The social conflict view in action

We now discuss three important examples to bring out the fact that conflict over eco­nomic institutions is critical to the functioning of the economy and that this conflict stems, not from differences in beliefs, ideology or historical accidents, but from the im­pact of economic institutions on distribution.

7.1. Labor markets

A market - an opportunity for individuals to exchange a commodity or service - is ob­viously a fundamental economic institution relevant for development. As Adam Smith (1776) argued, markets allow individuals to take advantage of the benefits of special­ization and the division of labor, and scholars such as Pirenne (1937) and Hicks (1969) argued that the expansion of markets was perhaps the driving forces in long-run devel­opment.

In the history of Europe a key transformation was from feudal labor market insti­tutions towards modern notions of a free labor market where individuals were able to decide who to work for and where to live. This process of institutional change was in­timately connected to the transition from a whole set of feudal economic institutions to the economic institutions we think of as ‘capitalist’. Most historians see this as key to the economic take-off that began in the nineteenth century. It was the countries which had made the transition away from feudalism most completely, such as England, the Nether­lands and France, thanks to the revolution of 1789, which developed most rapidly.

What can account for this differential evolution of feudalism? Scholars beginning with Postan (1937) saw the demographic collapse caused by the black death in the 1340’s as demolishing feudalism in Western Europe. By dramatically altering the land/labor ratio as approximately 40% of the population of Europe died [e.g., Cantor (2001)], the Black Death greatly increased the bargaining power of peasants and allowed them to negotiate a free status ending feudal obligations, particularly with respect to la­bor. Therefore, Postan’s demographic theory implicitly emphasizes the role of political power in the decline of feudalism: this set of economic institutions started to disappear when the political power of the peasants increased and that of lords declined.

In fact, the distribution of power may be even more important in the whole story than Postan’s theory suggests. As first pointed out by Brenner (1976), the demographic the­ory of the decline feudalism is not consistent with the comparative evidence. Although demographic trends were similar all over Europe and

“it is true that... in most of Western Europe serfdom was dead by the early sixteenth century. On the other hand, in Eastern Europe, in particular Pomerania, Brandenburg, East Prussia and Poland, decline in population from the late four­teenth century was accompanied by an ultimately successful movement towards imposing extra-economic controls, that is serfdom, over what had been, until then, one of Europe’s freest peasantries. By 1500 the same Europe-wide trends had gone a long way towards establishing one of the great divides in European history, the emergence of an almost totally free peasant population in Western Europe, the

debasement of the peasantry to unfreedom in Eastern Europe.” [Brenner (1976,

p. 41)].

What can explain these divergent outcomes? Brenner notes (p. 51): “It was the logic of the peasant to try to use his apparently improved bargaining position to get his free­dom.

Although we are far from an understanding of the determinants of the relative struc­ture of political power in different parts of Europe, Brenner suggests that an important element was the “patterns of the development of the contending agrarian classes and their relative strength in the different European societies: their relative levels of in­ternal solidarity, their self-consciousness and organization, and their general political resources - especially their relationships to the non-agricultural classes (in particular, potential urban class allies) and to the state” (p. 52). To substantiate this view, Brenner studies how villages tended to be organized differently in Eastern Europe, there was “more of a tendency to individualistic farming; less developed organization of collabo­rative agricultural practices at the level of the village or between villages; and little of the tradition of the ‘struggle for commons rights’ against the lords which was so char­acteristic of western development” (p. 57). This differential organization was due to the process of initial occupation of these Eastern lands.

Although many parts of Brenner’s analysis remain controversial, there is general agreement that the decline of feudalism and the transformation of European labor mar­kets were intimately related to the political power of the key groups with opposing interests, the peasants and the lords [see, for example, Aston and Philpin (1985) on re­actions to Brenner’s interpretation]. Feudal institutions, by restricting labor mobility and by removing the role of the labor market in allocating labor to jobs, undermined incen­tives and resulted in underdevelopment. But these same economic institutions created large rents for the aristocracy.

7.2. Financial markets

Much recent work on growth and development has focused on capital markets. Growth requires investment, so poor agents without access to financial markets will not have the resources to invest. Empirically many scholars have found correlations between the depth of financial markets and growth [see Levine (2005)] and absence of financial markets is at the heart of ambitious theories of comparative development by Banerjee and Newman (1993) and Galor and Zeira (1993).

If the stress on financial markets and financial intermediation is correct, a central issue is to understand why financial systems differ. For example, studies of the development ofbanking in the United States in the nineteenth century demonstrate a rapid expansion of financial intermediation which most scholars see as a crucial facilitator of the rapid growth and industrialization that the economy experienced. In his recent study Haber (2001, p. 9) found that in the United States, “In 1818 there were 338 banks in operation, with a total capital of $160 million-roughly three times as many banks and bank capital as in 1810. Circa 1860, the United States had 1,579 banks, with a total capital of $422.5 million. Circa 1914 there were 27,864 banks in the United States. Total bank assets totaled $27.3 billion”.

One might see this rapid expansion of banking and financial services as a natural feature. Yet Haber (2001) shows that the situation was very different in Mexico (p. 24). “Mexico had a series of segmented monopolies that were awarded to a group of insiders. The outcome, circa 1910 could not have been more different: the United States had roughly 25,000 banks and a highly competitive market structure; Mexico had 42 banks, two of which controlled 60 percent of total banking assets, and virtually none of which actually competed with another bank.”

The explanation for this huge difference is not obvious.

This structure, which looked remarkably like that which arose subsequently in Mex­ico, emerged because state governments had been stripped of revenues by the Con­stitution. In response, states started banks as a way to generate tax revenues. State governments restricted entry “in order to maximize the amount of rent earned by banks, rent which would then be shared with the state government in the form of dividends, stock distributions, or taxes of various types”.

Thus in the early nineteenth century, U.S. banks evolved as monopolies with regula­tions aimed at maximizing revenues for the state governments. Yet this system did not last because states began competing among themselves for investment and migrants.

“The pressure to hold population and business in the state was reinforced by a second, related, factor: the broadening of the suffrage. By the 1840s, most states had dropped all property and literacy requirements, and by 1850 virtually all states (with some minor exceptions) had done so. The broadening of the suffrage, however, served to undermine the political coalitions that supported restrictions on the number of bank charters. That is, it created a second source of political competition-competition within states over who would hold office and the policies they would enact.”

The situation was very different in Mexico. After 50 years of endemic political insta­bility the country unified under the highly centralized 40 year dictatorship of Porfirio Diaz until the Revolution in 1910.

In Haber’s argument political institutions in the United States allocated political power to people who wanted access to credit and loans. As a result they forced state governments to allow free competitive entry into banking. In Mexico political institu­tions were very different. There were no competing federal states and the suffrage was highly restrictive. As a result the central government granted monopoly rights to banks who restricted credit to maximize profits. The granting of monopolies turned out to be a rational way for the government to raise revenue and redistribute rents to political supporters [see North (1981, Chapter 3)].

A priori, it is possible that the sort of market regulation Haber found in Mexico might have been socially desirable. Markets never function in a vacuum, but rather within sets of rules and regulations which help them to function. Yet it is hard to believe that this argument applies to Mexico [see also Maurer (2002)]. Haber (2001) documents that market regulation was aimed not at solving market failures and it is precisely during this period that the huge economic gap between the United States and Mexico opened up [on which see Coatsworth (1993), Engerman and Sokoloff (1997)]. Indeed, Haber and Maurer (2004) examined in detail how the structure of banking influenced the Mexican textile industry between 1880 and 1913. They showed that only firms with personal contacts with banks were able to get loans. They conclude (p. 5):

“Our analysis demonstrates that textile mills that were related to banks were less profitable and less technically efficient than their competitors. Nevertheless, access to bank credit allowed them to grow faster, become larger, and survive longer than their more productive competitors. The implication for growth is clear: relatively productive firms lost market share to relatively unproductive (but bank-related) competitors.”

Despite the fact that economic efficiency was hurt by regulations, those with the political power were able to sustain these regulations.

7.3. Regulationofprices

As our final example we turn to the regulation of prices in agricultural markets (which is intimately related to the set of agricultural policies adopted by governments). The semi­nal study of agricultural price regulation in Africa and Latin America is by Bates (1981, 1989, 1997). Bates (1981) demonstrated that poor agricultural performance in Ghana, Nigeria and Zambia was due to government controlled marketing boards systematically paying farmers prices for their crops much below world levels.

“Most African states possess publicly sanctioned monopsonies for the purchase and export of agricultural goods... These agencies, bequeathed to the govern­ments of the independent states by their colonial predecessors, purchase cash crops for export at administratively determined domestic prices, and then sell them at the prevailing world market prices. By using their market power to keep the price paid to the farmer below the price set by the world market, they accumulate funds from the agricultural sectof’ [Bates (1981, p. 12)].

The marketing boards made surpluses which were given to the government as a form of taxation. Bates (1981, p. 15) notes

“A major test of the intentions of the newly independent governments occurred... [when] between 1959-60 and 1961-62, the world price of cocoa fell approx­imately £50 a ton. If the resources generated by the marketing agencies were to be used to stabilize prices, then surely this was the time to use the funds for that purpose. Instead... the governments of both Ghana and Nigeria passed on the full burden of the drop in price to the producers.”

Bates continues “Using the price setting power of the monopsonistic marketing agen­cies, the states have therefore made the producers of cash crops a significant part of their tax base, and have taken resources from them without compensation in the form of in­terest payments or of goods and services returned” (pp. 181-189). As a result of this pernicious taxation, reaching up to 70% of the value of the crop in Ghana in the 1970s, investment in agriculture collapsed as did output of cocoa and other crops. In poor coun­tries with comparative advantage in agriculture such a situation mapped into negative rates of economic growth.

Why were resources extracted in this way? Though part of the motivation was to promote industrialization, the main one is to generate resources that could be either expropriated or redistributed to maintain power

“governments face a dilemma: urban unrest, which they cannot successfully eradicate through co-optation or repression, poses a serious challenge to their in­terests... Their response has been to try to appease urban interests not by offering higher money wages but by advocating policies aimed at reducing the cost of living, and in particular the cost of food. Agricultural policy thus becomes a by­product of political relations between governments and urban constituents.” [Bates (1981, p. 33)].

In contrast to the situation in Ghana, Zambia and Nigeria, Bates (1981, 1989, 1997) showed that agricultural policy in Kenya and Colombia over this period was much more pro-farmer. The difference was due to who controlled the marketing board. In Kenya, farmers were not smallholders, as they were in Ghana, Nigeria and Zambia, and con­centrated landownership made it much easier to solve the collective action problem. Moreover, farming was important in the Kikuyu areas, an ethnic group closely related to the ruling political party, KANU, under Jomo Kenyatta [Bates (1981, p. 122)]. Farm­ers in Kenya therefore formed a powerful lobby and were able to guarantee themselves high prices. Even though the government of Kenya engaged in land reform after inde­pendence

“80% of the former white highlands were left intact and... the government took elaborate measures to preserve the integrity of the large-scale farms... [which] readily combine in defense of their interests. One of the most important collective efforts is the Kenya National Farmer’s Union (KNFU)... The organization... is dominated by the large-scale farmers... [but] it can be argued that the KNFU helps to create a framework of public policies that provides an economic environment favorable to all farmers.” [Bates (1981, pp. 93-94)].

Bates concludes (p. 95) that in Kenya

“large farmers... have secured public policies that are highly favorable by com­parison to those in other nations. Elsewhere the agrarian sector is better blessed by the relative absence of inequality. But is also deprived of the collective benefits which inequality, ironically, can bring.”

In Colombia, farmers were favored because of competition for their votes from the two main political parties. Bates (1997, p. 54) notes

“Being numerous and small, Colombia’s coffee producers, like peasants else­where, encountered formidable costs of collective action. In most similar instances such difficulties have rendered smallholders politically powerless. And yet... Colombia’s peasants elicited favorable policies from politicians, who at key mo­ments themselves bore the costs of collective action, provisioning the coffee sector with economic institutions and delegating public power to coffee interests.”

How could the coffee growers gain such leverage over national policy?

“A major reason they could do so... is because the structure of political insti­tutions, and in particular the structure of party competition, rendered them pivotal, giving them the power over the political fortunes of those with ambition for of­fice and enabling them to make or break governments. They thereby gained the power to defeat government officials who sought to orchestrate or constrain their behavior.” [Bates (1997, pp. 51, 54)].

A telling piece of evidence in favor of this thesis is that during the 1950s when a civil war broke out between the two parties, there was five years of military rule and policy turned decisively again the coffee growers, only to switch back again with the peaceful resumption of democracy in 1958.

7.4. Political power and economic institutions

These three examples of the creation of economic institutions have certain features in common. All these institutions, labor market regulation/feudalism, the rules govern­ing financial market development, and agricultural price regulation, clearly reflect the outcome of conscious choices. Feudalism did not end in England for incidental or ide­ological reasons, but because those who were controlled and impoverished by feudal regulations struggled to abolish them. In Eastern Europe the same struggle took place but with a different outcome. Similarly, Mexico did not end up with different financial institutions than the United States by accident, because of different beliefs about what an efficient banking system looked like, or because of some historical factor indepen­dent of the outcome. The same is true for differences in economic policies in Kenya and Ghana. Moreover, different sets of economic institutions arising in different places cannot be argued to be efficient adaptations to different environments. Most histori­ans believe that the persistence of feudal institutions in Eastern Europe well into the nineteenth century explains why it lagged far behind Western Europe in economic de­velopment. The difference between the financial institutions of Mexico and the United States also plausibly played a role in explaining why they diverged economically in the nineteenth century. The same holds with respect to agricultural price regulation.

The driving force behind all three examples is that economic institutions are chosen for their distributional consequences. Which specific economic institutions emerge de­pends on who is able to get their way - who has political power. In England, peasant communities had developed relatively strong local political institutions and were able to consolidate on the shock of the Black Death to put an end to feudal regulations. In Eastern Europe it was the lords who had relatively more power and they were able to intensify feudalism in the face of the same demographic shock [as Domar (1970) pointed out, the Black Death actually made serfdom more attractive to the lords even if at the same time it increased the bargaining power of the peasants]. In the case of bank­ing in the nineteenth century, Haber’s research shows while the authoritarian regime in Mexico had the political power to freely create monopolies and create rents in the banking industry, the United States was different because it was federal and much more democratic. The political institutions of the United States prevented politicians from ap­propriating the rents that could flow from the creation of monopolies. Finally, in Bates’s analysis, distortionary price regulations arose in Ghana and Zambia, but not in Kenya and Colombia, because in the latter countries agricultural producers had more political power and so could prevent the distortionary policies that would harm their interests.

It is also useful to consider in the context of these examples the mechanisms we dis­cussed in Section 6 which underlie the adoption of inefficient economic institutions. Why could not the peasants and lords of feudal Europe negotiate and allow the intro­duction of a set of economic institutions that would have given peasants incentives to innovate and would have allowed for the efficient allocation of labor? Why could not either the lords have promised not to expropriate any benefits that accrued from in­novation, or alternatively the peasants agreed to compensate the lords if feudal labor institutions were abolished? Though it is difficult to find direct evidence on such coun- terfactuals from the Medieval period, the most plausible explanation is that such ‘deals’ were impossible to make credible. The political power of the lords was intimately con­nected to feudal institutions and thus dismantling these would not only have increased peasant incentives to innovate, but would also have dramatically altered the balance of political power and the distribution of rents in society. Moreover, under feudal regula­tions peasants were tied to the land. The introduction of free labor mobility would have given workers an exit option, thus increasing their bargaining power with the lords over the division of output. Thus lords might anticipate being both political and economic losers from the ending of feudalism, even if total output would have increased.

In the case of agricultural price regulation, similar arguments are plausible. Cocoa farmers in Ghana would not have believed promises by governments that they would not expropriate the fruits of higher investment, and the governments themselves would not have believed promises by the farmers to compensate them if they left office. Moreover, efficient sets of economic institutions in Ghana or Nigeria would have strengthened the economic base of the rural sector at the expense of the political power of the then dominant urban sector. Indeed, for Ghana in the 1960s, we have direct evidence from the urban economy that the threat of being a political loser led to inefficient economic institutions. This emerges in the analysis of Killick (1978, p. 37) of the attempt by the government of Kwame Nkrumah to promote industrialization. Killick notes:

“Even had there been the possibility [of creating an indigenous entrepreneurial class] it is doubtful that Nkrumah would have wanted to create such a class, for reasons of ideology and political power. He was very explicit about this saying ‘we would be hampering our advance to socialism if we were to encourage the growth of Ghanian private capitalism in our midst’. There is evidence that he also feared the threat that a wealthy class of Ghanaian businessmen might pose to his own political power.”

Further evidence on the importance of political loser considerations comes from E. Ayeh-Kumi one of Nkrumah’s main economic advisers who noted after the coup that ousted Nkrumah in 1966 that Nkrumah: “informed me that if he permitted African business to grow, it will grow to becoming a rival power to his and the party’s prestige, and he would do everything to stop it, which he actually did” [Killick (1978, p. 60)].

In this context, it is interesting that Nkrumah’s solution to consolidate his power was to limit the size of businesses that Ghanaians could own. This caused problems for his industrialization policy which he got round by allowing foreign businessmen to enter Ghana. Though this was inconsistent with his aggressively nationalistic and anti- imperialistic rhetoric, these businessmen did not pose a domestic political threat. Killick notes “Given Nkrumah’s desire to keep Ghanaian private businesses small, his argument that ‘Capital investment must be sought from abroad since there is no bourgeois class amongst us to carry on the necessary investment’ was disingenuous” (p. 37). He goes on to add that Nkrumah “had no love of foreign capitalists but he preferred to encourage them rather than local entrepreneurs, whom he wished to restrict” (p. 40).

All these examples show that the distribution of political power in society is crucial for explaining when economic institutions are good and when they are bad. But where does political power come from and who has political power? In addressing these ques­tions we will develop our theory of economic institutions. In a theory based on social conflict where economic institutions are endogenous, it will be to differences in political institutions and the distribution of political power that we must look to explain variation in economic institutions.

8.