mercantilism – to favour domestic producers over consumers.

Mercantilism, as we have seen with the recent export-led growth of Asian economies, can be helpful in the initial stage of a country’s growth, provided other countries do not join in. If, however, other countries practise a tit-for-tat mercantilism, it impoverishes everyone. Moreover, as economic philosopher David Hume argued, if a country did prove successful in exporting more than it imported through mercantilist policies, the resulting inflow of gold and silver would eventually raise domestic wages, rendering its producers uncompetitive.22 Furthermore, mercantilism, appealing as it was to producer interests in the short run, created distortions over the long run. It led to inefficient production methods and investment in the wrong industries. It raised prices of goods domestically, and hurt consumers who consequently had to consume less. It prevented the imports of capital equipment that could help make industry more competitive (in some industries, then as now, countries also forbade the export of capital equipment or knowhow or even travel by expert workers for fear of giving up their competitive edge). Finally, it made producers yet more dependent on the sovereign for protection, preventing them from emerging as an independent power.

Clever monarchs repeatedly emphasised national identity as an alternative to religious, regional, feudal, or community loyalties. This made mercantilism easier for the public to swallow. Nationalism helped justify higher prices, for they were the cost of keeping jobs at home, thus making the nation stronger. For example, the preamble to the Book of Rates in 1610 (which set trade tariffs in England) appealed to this sentiment, stating that importing unfinished raw materials from other countries was better for ‘the people of our kingdom might thereby be set on work’. Other finished goods imports were frivolous and not ‘for the necessary use of our subjects or any ways for enriching our kingdom’. If it was desirable to prefer ‘our own people to strangers’, it was better to set tariffs on such imports ‘than that the people of our own kingdom should not be set on work or the country impoverished by the importation of unprofitable or unnecessary merchandises’.23 There is probably no pithier statement of mercantilist nationalism – import less, consume less, produce more!

Nationalism attempted to bring the country together under one monarch. The advantage, then as now, is that it provided a potent force to motivate citizens to support a national programme, usually war, as the power of religion to motivate waned. It also allowed the monarch to break down internal barriers – instead of town-based guilds with small local markets, the monarch encouraged nationwide guilds. The disadvantage, then as now, is that it could be misused to persuade people to support unnecessary wars or policies like mercantilism that served narrow interests, and were against the collective good.

Fortunately for England, it was hard to suppress competition and the market indefinitely. As with the feudal manor, market forces started eroding some of these cozy restrictive arrangements.24 Skilled craftsmen who were unwilling to put up with the guild’s anticompetitive rules moved to suburban and rural areas, outside the guild’s reach.25 Adam Smith wrote, ‘If you would have your work tolerably executed, it must be done in the suburbs where the workmen, having no exclusive privileges, have nothing but their character to depend upon, and you must then smuggle it into the town as well as you can.’26

Competition from foreign producers was also a constraint on how restrictive local guilds or monopoly companies could be. In countries with long coastlines close to major towns such as England or the Netherlands, ships could bring goods quickly in bulk. If there was a sufficient gap between foreign and domestic prices, either because the guild set prices high or because it produced too little given unexpected demand, imports would flood in. The guild could collude with the mercantilist government to impose high tariffs, but with governments having limited resources with which to police borders, smuggling went on all the time to thwart such intent.27 Most entities therefore had to be somewhat competitive, and could not become overly dependent on the state for protection and profits. Along with its independent gentry, therefore, England had a number of independent merchants and craft-masters, even amidst the monarchy-sanctioned monopolies.

In the next section, we will see how the monarchy became constitutionally limited and more able to borrow directly from citizens, but once it achieved this, it had no real need to continue to privilege certain businesses, especially as it also built out a reliable revenue service to collect its taxes. Conversely, with the government more predictable and solvent, business did not need the extra protection of organisations like guilds or merchant companies. Guilds became largely toothless in the two most constitutionally limited and market-oriented European states, England and Holland, by the end of the seventeenth century. They morphed into brotherhoods and friendship societies, characterised by annual dinners full of pomp and show and plenty of alcohol, but with little actual business.28

SUSTAINABLE FINANCING FOR THE STATE

Let us return to the problem of state revenues. Ideally, the state’s freedom to act would be limited to legitimate actions, not arbitrary or despotic ones, but it should have the capability to act firmly and quickly to deal with the nation’s domestic or external problems when needed. Herein lay the catch. If the king had a powerful standing army and a professional revenue service that collected substantial taxes, that is he had the capability to act, he also typically obtained the freedom to commit any act – hence the absolute monarchy of Louis XIV in France, for example. An alternative was to have a king with very modest government capability, for example one with a small army and no revenue service, as in England under the Stuarts. However, even though the weak monarchy’s capabilities were constrained by the need to raise money to fund any new action, it had not given up its freedom to act. As a result, it tussled constantly with Parliament. England needed firm prespecified boundaries on what the monarch could do so that he could be freed to roam within them.

The gentry and the increasingly independent merchants and moneylenders were a potential bulwark against the king, a force that could place these boundaries. The king had to unite the forces against him, though, for them to have enough influence. This the Stuarts unwittingly managed to do.

The Stuarts’ Errors

The Stuarts’ need for funds led them to antagonise the propertied, both landowners as well as businessmen. James I started selling knighthoods, a practice continued by his son, Charles I. When the going rate for a title declined because so many were sold, they sold higher titles and even peerages. Not only was the old aristocracy aggrieved because their status had been diluted as they were joined by the newly wealthy, even the latter were angry because the titles they had paid so much for were devalued through overissue. Businessmen were angry because customs duties were raised frequently without notice or Parliamentary approval, and when no other sources of revenue could be found, loans were extracted forcibly from the wealthy, offering little prospect of repayment. There were other irritations, but having united powerful elements of the landed interests and rich businessmen against them, was it any surprise that the English Civil War between the Royalist supporters of the Stuarts and the Parliamentarians ended in the victory of the latter and the beheading of Charles I in 1649? Parliament and the forces it represented, when provoked, was stronger than the king.

The Stuarts got another chance. After the death of the parliamentary leader, Oliver Cromwell, the Stuarts were restored to the throne. However, what Talleyrand said of the Bourbons was true of the Stuarts too: ‘They had learned nothing and forgotten nothing.’ The Stuarts tried to weaken Parliament once again. Matters came to a head during the reign of James II, who was suspected of having Catholic sympathies. Catholicism was associated with an absolute despotic monarchy, as exemplified by Louis XIV. 29 With the economy buoyant and customs revenues pouring in, James did not need Parliament to vote on new taxes to fund his small standing army. He increased Parliament’s sense of alarm by recruiting Catholic officers into the army, and expanding it.30 Parliament was further weakened because the king could dissolve it at his whim, and he did so repeatedly until he got one that was cooperative.

In his attempt to restore the dominance of the monarchy, as well as possibly Catholicism, James went too far and united the opposition. When James’s Catholic wife gave birth to a son who would be a Catholic successor to the throne, both the party of the landed interests, the Conservatives, and the party of the moneyed commercial interests, the Whigs, invited William of Orange and his wife Mary to take the throne of England, setting off what would be termed the Glorious Revolution of 1688.

The Declaration of Rights

James fled England. Given a second chance to restrain the monarchy with a shorter leash, Parliament was determined not to err again. An elected Convention, which later became the new Parliament, presented to William and Mary a Declaration of Rights, which listed the legal rights of the subjects that James had violated, and that the monarchy now was expected to uphold. The supremacy of Parliament over the king was established de jure, and the sovereign was now the ‘king in Parliament’, not the king alone.31 The monarch could no longer call or disband Parliament at whim, the monarchy’s independent sources of revenue were curtailed, and all taxes had to be approved by Parliament, which could monitor spending and veto it if necessary. Similarly, the monarch’s ability to override courts was substantially weakened, and judges were made independent by taking away the king’s power to remove them. They were liable to removal only through conviction or by vote of both Houses of Parliament.

By curtailing the arbitrary powers of the sovereign, Parliament essentially allowed the monarch to become more trustworthy. He could be permitted to acquire more capabilities without raising concerns that he would convert them into unfettered power over citizens. For instance, the government built a dedicated reliable service to collect excise taxes. Between 1690 and 1782, the number of full-time government employees in this function rose from 1211 to 4908, an over-fourfold increase.32 Similarly, standing military forces, especially the navy, were augmented substantially. England became a leading European power.

Of particular importance, the government’s access to borrowing, especially long-term funds, increased. This did not happen overnight, and England had its share of luck in its early borrowing years as we will see, but the government’s ability to raise financing cheaply, quickly, and easily from its increasingly wealthy citizens became key to England’s subsequent military prowess. For instance, because of its better ability to finance goods purchases for its ships by issuing naval bills, the English fleet could stay on the seas for a period of six months without returning to shore. This was far more than the few weeks that were possible when its finances were weaker.33 The fleet was now more effective, for instance in enforcing economic blockades of enemies. Money had indeed become the sinews of power.

Constraints and Capabilities

The Glorious Revolution changed nothing for England overnight. Indeed, the initial loans that were available to the new government were still short-term, and the first attempt at issuing long-term debt in 1693 ended in abject failure, raising just over one tenth of the desired amount.34 Subsequent attempts were more successful but the greatest share of early borrowing was not from the public but from government debt issued to an entirely more traditional source, three monopoly joint-stock companies, the East India Company, the Bank of England, and the South Sea Company.

The Revolution’s effects did manifest themselves over time. The Crown’s borrowing was no longer on the personal account of the monarch, but was the responsibility of a permanent sovereign entity, the state. Future governments would continue to bear responsibility for repayment so debt could be issued for a longer term and repayment smoothed out. With improved and more professional dedicated tax administration, tax revenues were more predictable. So debt could be assigned specific streams of revenues. Lenders had more confidence in such ‘funded’ debt for they knew that the tax revenues that were earmarked could not be diverted elsewhere without the Parliament’s notice.

These ‘tripwires’ were backed by an elaborate mechanism of monitoring. Many of those with savings to invest, as well as the stockholders in the three joint-stock companies, came from the landowning or business class, with a presence or influence in Parliament. So investors in government debt, through Parliamentary reports and committees, had information about government finances, and could vote to curtail or repurpose government spending if it impaired the chances of them recovering their investments. Property rights were protected by political power.

Government debt became traded in the market over time, so investors who might need money quickly could still invest in long-term government debt and sell it in the market if they had a need for funds – their loans were now liquid. Also, if they became worried about government finances, they were not locked in, and other, more optimistic, or more influential (over government) investors could buy. The availability of a liquid resale market for long-term government paper thus increased demand for it, and broke the need for investors to be tied for the long term to the government.

Even the three monopoly companies were not inconsequential in the development of the government debt market. The East India Company built a colonial empire in the East that was an important contributor to England’s fortunes. The Bank of England, with its monopoly over banking services, could issue stock easily, and the proceeds were invested in long-term government debt. It also proved reliable in funding the government’s short-term needs, which enhanced the public’s perception that the government would not run short of funds. Greater surety about the availability of funds to the government enhanced the public’s confidence that long-term government debt would be a safe investment. Over time, the Bank of England lost its banking monopoly, but it became England’s central bank and retained a monopoly over money creation.

And finally, the South Sea Company, which was granted the dubious monopoly of trading with the South Seas (where there was little trade), helped in putting government finances on a sustainable track in a very fortuitous way.35 The initial issuances of government debt after the Glorious Revolution were in the form of very high interest annuities that could not be redeemed by the government. The South Sea Company offered a deal to the government: it would buy the annuities from current holders and turn them over to the government in return for lower-interest government paper (and monopoly privileges). It offered its annuity holders the choice of its own stock or cash in exchange. In the meantime, both the government and company directors talked up the prospects of the South Sea Company into a full-blown stock bubble. Drawn into the frenzy, annuity holders converted to company stock at inflated prices expecting it to go up further still. Fully 85 per cent of the government’s high-interest debt was converted into low-interest debt. The erstwhile comfortable annuity holders were devastated when the stock price crashed. England’s government finances benefited, stabilized in its early years by the South Sea Bubble.

More generally, all these developments meant that the high-cost short-term borrowing or bills that the government issued to fund emergencies like wars could be converted to lower-cost long-term borrowing once the war was over. Repayment would then be stretched out to smooth the burden on the taxpayer. The government’s increased capacity to borrow during those emergencies meant there was little likelihood it would invoke the spectre of national emergency to expropriate money from the wealthy through extortionate taxes or forced loans. For wealthy landowners and businessmen, healthy government finances meant greater predictability about continued moderate taxation. This gave them the confidence to make larger fixed investments in canals, roads, and eventually railroads that paved England’s path to wealth, and indeed the Industrial Revolution.

Sounder government finances also meant the government no longer had to do special deals with a few favoured individuals or companies to raise money. It could set itself more at arm’s length, more bureaucratic in the sense of working according to a set of transparent rules, and thus create a level playing field for all its citizens. This also meant the possibility of a less-constrained, freer, and more arm’s-length market. And the drumbeat for that, as we will see in the next chapter, started increasing.

What Did the Glorious Revolution Do?

As economic historians Douglass North and Barry Weingast argue, the Glorious Revolution tethered the monarchy more effectively through Parliamentary and judicial oversight so that its freedom to go in inappropriate directions was more limited.36 What was not spelled out in any detail is what would happen if the tether was cut – for example, if some monarch turned his standing army against Parliament in violation of the unwritten constitution. This is where the previous history was relevant. Parliament had demonstrated through the Civil War, and by deposing James II in the Glorious Revolution, its ability to come together to defend its rights. Its power to have its way when provoked is what gave teeth to the Declaration of Rights and subsequent reforms.37

This point sometimes gets lost in the debate about the role of institutions in development. There is a strong correlation between the existence of ‘good’ institutions in a country and its economic growth and prosperity, so much so that one of the more influential recent papers on the subject is titled triumphantly, ‘Institutions Rule’.38 While institutions matter, they rest on a bedrock of an underlying distribution of power among the constituencies in a country, which may have its sources largely elsewhere. For instance, the independent power of the gentry came from their commercial aptitude, their wealth, and their closeness to their tenants, who looked to them for sound management and good livelihoods. Unlike the landed magnates, no member of the gentry was extremely powerful on their own, hence they needed transparent rules and law to protect them, as well as a body like the House of Commons to help them coordinate their actions. At the same time, their numbers meant they could not be expropriated with the stroke of a pen or collectively accused of treason. The mistake when institutions function well is to believe that they would function similarly well elsewhere, ignoring the possibly different underlying distribution of power. The United States Constitution, when adopted by Liberia, turned out to be just a piece of paper, with none of the effective checks and balances that fill the Federalist Papers and characterize how the United States works.39

While we know a fair amount about the kinds of institutions that exist in advanced states, there has been far less study of how to create the right distribution of power. Simply distributing property does not help, because what is given can be taken back. As we will see again and again in this book, the existence of vibrant competitive markets that allow productive and independent owners to emerge is a large part of the answer – markets help constrain the state and protect property as part of the balance. As our discussion of England’s emergence as a constitutionally limited state suggests, getting the right distribution of power also involves much luck. Perhaps this is why nation-building exercises in Libya and Afghanistan have largely proved failures so far.

OTHER COUNTRIES

The transformation from feudal vassal to commercial tenant, and the resulting shift in power from the landed magnate to the more numerous and dispersed gentry, did not take place everywhere, and rarely in the same way. Nevertheless, while every modern liberal democracy had its own idiosyncratic path toward constitutionally limited government, there were generalisable elements from England’s experience. The key development, as argued in this chapter, was the transfer of large unproductive land holdings from the monasteries and aristocrats into the hands of the more commercially minded gentry. In the process of dispersing economic and political power away from the church and the aristocracy, a new independent constituency arose that benefited from a more open rule-based system.

In the United States in the early nineteenth century, settlers poured into the newly surveyed and auctioned lands in the West. Land was widely owned, and those who could not make a go of it sold quickly to those who could, so it was also productively held. The exception was the South, where both corruption and climate conspired to create large, concentrated plantations run on the backs of slave labour.40 Studies show wider distribution of land, especially when also efficient, helped improve local governance. Rodney Ramcharan of the University of Southern California finds that US counties where there were large farms and concentrated land holdings (because of the kind of crops favoured by rainfall patterns) tended to have less spending on education, a key measure of the democratic responsiveness of the government to public need.41 In a joint study with him, we found that such counties had far fewer banks per capita in the early twentieth century, a measure of broad-based economic opportunity.42 We traced such differences to the nature of governance in those areas. Therefore, even within a developed large country not so long ago, land distribution affected local governance, and thence economic opportunities.

As economic historians Stanley Engerman and Kenneth Sokoloff have argued, there is a more general pattern here. For example, countries in Latin America that started out with more plantation-based agriculture, and thus large concentrated land holdings, tend to have less broad-based political and social institutions today.43 The lesson is not simply that land holdings concentrated among the few are bad for democracy – a point made forcibly by political sociologist Barrington Moore – but that substantial wealth held by a few with close ties to government reduces the possibility of the state working for the many. Such lessons apply even today. It is one reason we should be concerned about the rise of megacorporations dependent on intellectual property, as I will argue later in the book.