Monday, October 12, 2015

Private Governance

Private Governance by Edward Peter Stringham was an excellent and truly enjoyable book. The title by itself succinctly makes a libertarian point: governance does not have to come from the government. Too often unthoughtful commentators forget this very basic point. If the government fails to govern effectively, or if there is no governing entity, private institutions fill the gaps. How well or how poorly private institutions can provide governance is an empirical question. Stringham provides several real-world examples in which the government is totally absent, is indifferent to a problem requiring adjudication/enforcement, or is incompetent at policing a problem. His book explores privately supplied rules, private rule enforcement, and private adjudication, which are often perfectly adequate to solve existing problems.

Some passages that I highlighted:

Focusing on actual rather than hypothetical examples eliminates the need to speculate about whether certain problems could be solved. For example, one need not debate whether complex financial transactions can take place without external enforcement (something that Olson [1996] asserts is impossible), if one can observe them taking place for centuries.

It really is funny that there is so much navel-gazing on what is at its heart an empirical question. The relative performance of private vs government supplied governance is a question that can’t be answered without real world data and examples. Once again, the book provides several.

[The analogy of the ‘fox guarding the chicken coop’] implies that a stock exchange will create rules that help brokers at the expense of investors, an apartment complex will create rules at the expense of tenants, or a firm will create rules at the expense of its employees. The implication is that government , as a disinterested third party, is better suited to create rules than members of a given industry.
This is a very odd assumption, that someone is interested in effectively solving your problems for you just because they hold the levers of power. The relationships described in this passage are voluntary bi-lateral agreements. They are disciplined by the threat of exit by either party, so brokers, landlords, and firms are compelled to offer better terms than other brokers, landlords, and firms. (Investors, tenants, and employees decide which of these institutions make the best offer and choose to associate with them.) Government, on the other hand, faces only very weak feedback if it misbehaves or offers a terrible product. Many commentators get this exactly backwards and somehow reach the conclusion that government is *more* responsive than businesses to the needs of those businesses’ customers.

Go into the Exchange in London, that place more venerable than many a court, and you will see representatives of all the nations assembled there for the profit of mankind. There the Jew, the Mahometan, and the Christian deal with one another as if they were of the same religion, and reserve the name of infidel for those who go bankrupt.

This quote by Voltaire is at the intro of chapter 5. It’s a lovely comment on how commerce tames our baser instincts. Misbehaving tends to lose you money in the long run. Behaving yourself and developing a good reputation for fairness and honesty serve your long-run interests a lot better. Even someone motivated entirely by greed will tend to behave well, so long as they are governed by their long-term self-interest.

When the Securities Act and the Securities Exchange Act were implemented in 1933 and 1934, they simply mandated many of the requirements that the New York Stock Exchange had already adopted.

This passage comes from chapter 6, on the history of New York financial exchanges. As with many things, private governance came first. The legislated law simply codified an informal legal order that emerged in the private sphere. In other words, the law already existed. The government just affirmed it.

The government officials were hardly experts. [Peter Thiel] stated, “The level of incompetence we dealt with was amazing.” At the time he stated that the FBI did not “even have a working email system.” In one case PayPal conducted an internal investigation and determined that a man named Mr. Yagolnitser was defrauding the company of money. After reporting the culprit to the authorities, law enforcement was of little help.

The above passage is from a lovely anecdote about PayPal’s exploits in the world of fraud detection. Pay Pal was lightyears ahead of the FBI in detecting fraudulent transactions, but the FBI was apparently uninterested in investigating actual crimes. This was a very clear case of a private for-profit company solving a problem that the government was uninterested in solving, even though this is exactly the kind of problem government is charged with solving.

I am sure some people will think, “It is unfair that paying customers receive service and people without money to spare for the service do not.” Do not forget that for issues that government considers unimportant, nobody receives responses.
The above passage is from a section on San Francisco’s Patrol Special Police, an entirely private police force. It’s often asserted that *only* government can supply the police. It’s important to remember that we have instances (historical and current) that disprove this assertion.

The next two passages dispel a common man-on-the-street economic notion: that big institutions can get their way on account of their “big-ness” and the little guy just has to take their terms as given. This is the notion that “market power” allows the big guy to trample the little guy.

Even if one party is larger and offers the terms of adjudication on a take-it-or-leave-it basis, the requirement for a compromissum creates incentives to maximize joint benefit and minimize potential problems such as bias or waste. Suppose, for example, that buyers on eBay accurately predict a 10 percent chance of the seller not delivering and that eBay adjudication always found in favor of these delinquent sellers (and suppose for the moment this 90 to 10 percent ratio is stable). Here a $ 100 tie would be sold only for $ 90 (or less if we add risk aversion), meaning the cost of any proseller bias would be borne by the seller. Whether the sellers are big corporations and the buyers are little guys is irrelevant. Rules that harm buyers negatively affect their willingness to pay for a transaction.

Whether we are talking about potential disputes between stockbrokers and clients, banks and customers, cell phone carriers and users, or landlords and tenants, attempting to stack the deck against one side does not pay when that party can adjust his willingness to enter an agreement. The cost of biased rules or procedures is borne by the party that the rules were intended to bias.

In other words, a big retailer, employer, bank, or landlord can make rules that are biased in favor of themselves, but not without compensating their customers, employees, lenders, or tenants for the burden of those biased rules. It’s worth understanding this argument. Even if there are some special circumstances in the real world where “market power” is real and significant, a modern enlightened thinker needs to understand that there are competitive forces working against it. There is a great deal of populist blather that totally ignores the role of competition.

The following part was a big surprise to me, even though it's not obviously connected to the book's general thesis:

The value of mortgage-backed securities fell during the economic downturn, but because most underlying mortgages continue to pay, they have actually performed quite well in the long run. Figure 11.4 shows the growth from 2004 to 2014 of $ 10,000 invested in mortgage-backed securities funds from BlackRock, JP Morgan, Legg Mason Western Asset, PIMCO, Prudential, and Vanguard (BGPAX, OMBAX, SGSYX , PTRIX, TGMBX, and VMBIX). While a $ 10,000 investment in high-yield municipal bonds would have increased to $ 14,334 during this time, a $ 10,000 investment in mortgage-backed securities would have increased to between $ 15,964 and $ 16,540 depending on the fund chosen.
Read the entire chapter for the details and nuance, but in short those awful, toxic assets that supposedly destroyed our financial markets were actually pretty decent investments.

Credit default swaps have been vilified by economically illiterate comedians such as Jon Stewart and scores of politicians.

If you’re someone who’s been “educated” by Jon Stewart (on this topic or some other), ask yourself if you’ve really been exposed to a contrary viewpoint. “Private Governance” has it. As a former (perhaps recovering?)  Jon Stewart fan, I found this cheap shot amusing. 

A couple quotes on the Bernie Madoff affair, which is in my opinion a glorious failure of the federal government’s attempt to govern:

The more important lesson, however, is that many mechanisms of private governance that easily could have prevented such fraud were available to investors, and they chose not to demand them. Despite the fact that Madoff’s returns were questioned by many, none demanded the private third-party administration and accounting services that other hedge funds were using.

The Securities and Exchange Commission ( Kotz, 2009 , p. 5) reports that “numerous private entities conducted basic due diligence of Madoff’s operations and … came to the conclusion that an investment with Madoff was unwise.”

Madoff’s $ 13 billion shortfall also pales in comparison to the $ 20 trillion by which Social “Security” is underfunded ( Kotlikoff, 2012 ). I have no respect for Madoff, but he at least had decency to trick investors into his fraudulent scheme, rather than force investors to hand over their money or force workers to “invest” 12.4 percent of all earnings in a retirement scheme.

In 2000 Markopolos and colleagues sent a report to the Securities and Exchange Commission stating that “the entire fund is nothing more than a Ponzi Scheme” ( Kotz, 2009 , p. 7) and followed up with additional complaints, including Markopolos’s 2005 report to the Securities Exchange and Commission titled “The World’s Largest Hedge Fund Is a Fraud.”
In other words, Madoff was handed to the SEC on a silver platter. Private entities that scrutinized Madoff’s fund found irregularities, if not slam-dunk proof of fraud. The policing function was being supplied by private institutions, but Madoff’s investors couldn’t be bothered to pay attention. It's not at all clear that the Madoff affair was a failure of the market to regulate itself. The self-regulating framework was clearly in place. It successfully identified the problem and even alerted the authorities. Neither Madoff's investors nor the federal government heeded the warning. It's patently bizarre to frame this episode as a failure of free markets. 

I’ll share the following two passages without commentary, other than to say I liked them:

Readers who have not had to deal with financial or business regulations are invited to read the Code of Federal Regulations. At 150,000 pages, it’s wildly interesting reading and not too hard to keep up with: just read one hundred pages each day, and you can get through the existing set of regulations in five years, and hope that they haven’t added too many others by the time you are done. Many of my friends work as compliance officers on Wall Street, and they say that although the regulations all but guarantee them employment, they would not wish the regulations on their worst enemy.
With little way to evaluate the goodness of any given rule or the performance of any individual judge, the public will be left wondering if the judge’s opinion or the legislature’s laws are simply personal opinions shrouded in false cloak of justice. Without profits and losses providing a feedback mechanism, judges and legislatures have little way of determining Hayek’s nomos or law of liberty.

The book closes with the following beautiful passage:

Private governance, in all of its forms— driven principally by the reliable engine of self-interest— brings people together to cooperate and to expand the scope of mutually beneficial exchange. With so much at stake and so much to gain, providers of private governance constantly experiment and collaborate to discover ways of eliminating problems. The mechanisms of private governance are potentially limitless. They facilitate cooperation in close-knit groups and among relative strangers. They facilitate cooperation between billions of people across political boundaries and anywhere where the government legal system is not capable of or uninterested in facilitating exchange. Private governance is responsible for cooperation in simple informal markets as well as the most advanced markets: stock markets, insurance markets, futures markets, and electronic commerce. Private governance makes markets work. Private governance replaces threats of coercion with numerous noncoercive mechanisms that expand the scope of trade, and it should be seen as one of the most successful peace projects in the history of the world.

I'm a self-identified anarcho-capitalist. I think almost everything the government does could be done better by private institutions. I have lingering doubts that you could privatize absolutely *everything*. But I have little doubt we could move 90% of the way there and things would get better and better without getting worse. I'm comfortably agnostic on whether things would deteriorate somewhere on that final span of 10%. I know that this is a fringe belief and that many people are uncomfortable with it. Reading Private Governance reminded me that my anarcho-capitalist beliefs are intellectually respectable.

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