Markets for rules

Oliver and I had a minor disagreement in last week's Insights newsletter.

He argued that the Volkswagen case was terrible and that everybody should follow the rules.*

I said that regulators and car companies have been playing cat and mouse with each other on this stuff for ages, that customers would put in workarounds if the emissions controls denigrated performance too much anyway, and that civilisation would collapse if everybody followed all the government rules all the time.

That's especially true when government sets rules to be seen to be doing something rather than because they think the rules are a good idea. You occasionally hear stories around the traps of governments doing things that they hope get overturned by the courts on appeal, so that they can have their cake and eat it too: politicians get kudos from voters for having done something feel-good and dumb, but suffer none of the economic consequences of bad regulation because some grown-up elsewhere in the system bats it back.

Are there alternatives?

The latest Cato Unbound has an excellent contribution from my old classmate Ed Stringham. He points out that government is neither the only nor the best source for rules. In fact, for a couple of centuries, governments tried to ban stock markets as being sinful gambling. So traders set up and enforced their own rules despite government trying to ban their doing so and despite government refusing to enforce contracts. And it's hardly an isolated case.

Here's Ed:

In all of the world’s first major stock markets, government officials considered much of the trading as a form of gambling or speculation used to manipulate prices. In the first stock market in seventeenth century Amsterdam, government refused to enforce all but the simplest securities contracts. After the founding of the Dutch East India Company in 1602 a secondary market for shares emerged among brokers who began specializing in trading stocks. Officials soon passed edicts outlawing their nascent market, but stockbrokers continued trading and developed many sophisticated transactions including forward contracts, short sales, and options. How is that possible? Instead of formal rules, stockbrokers relied on reciprocity and reputation mechanisms to encourage contractual compliance. In contrast to the one shot prisoners’ dilemma story, most business is repeated and brokers had to be reliable if they wanted others to do business with them. Not only would a defaulter sour his relationship with his trading partner, but he would be boycotted by everyone else who found out. Reputation thus served as a substitute to formal rules. The market was wildly successful and helped finance the Dutch Golden Age. Some estimates put the market capitalization of the Dutch East India Company in current dollars at $7 trillion. Modern New Yorkers can thank the Dutch East India Company for financing Henry Hudson’s first voyage to New York’s North River (the Hudson River) and the Dutch West India Company for founding New Amsterdam (New York).[4]

...Other financial intermediaries also assume and manage risks on behalf of customers. When doing business with PayPal or with most credit cards, if fraudsters make bogus transactions or attempt to takes money out of an account PayPal is on the hook. By 2001 fraudsters were stealing more $10 million from PayPal per month at a time when its gross annual revenue per year was only $14 million. At first PayPal contacted the FBI and found that it was of little help. After seeing the evidence, the FBI asked questions such as “What’s a banner ad?” These government officials were not at the forefront of technology, but even if they were, they still would have been powerless against anonymous fraudsters on the other side of the globe. Rather than sitting around and hoping that government would solve the problems, PayPal came up with private solutions to deal with fraud before it occurred. They developed human-assisted artificial intelligence to monitor accounts, search for suspicious activity, and temporarily or permanently suspend accounts. By assuming and managing risks on behalf of customers, PayPal transformed what many people assume must be legal questions into risk management questions. When parties can deal with problems ex ante, ex post contract enforcement is not the “necessity” that theorists like Kirzner or Olson assume.

* Hic-A-Doo-La means obeying all the rules!