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

Raghuram Rajan

From one of the most important economic thinkers of our time, a brilliant and far-seeing analysis of the current populist backlash against globalization and how revitalising community can save liberal market democracy. Raghuram Rajan, author of the 2010 FT & Goldman-Sachs Book of the Year Fault Lines, has an unparalleled vantage point onto the social and economic consequences of globalization and their ultimate effect on politics and society. In The Third Pillar he offers up a magnificent big-picture framework for understanding how three key forces – the economy, society, and the state – interact, why things begin to break down, and how we can find our way back to a more secure and stable plane.The ‘third pillar’ of the title is society. Economists all too often understand their field as the relationship between the market and government, and leave social issues for other people. That's not just myopic, Rajan argues; it's dangerous. All economics is actually socioeconomics – all markets are embedded in a web of human relations, values and norms. As he shows, throughout history, technological innovations have ripped the market out of old webs and led to violent backlashes, and to what we now call populism. Eventually, a new equilibrium is reached, but it can be ugly and messy, especially if done wrong. Right now, we're doing it wrong. As markets scale up, government scales up with it, concentrating economic and political power in flourishing central hubs and leaving the periphery to decompose, figuratively and even literally. Instead, Rajan offers a way to rethink the relationship between the market and civil society and argues for a return to strengthening and empowering local communities as an antidote to growing despair and unrest. The Third Pillar is a masterpiece of explication, a book that will be a classic of its kind for its offering of a wise, authoritative and humane explanation of the forces that have wrought such a sea change in our lives. His ultimate argument that decision-making has to be watered at the grass roots or our democracy will continue to wither is sure to be both provocative and agenda-setting across the world.

## Copyright

William Collins

An imprint of HarperCollinsPublishers 1 London Bridge Street London SE1 9GF WilliamCollinsBooks.com This eBook first published in Great Britain by William Collins in 2019 Copyright © 2019 by Raghuram Rajan Cover design by Jack Smyth Raghuram Rajan asserts the moral right to be identified as the author of this work A catalogue record for this book is available from the British Library All rights reserved under International and Pan-American Copyright Conventions. By payment of the required fees, you have been granted the non-exclusive, non-transferable right to access and read the text of this e-Book on-screen. No part of this text may be reproduced, transmitted, downloaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any form or by any means, whether electronic or mechanical, now known or hereinafter invented, without the express written permission of HarperCollins Publishers. Source ISBN: 9780008276263 Ebook Edition © February 2019 ISBN: 9780008276294 Version: 2019-02-06

To Radhika

## CONTENTS

Cover

Title Page

Copyright

Dedication

Also by Raghuram Rajan

Preface

Introduction: The Third Pillar

PART I

HOW THE PILLARS EMERGED

1. Tolerating Avarice

2. The Rise of the Strong but Limited State

3. Freeing the Market … Then Defending It

4. The Community in the Balance

PART II

IMBALANCE

5. The Pressure to Promise

6. The ICT Revolution Cometh

7. The Reemergence of Populism in the Industrial West

8. The Other Half of the World

PART III

RESTORING THE BALANCE

9. Society and Inclusive Localism

10. Rebalancing the State and the Community

11. Reinvigorating the Third Pillar

12. Responsible Sovereignty

13. Reforming Markets

Epilogue

Acknowledgments

Notes

Index

About the Author

About the Publisher

ALSO BY RAGHURAM RAJAN

I Do What I Do

Fault Lines

Saving Capitalism from the Capitalists

(with Luigi Zingales)

## PREFACE

We are surrounded by plenty. Humanity has never been richer as technologies of production have improved steadily over the last two hundred and fifty years. It is not just the developed countries that have grown wealthier; billions across the developing world have moved from stressful poverty to a comfortable middle-class existence in the span of a generation. Income is more evenly spread across the world than at any other time in our lives. For the first time in history, we have it in our power to eradicate hunger and starvation everywhere.

Yet even though the world has achieved economic success that would have been unimaginable even a few decades ago, some of the seemingly most privileged workers in developed countries are literally worried to death. Half a million more middle-aged non-Hispanic white American males died between 1999 and 2013 than if their death rates had followed the trend of other ethnic groups.[1] The additional deaths were concentrated among those with a high school degree or less, and largely due to drugs, alcohol, and suicide. To put these deaths in perspective, it is as if ten Vietnam wars were simultaneously taking place, not in some faraway land, but in homes in small-town and rural America. In an era of seeming plenty, a group that once epitomised the American dream seems to have lost hope.

The anxieties of the moderately educated middle-aged white male in the United States are mirrored in other rich developed countries in the West, though perhaps with less tragic effects. The primary source of worry seems to be that moderately educated workers are rapidly losing, or are at risk of losing, good ‘middle-class’ employment, and this has grievous effects on them, their families, and the communities they live in. It is widely understood that job losses stem from both global trade and the technological automation of old jobs. Less well understood is that technological progress has been the more important cause. Nevertheless, as public anxiety turns to anger, radical politicians see more value in attacking imports and immigrants. They propose to protect manufacturing jobs by overturning the liberal rules-based postwar economic order, the system that has facilitated the flow of goods, capital, and people across borders.

There is both promise and peril in our future. The promise comes from new technologies that can help us solve our most worrisome problems like poverty and climate change. Fulfilling it requires keeping borders open so that these innovations can be taken to the most underdeveloped parts of the world, even while attracting people from foreign lands to support aging rich country populations. The peril lies not just in influential communities not being able to adapt and instead impeding progress but also in the kind of society that might emerge if our values and institutions do not change as technology disproportionately empowers and enriches some.

DISRUPTIVE TECHNOLOGICAL CHANGE

Every past technological revolution has been disruptive, prompted a societal reaction, and eventually resulted in societal change that helped us get the best out of the technology. Since the early 1970s, we have experienced the Information and Communications Technology (ICT) revolution. It built on the spread of mass computing made possible by the microprocessor and the personal computer, and now includes technologies ranging from artificial intelligence to quantum computing, touching and improving areas as diverse as international trade and gene therapy. The effects of the ICT revolution have been transmitted across the world by increasingly integrated markets for goods, services, capital, and people. Every country has experienced disruption, punctuated by dramatic episodes like the Global Financial Crisis in 2007–2008 and the accompanying Great Recession. We are now seeing the reaction in populist movements of the extreme Left and Right. What has not happened yet is the necessary societal change, which is why so many despair of the future. We are at a critical moment in human history, when wrong choices could derail human economic progress.

This book is about the three pillars that support society and how we get to the right balance between them so that society prospers. Two of the pillars I focus on are the usual suspects, the state and markets. Many forests have been consumed by books on the relationship between the two, some favouring the state and others markets. It is the neglected third pillar, the community – the social aspects of society – that I want to reintroduce into the debate. When any of the three pillars weakens or strengthens significantly, typically as a result of rapid technological progress or terrible economic adversity like a depression, the balance is upset and society has to find a new equilibrium. The period of transition can be traumatic, but society has succeeded repeatedly in the past. The central question in this book is how we restore the balance between the pillars in the face of the ongoing disruptive technological and social change.

I will argue that many of the economic and political concerns today across the world, including the rise of populist nationalism and radical movements of the Left, can be traced to the diminution of the community. The state and markets have expanded their powers and reach in tandem, and left the community relatively powerless to face the full and uneven brunt of technological change. Importantly, the solutions to many of our problems are also to be found in bringing dysfunctional communities back to health, not in clamping down on markets. This is how we will rebalance the pillars at a level more beneficial to society and preserve the liberal market democracies many of us live in.

DEFINITIONS

To avoid confusion later, let us get over the tedious but necessary issue of definitions quickly. Broadly speaking, the state in this book will refer to the political governance structure of a country. In much of this book, it will refer to the federal government. In addition to the executive branch, the state will also include the legislature and the judiciary.

Markets will include all private economic structures facilitating production and exchange in the economy. The term will encompass the entire variety of markets, including the market for goods and services, the market for workers (the labour market), and the market for loans, stocks, and bonds (the capital or financial market). It will also include the main actors from the private sector, such as businesspeople and corporations.

According to the dictionary, a community ‘is a social group of any size whose members reside in a specific locality, share government, and often have a common cultural and historical heritage’.[2] This is the definition we will use, with the neighbourhood (or the village, municipality, or small town) being the archetypal community in modern times, the manor in medieval times, and the tribe in ancient times. Importantly, we focus on communities whose members live in proximity – as contrasted with virtual communities or national religious denominations. We will view local government, such as the school board, the neighbourhood council, or town mayor, as part of the community. A large country has layers of government between the federal government (part of the state) and the local government (part of the community). In general, we will treat these layers as part of the state. Finally, we will use the terms society, country, or nation interchangeably as the composite of the state, markets, communities, people, territory, and much else that compose political entities like China or the United States.

WHY THE COMMUNITY STILL MATTERS

Definitions done, let us get to substance. For early humans the tribe was their society – their state, markets, and community rolled into one. It was where all activities were conducted, including the rearing of children, the production and exchange of food and goods, and the succour of the ill and the elderly. The tribal chief or elders laid down the law and enforced it, and commanded the tribe’s warriors in defense of their lands. Over time, as we will see in Part I of the book, both markets and the state separated from the community. Trade with more distant communities through markets allowed everyone to specialise in what they were relatively good at, making everyone more prosperous. The state, aggregating the power and resources of the many communities within it, not only regulated markets but also enforced the law within its political boundaries, while defending the realm against aggressors.

Markets and the state have not only separated themselves from the community in recent times but have also steadily encroached on activities that strengthened bonds within the traditional community. Consider some functions the community no longer performs. In frontier communities, neighbours used to help deliver babies; today most women check into a hospital when they feel the onset of childbirth. They naturally prefer the specialist’s expertise much more than they value their neighbour’s friendly but amateurish helping hand. On a more mundane level, we used to offer to take our elderly neighbour shopping because she did not have a car. Today, she orders her groceries online. Similarly, the community used to pitch in to rebuild a household’s home if it caught fire; today the household collects its fire insurance payment and hires a professional builder. Indeed, given the building codes in most developed countries, it is unlikely that a home reconstructed by neighbours would be legal.

The community still plays a number of important roles in society. It anchors the individual in real human networks and gives them a sense of identity; our presence in the world is verified by our impact on people around us. By allowing us to participate in local governance structures such as parent-teacher associations, school boards, library boards, and neighbourhood oversight committees, as well as local mayoral or ward elections, our community gives us a sense of self-determination, a sense of direct control over our lives, even while making local public services work better for us. Importantly, despite the existence of formal structures such as public schooling, a government safety net, and commercial insurance, the goodness of neighbours is still useful in filling in gaps. When a neighbouring engineer tutors our son in mathematics in her spare time, or the neighbourhood comes together in a recession to collect food and clothing for needy households, the community is helping out where formal structures are inadequate. Given the continuing importance of the community, healthy modern communities try to compensate for the encroachment of markets and the state with other activities that strengthen community ties, such as social gatherings and neighbourhood associations.

Economists Raj Chetty and Nathaniel Hendren attempt to quantify the economic impact of growing up in a better community.[3] They examine the incomes of children whose parents moved from one neighbourhood into another in the United States when the child was young. Specifically, consider neighbourhood Better and neighbourhood Worse. Correcting for parental income, the average incomes of children of longtime residents when they become adults is one percentile higher in the national income distribution in neighbourhood Better than it is in neighbourhood Worse. Chetty and Hendren find that a child whose parents move from neighbourhood Worse to Better will have an adult income that is, on average, 0.04 percentile points higher for every childhood year it spends in Better. In other words, if the child’s parents move when it is born and they stay till it is twenty, the child’s income as an adult will have made up 80 per cent of the difference between the average incomes in the two neighbourhoods.

Their study suggests that a child benefits enormously by moving to a community where children are more successful (at least as measured by their future income). Communities matter! Perhaps more than any outside influence other than the parents we are born to, the community we grow up in influences our economic prospects. Importantly, Chetty and Hendren’s finding applies for a single child moving – movement is not a recipe for the development of an entire poor community. Instead, the poor community has to find ways to develop in situ, while holding on to its best and brightest. It is a challenge we will address in the book.

There are other virtues to a healthy community. Local community government acts as a shield against the policies of the federal government, thus protecting minorities against a possible tyranny of the majority, and serving as a check on federal power. Sanctuary communities in the United States and Europe have resisted cooperating with national immigration authorities in identifying and deporting undocumented immigrants. Under the previous US presidential administration, communities in the state of Arizona resisted in the opposite direction, ignoring the federal government while implementing stern penalties on undocumented immigration.

Although no country can function if every community picks and chooses the laws they will obey, we will see that some decentralisation in legislative powers to the community can be beneficial, especially if there are large differences in opinion between communities.

A critical function the community plays in modern market democracies is to serve as a training ground for aspiring politicians – recall that Barack Obama was a community organiser – with the community itself constituting a ready-made structure for political mobilisation. Furthermore, it is community-based movements against corruption and cronyism that time and again prevent the leviathan of the state from getting too comfortable with the behemoth of big business. Indeed, as we will see in the book, healthy communities are essential for sustaining vibrant market democracies. This is perhaps why authoritarian movements like fascism and communism try to replace community consciousness with nationalist or proletarian consciousness.

In sum, the proximate community is still relevant today, even in cosmopolitan cities where ties of kinship and ethnicity are limited, and even in individualistic societies like those of the United States and Western Europe. Once we understand that the community matters, then it becomes clear why it is not enough for a country to experience strong economic growth – the professional economist’s favourite measure of economic performance. How that growth is distributed across communities in the country also matters immensely. People who value staying in their community are not very mobile. Since they cannot move to work where growth occurs, they need economic growth in their own community. If we care about the community, we need to care about the geographic distribution of growth.

What then is the source of today’s problems? In one word, imbalance! When the three pillars of society are appropriately balanced, society has the best chance of providing for the well-being of its people. The modern state provides physical security, as it always has, but also tries to ensure fairness in economic outcomes, which democracy demands. To do this, the state sets limits on the markets while also ensuring they offer people a level playing field. It also has to make sure that most people have the ability to participate on equal terms in the market, and are buffered against its fluctuations. The competitive markets ensure that those who succeed in it are efficient and produce the maximum output with the resources available. The successful have both wealth and some independence from the state, thus they have the ability to check arbitrary actions by the state. Finally, the people in industrial democracies, engaged in their communities and thereby organised socially and politically, maintain the necessary separation between markets and the state. By doing this they enable sufficient political and economic competition that the economy does not descend into cronyism or authoritarianism.

Society suffers when any of the pillars weakens or strengthens overly relative to the others. Too weak the markets and society becomes unproductive, too weak a community and society tends toward crony capitalism, too weak the state and society turns fearful and apathetic. Conversely, too much market and society becomes inequitable, too much community and society becomes static, and too much state and society becomes authoritarian. A balance is essential!

THE EFFECTS OF TRADE AND THE ICT REVOLUTION ON THE COMMUNITY

The pillars are seriously unbalanced today. The direct effects of the ICT revolution through automation, and the indirect but more localised effects through trade competition, have led to large job losses in some communities in developed countries. Typically, these have been middle-income jobs held by the moderately educated. With male workers least able to adjust, families have been tremendously stressed, with an increase in divorces, teenage pregnancies, and single-parent households. In turn, these have led to a deterioration in the environment for children, resulting in poor school performance; high dropout rates, the increased attractiveness of drugs, gangs, and crime; and persistent youth unemployment. Importantly, community decline tends to feed on itself, as still-functional families escape so that their children do not get affected by the unhealthy environment.

In the United States, minority and immigrant communities were hit first by joblessness, which led to their social breakdown in the 1970s and 1980s. In the last two decades, communities in small towns and semirural areas, typically white, have been experiencing a similar decline as large local manufacturers close down. The opioid epidemic is just one symptom of the hopelessness and despair that accompanies the social breakdown of once-healthy communities.

The technological revolution has been disruptive even outside economically distressed communities. It has increased the wage premium for those with better capabilities significantly, with the best employed by high-paying superstar firms that increasingly dominate a number of industries. This has put pressure on upper-middle-class parents to secede from economically mixed communities and move their children to schools in richer, healthier communities, where they will learn better with other well-supported children like themselves. The poorer working class are kept from following by the high cost of housing in the tonier neighbourhoods. Their communities deteriorate once again, this time because of the secession of the successful. Technological change has created that nirvana for the upper middle class, a meritocracy based on education and skills. Through the sorting of economic classes and the decline of the mixed community, however, it is also becoming a hereditary one, where only the children of the successful succeed.

The rest are left behind in declining communities, where it is harder for the young to learn what is needed for good jobs. Communities get trapped in vicious cycles where economic decline fuels social decline, which fuels further economic decline … The consequences are devastating. Alienated individuals, bereft of the hope that comes from being grounded in a healthy community, become prey to demagogues on both the extreme Right and Left, who cater to their worst prejudices. Populist politicians strike a receptive chord when they blame the upper-middle-class elite and establishment parties.

When the proximate community is dysfunctional, alienated individuals need some other way to channel their need to belong.[4] Populist nationalism offers one such appealing vision of a larger purposeful imagined community – whether it is white majoritarianism in Europe and the United States, the Islamic Turkish nationalism of Turkey’s Justice and Development Party, or the Hindu nationalism of India’s Rashtriya Swayamsevak Sangh.[5] It is populist in that it blames the corrupt elite for the condition of the people. It is nationalist (more precisely, ethnic nationalist, but I will leave the nitpicking for later) in that it anoints the native-born majority group in the country as the true inheritors of the country’s heritage and wealth. Populist nationalists identify minorities and immigrants – the favourites of the elite establishment – as usurpers, and blame foreign countries for keeping the nation down. These fabricated adversaries are necessary to the populist nationalist agenda, for there is often little else to tie the majority group together – it is not really based on any true sense of community, for the differences between various subgroups in the majority are usually substantial.

Populist nationalism will undermine the liberal market democratic system that has brought developed countries the prosperity they enjoy. Within countries, it will anoint some as full citizens and true inheritors of the nation’s patrimony while the rest are relegated to an unequal, second-class status. It risks closing global markets down just when these countries are aging and need both international demand for their products and young skilled immigrants to fill out their declining workforces. It is dangerous because it offers blame and no real solutions, it needs a constant stream of villains to keep its base energised, and it moves the world closer to conflict rather than cooperation on global problems. While the populist nationalists raise important questions, the world can ill afford their shortsighted solutions.

RESTORING THE COMMUNITY PILLAR TO HEALTH

Schools, the modern doorway to opportunity, are the quintessential community institution. The varying qualities of schools, largely determined by the communities they are situated within, dooms some while elevating others. When the pathway to entering the labour market is not level, and steeply uphill for some, it is no wonder that people feel the system is unfair. They then are open to ideologies that propose abandoning the liberal market system that has served us so well since World War II. The way to address this problem, and many others in our society, is not primarily through the state or through markets. It is by reviving the community and having it fulfill its essential functions, such as schooling, better. Only then do we have a chance of reducing the appeal of radical ideologies.

We will examine ways of doing this, but perhaps the most important is to give the power the state has steadily taken away back to the community. As markets have become global, international bodies, driven by their bureaucrats or the interests of powerful countries, have drawn power from nations into their own hands, ostensibly to make it easier for global markets to function. The populist nationalists exaggerate the extent to which power has migrated into international bodies, but it is real. More problematic, within a country, the state has usurped many community powers in order to meet international obligations, harmonise regulations across domestic communities, as well as to ensure that the community uses federal funding well. This has further weakened the community. We must reverse this. Unless absolutely essential for good order, power should devolve from international bodies to countries. Furthermore, within countries, power and funding should devolve from the federal level to the communities. Fortunately, the ICT revolution helps in doing this, as we will see. If effected carefully, this decentralisation will preserve the benefits of global markets while allowing people more of a sense of self-determination. Localism – in the sense of centering more powers, spending, and activities in the community – will be one way we will manage the centrifugal disorienting tendencies of global markets and new technologies.

CIVIC NATIONALISM

Instead of allowing people’s natural tribal instincts to be fulfilled through populist nationalism, which combined with national military powers makes for a volatile cocktail, it would be better if they were slaked at the community level. One way to accommodate a variety of communities within a large diverse country is for it to embrace an inclusive civic definition of national citizenship – where one is a citizen provided one accepts a set of commonly agreed values, principles, and laws that define the nation. It is the kind of citizenship that Australia, Canada, France, India, or the United States offer. It is the kind of citizenship that the Pakistani-American Muslim, Khizr Khan, whose son died fighting in the United States Army, powerfully reminded the 2016 Democratic National Convention of, when he waved a copy of the United States Constitution. That document defined his citizenship and was the source of his patriotism.

Within that broad inclusive framework, people should have the freedom to congregate in communities with others like themselves. The community, rather than the nation, becomes the vehicle for those who cherish the bonds of ethnicity and want some cultural continuity. Of course, communities should be open so that people can move in and out if they wish. Some will, no doubt, prefer to live in ethnically mixed communities while others will choose to live with people of their own ethnicity. They all should have the freedom to do so. Freedom of association, with active discrimination prohibited by law, has to be the future of large diverse countries. We will eventually learn to cherish the other, but till then let us live peaceably, side by side if not together.

Markets too must become more inclusive. Large corporations dominate too many markets, increasingly fortified by privileged possession of data, ownership of networks, and intellectual property rights. Credentialed licensed professionals dominate too many services, preventing competition from those who do not have the requisite licenses (one reason friendly neighbours cannot help rebuild a house today). In every situation, we must locate barriers to competition and entry and remove them so that opportunity is available to all. Thus, as we strive for an inclusive state and inclusive markets, which embed the empowered community in society and keep it engaged and dynamic, we will achieve an inclusive localism, which will be essential to community revival and a rebalancing of the pillars.

Even in such a setting, though, community effort to pull itself up will be critical. Consider the community of Pilsen on the southwest side of Chicago, a few miles from my home. This once terribly damaged community is now turning a corner.

A Real Community Pulling Itself Up

Pilsen used to be populated by Eastern European immigrants, working in manufacturing establishments around Chicago. Since the middle of the last century, Hispanic immigrants and African Americans moved in steadily, and the Eastern Europeans moved out.[6] In 2010, Hispanics or Latinos made up 82 per cent of the population, and African Americans 3.1 per cent. Non-Hispanic whites composed 12.4 per cent of the population in 2010, up from 7.9 per cent in 2000.

Pilsen is poor, with median household income averaged over 2010–2014 at $35,100, about half that of metropolitan Chicago as a whole. It has an unemployment rate of nearly 30 per cent averaged over 2010–2014. Over 35 per cent of individuals over twenty-five have not graduated from high school. Only 21.4 per cent of individuals over twenty-five have a bachelor’s degree, less than half the comparable ratio in the overall US population. Nearly half of renters or homeowners have housing costs that account for more than 30 per cent of their income. Keeping people in their homes is essential for community stability, and Pilsen has a hard time of it.

Low education, low incomes, and high unemployment are a recipe for drugs, alcohol, and crime. At its peak in 1979, there were 67.4 murders per 100,000 residents in Pilsen, over double the wider city rate. In comparison, Western Europe averages a murder rate of about 1 per 100,000 per year. The average military death rate for Germany and the Soviet Union during World War II was about 140 per year per 100,000 of population.[7] Pilsen was thus truly a war zone – in 1988, a Chicago Tribune reporter counted twenty-one different gangs along a two-mile stretch on the main 18th Street thoroughfare. The 1980s and 1990s were years of horrific gang fights and bloodshed.

Yet Pilsen is a community that is trying to pull itself up. One sign it is succeeding is that the murder rate has been significantly below the overall Chicago rate for a number of years since the early 2000s, exceeding it slightly only every few years. As we will see, communities typically do not pick themselves up spontaneously – leaders emerge to coordinate the revival. Among those driving Pilsen’s revival is Raul Raymundo, the CEO of the Resurrection Project, a nongovernmental organisation (NGO) whose motto is ‘Building relationships, creating healthy communities.’ Raul came to the United States from Mexico as a seven-year-old immigrant, went to Benito Juarez High School in Pilsen, attended college (including some time in graduate school at the University of Chicago), and started helping out in the community. He found his vocation after the murder of a young man just outside his church, when his pastor asked the congregation what the community was going to do about it. Answering the call, Raul and a few others started the Resurrection Project, with $5,000 each from six local churches. When the candidate they found to head the project declined to take the job, Raul stepped in, and he is still there, after twenty-seven years. Today, the Resurrection Project has funneled over $500 million in investment into the community.

As with other revival projects, the community first undertook an inventory of its assets to figure out what it could build around. It had its churches that would provide moral, vocal, and financial support for any revival, it had decent schools, it had a strong Mexican-American community with tightly knit families, and it was in Chicago, a city that goes through ups and downs but is still one of America’s great cities.

The first order of action was to make the community more livable, which meant keeping it clean, ridding the streets of crime, and strengthening the schools. Residents were organised to hound the city sanitation department to do their job – clean the streets and collect garbage. People were urged to form block clubs and ad hoc groups against crime. They would walk out of their houses when they saw suspicious activity so as to crowd the criminals out, or jointly call the police so that the criminals would not know who to blame. The community campaigned successfully for a moratorium on city liquor licenses in Pilsen, got some especially problematic bars closed down, and worked with police, churches, and absentee landlords to target and close down known gang houses.[8] Remedial education, after-school extracurricular programmes, and job-training programmes increased, enabling young people to get more from their schoolwork, and giving them a ladder to jobs. Parents were urged to get involved in the schools, and they did. New school programmes started – one example is the Cristo Rey Catholic School, which aims to give its students a quality education like that obtainable at St. Ignatius, one of Chicago’s premier Catholic schools, while keeping it affordable. Cristo Rey raised funds from local businesses, in return for which students work one day a week for their sponsoring business. The student attends school the other four days, getting both a good education and work experience each week.

As the community members saw revival efforts paying off, they got more engaged, and virtuous cycles started emerging. As some older gang members turned to legitimate business, their prosperity inspired other gang members to develop skills other than the ability to inflict violence. The proliferation of youth-oriented programmes at the schools gave them a way to escape their past. As crime came down, new businesses started opening, including franchises like McDonald’s, and they offered low-level entry jobs that drew youth into work. With Chicago becoming more of a hub for the regional distribution of goods, more jobs were created as wholesale warehouses and refrigeration centers opened in Pilsen, drawn by the still-low real estate prices and falling crime.

With the area more livable, the Resurrection Project turned to keeping the poor, some of who have very few assets and very little buffer against a sudden loss of job or illness, in their rented homes. This would stabilise the community. Ironically, it is getting harder as the community strengthens because rents are increasing and buying is becoming costlier. Large banks, of which a growing number have now set up in the community, are not well equipped to understand community practices. This hampers their lending. In Pilsen, a working woman’s mother will often cook for her and babysit her children, so the worker’s salary goes a much longer way because she does not pay for these services. Similarly, family members may lend each other money, making it possible for someone to keep up loan payments even if their income is volatile. Typically, such practices are hard for a loan officer from a large bank to substantiate or document, which is why he has to go primarily on the explicit record of income.[9] Community-based financial institutions, where decisions are made locally based on the soft information available in the community, understand the worker is more creditworthy than her salary slip might suggest. Being free from the tyranny of requiring hard documentation, they are more willing to lend locally than large banks.

Recognising the importance of local institutions, in 2013 the Resurrection Project helped rescue a failing community bank, Second Federal. At that time, 29 per cent of the bank’s mortgages were delinquent, and many local borrowers would have faced eviction if the bank had been closed or sold outside the community. Vacancies would have depressed house prices and brought back crime. Second Federal’s delinquencies are now down to 4 per cent of its mortgage portfolio, because it worked with its borrowers and nursed the loans back to health. People continue to use its branch as a community center, meeting there to chat with neighbours, or bringing their mail to have it translated by tellers.

The Resurrection Project has itself built affordable housing that it rents to needy families, nudging them to move out when they can afford market rents. One of its developments, Casa Queretaro, looks sleek and welcoming, seeming more luxury housing than affordable – in management’s view, there is no reason why so much affordable housing should look run down. The Resurrection Project also tries to increase access to credit locally. Its volunteers work with community members to improve their financial understanding, to get them to build and improve their credit histories by, for example, paying their utility bills regularly and on time.

There is much more to community revival, but the picture should be clear. Pilsen is by no means a rich or prosperous community but it now has hope. It has built on its Mexican connections – it has a National Museum of Mexican Art – though it is proudly American. Cinco de Mayo, a Mexican festival, is celebrated with great gusto, but over two hundred fifty thousand people join the Fourth of July parade in Pilsen. Raul Raymundo’s aim is to welcome people of every ethnicity into Pilsen while building on the core stability of the existing community. As he tells people when they buy a house, ‘You are not buying a piece of property, you are buying a piece of the community.’

FINAL PRELIMINARIES

Who am I and why do I write this book? I am a professor at the University of Chicago, and I have spent time as the Chief Economist and head of Research at the International Monetary Fund, where we gave advice to a variety of industrial and developing countries. I also was the Governor of India’s central bank, where we undertook reforms to improve India’s financial system. I have experience working in both the international financial system and in an emerging market. In my adult life, I have never been more concerned about the direction our leaders are taking us than I am today.

In my book Fault Lines: How Hidden Fractures Still Threaten the World Economy, published in 2010, I worried about the consequences of rising inequality, arguing that easy housing credit before the Global Financial Crisis was, in part, a way for politicians to deflect people’s attention from their stagnant paychecks. I was concerned that instead of drawing the right lesson from the crisis – that we need to fix the deep fault lines in developed societies and the global order – we would search for scapegoats. I wrote:

‘The first victims of a political search for scapegoats are those who are visible, easily demonised, but powerless to defend themselves. The illegal immigrant or the foreign worker do not vote, but they are essential to the economy – the former because they often do jobs no one else will touch in normal times, and the latter because they are the source of the cheap imports that have raised the standard of living for all, but especially those with low incomes. There has to be a better way …’[10]

The search for scapegoats is well and truly on. I write this book because I see an increasingly polarised world that risks turning its back on seventy years of widespread peace and prosperity. It threatens to forget what has worked, even while ignoring what needs to change. The Populist nationalists and the radical Left understand the need for reform, but they have no real answers as they resort to the politics of anger and envy. The mainstream establishment parties do not even admit to the need for change. There is much to do, and the challenges are mounting. The state, markets, and the community can be brought into a much better balance. We must start now.

The rest of this book is as follows. I start by describing the third pillar, the community. To some, the community stands for warmth and support. To others, it represents narrow-mindedness and traditionalism. Both descriptions can be true, sometimes simultaneously, and we will see why. The challenge for the modern community is to get more of the good while minimising the bad. We will see how this can be obtained through the balancing influence of the other two pillars – the state and markets. To continue our exploration, we must understand how these pillars emerged historically. In Part I, I trace how the state and markets in today’s advanced countries grew out of the feudal community, taking over some of its activities. I explain how a vibrant market helped create independent sources of power that limited the arbitrary powers of the state. As the state became constitutionally limited, markets got the upper hand, sometimes to the detriment of communities. The extension of suffrage reempowered communities and they used it to press the state to impose regulatory limits on the market. People also demanded reliable social protections that would buffer them against market volatility. All these influences came together in the liberal market democracies, which emerged across the developed world in the early twentieth century. However, market downturns, especially following technological revolutions, were, and are, disruptive. The Great Depression, followed by the Second World War, seemed to sound the death knell of liberal market democracies in much of the world, and the ascent of the state.

In Part II, I describe how the United States shaped the postwar liberal order, and how both the state and markets grew once again. Democracy was given firmer roots. The thirty years of strong postwar growth, however, were followed by years of relative stagnation as developed countries struggled for new ways of reviving growth. In response, the Anglo-American countries empowered the markets at the expense of the state, while continental European reforms favoured the superstate and the integrated market. Both sets of reforms came at the expense of the community. These different choices left countries differently positioned for the ICT revolution, the subsequent Global Financial Crisis, and the backlash against the global order. I describe the reasons for the rise of populism and trace related developments in China and India.

I turn to possible solutions in Part III. To strengthen the chances that society will stay liberal and democratic, we need profound changes that rebalance the three pillars in the face of technological change. We need more localism to empower the community while drawing on the state and markets to make society more inclusive.

Finally, some caveats. I intend this book to be comprehensive, but not exhaustive. Therefore, I illustrate the course of history with examples from prominent countries, but it would tax the reader’s patience (as well as my editor’s) if I substantiated points with the detail that specialists require. This book offers a broad thesis of its own, and draws on much academic work, but it is aimed at a wide audience. I also offer policy proposals, not as the final word but to provoke debate. We face enormous challenges, to which we need not just the right solutions but also ones that inspire us to act. It is worth recalling the words of Chicago architect Daniel Burnham, ‘Make no little plans; they have no magic to stir men’s blood and probably themselves will not be realized.’[11] I hope this book stirs your blood.

## INTRODUCTION. THE THIRD PILLAR

Why do our neighbours matter when we can reach people across the world with a click? What role do proximate communities play today in an advanced country that has both a well-functioning state and vibrant markets? Despite the state and markets having taken up many of the early community’s functions, the proximate community still performs important ones. It helps define who we are. It gives us a sense of empowerment, an ability to shape our own futures in the face of global forces. It also offers us help in times of adversity when no one else will. Of course, the community can also be narrow-minded, traditional, and resistant to change. A successful modern community supports its members even while being more open, inclusive, and dynamic. We will see why it is difficult for a community to do all this, but also why it is necessary if the community is to address the problems we face.

THE PROXIMATE COMMUNITY

We are shaped by the people who surround us. Our joys are more pleasurable when they are cherished by our friends, our successes more enjoyable when they are applauded by those whose opinions we care about, our protests are less lonely and our indignation less unsure when shared by our supporters, our hatreds more corrosive when goaded by fellow zealots, our sorrows less burdensome when borne with our family. Moreover, we gauge our actions based on how they affect people near us, on the indentations our actions make on their lives. Without such effects, we would be ephemeral passersby, with little evidence of ever having existed. Each one of us draws from multiple overlapping communities that help define who we are, that give us identity over and above the core we think is uniquely us.

There are varieties of communities, some more tightly bound than others. A community could be a group of people who are linked together by blood (as a family or clan) or who share current or past physical proximity (as people in, or having emigrated from, a village). A community could be those who have a common view on how to live a good life (as in a religious sect), share a common profession (as in the movie industry), or frequent the same website or chat groups (as in my college alumni group, where everyone seems to have a different opinion on everything that they absolutely must express). Each one of us has multiple identities, based on the groups we belong to.[1] Moreover, some of us have virtual identities in addition to real ones.

As communication has improved, and transportations costs have come down, more distant communities have gained importance. For some of us, these communities may be much more important than our neighbourhood. Indeed, a central concern in this book is about the passions that are unleashed when an imagined community like the nation fulfills the need for belonging that the neighbourhood can no longer meet.

Nevertheless, we will focus on the proximate community for much of the book for a variety of reasons. Through most of history when distances really mattered, it was the only kind of community that had a serious influence on most people’s lives. Even today, it is where much economic activity is centered. For most of us, the neighbourhood is still what we encounter every day, and what anchors us to the real world. It is where we participate as sociable humans, not as clan members, co-religionists, professionals, or disembodied opinions on the web. It is where we have the best chance of persuading others that our humanity unites us more than our ethnicity, profession, or national origin differentiates us. It certainly is where we debate and persuade as we elect officeholders and participate in the governance of the local public services that affect us. It is where we congregate to start broader political movements. As we will see later in the book, a healthy, engaged, proximate community may therefore be how we manage the tension between the inherited tribalism in all of us and the requirements of a large, diverse nation. Looking to the future, as more production and service jobs are automated, the human need for relationships and the social needs of the neighbourhood may well provide many of the jobs of tomorrow.

In closely knit communities, a variety of transactions take place without the use of money or enforceable contracts. One side may get all the benefits in some transactions. Sometimes, the expectation is that the other side will repay the favour, but this may never actually happen. In a normal family, members typically help one another without drawing up papers and making payments. In many societies, friends don’t really care who pays the bill at dinner, indeed the ability to not keep count is the mark of true friendship.

Contrast transactions within a community with a typical market transaction. I just bought a bicycle tire tube. I searched for one of adequate quality at a reasonable price through an online platform, paid by credit card, and the tube was delivered within the time promised. Even though this transaction took little time, there is an elaborate explicit understanding or contract behind it. If the tube is not delivered or it proves defective, I have contractual remedies. The transaction is arm’s length and one-off. Neither the seller nor I know each other. Each one of us is satisfied we are better off from the transaction even if we never transact again. We do not look for further fulfilment through a continuing relationship.

The more explicit and one-off the transaction, the more unrelated and anonymous the parties to the transaction, and the larger the set of participants who can transact with one another, the more the transaction approaches the ideal of a market transaction. The more implicit the terms of the transaction, the more related the parties who transact, the smaller the group that can potentially transact, the less equal the exchange, the broader the range of transactions and the more repetitive transactions are over time between the same parties, the more the transactions approach a relationship. The thicker the web of relationships tying a group of individuals together, the more it is a community. In a sense, the community and the market are two ends of a continuum.

In his magisterial work, Gemeinschaft und Gesellschaft (‘Community and Society’), nineteenth-century German sociologist Ferdinand Tönnies argued that in a community tied together by strong relationships, individual interests are suppressed in favour of the collective interest whenever these interests diverge. By contrast, in a market transaction, ‘nobody wants to grant and produce anything for another individual, nor will he be inclined to give ungrudgingly to another individual, if it not be in exchange for a gift or labour equivalent that he considers at least equal to what he has given.’[2] In this sense, only individual interests matter, and they have to be met transaction by transaction.

In this chapter, we will examine what makes communities useful.[3] Those hearkening to the past, as in many a fantasy novel, often invoke an idyllic view of the community. Typically, this is a village – an arcadia where simple honest people look out for one another, offering goods and services without demanding prompt or equal compensation. The village community can be warm and supportive. Yet, it can also be small, closed, and intrusive. We will see how a community facilitates economic and social transactions, but we’ll also recognise there are limits to community effectiveness, and indeed situations where a community may be harmful to its members’ interests. That will be why a community works best as part of the balance.

THE POSITIVE ROLES OF THE COMMUNITY

Evolutionary psychologists argue that we help others who are related to us or look like us because it is genetically hardwired into us – to the extent altruism toward kin is a genetic trait that helped its own survival in the Stone Age, when much of our evolution happened, it helped itself be passed on.[4] Similarly, we may be genetically evolved to help others, provided they reciprocate the favour, and we are programmed to have a strong distaste for freeloaders who do not. Since evolution is slow, we are fully adapted to the challenges of the Stone Age, and we continue to retain such propensities, even if no longer critical for survival. In other words, we are predisposed to be social.

We have built on this predisposition. People have always banded together because a group is better at defense (or attack) than an individual. In modern society, healthy communities continue to police themselves and their surroundings to ensure safety for their members. They do more, though – much more.

They offer their members a sense of identity, a sense of place and belonging that will survive the trials and tribulations of modern life. They do this through stories, customs, rituals, relationships, and joint celebrations or mourning so that when faced with a choice between self-interest and community interest, or between community members and others, members are more inclined to put their own community first. Often, communities inculcate shared values and goals in members, as well as imbue in them a sense of personal utility from various actions that benefit the community.

The community also monitors economic transactions as well as noneconomic ‘favours’ within the community, and it sees that everyone delivers their promised part fairly, if not immediately then over time. It assists those falling behind, as members contribute to those in need. It also aggregates the capabilities of all its members and brings them to bear to enhance collective well-being. Let us examine all these roles in greater detail.

Survival: Training and Socialising the Young

A community needs to train its young to be productive, to take over from current adult members as they age. Equally important, the values of the young members have to be shaped to protect the well-being of the community. Most communities train their young through apprenticeships, where they are taught skills and learn to internalize the norms and values of the community.

Apprenticeship often ends with a rite of passage that signals the coming of age of a youth into adulthood. In a number of tribes such as the Aborigines in Australia or the Papuans of New Guinea, the rites were so physically brutal that those up for initiation occasionally died.[5] Not only did the ordeal prevent those who did not have the requisite tolerance for pain, or desire for greater power and responsibility in the tribe, from achieving full manhood, but those who did survive it also would likely be even more committed to the tribe. Modern communities like fraternities at colleges, law firms, research universities, or the military have their own rites of passage, differing only in the degree of physical or mental pain from tribal initiation ceremonies.

The community plays a very important role in supporting education, even in modern schooling systems. As Chicago Nobel laureate economist James Heckman emphasises, a child’s attitudes toward learning, as well as her future health, are shaped in the critical preschool years where the family and community matter far more than the formal education system. Moreover, even after children enter the formal schooling system, the community determines whether they make use of it to the fullest extent. Whether children are given the time, encouragement, and the support to do homework depends on the environment at home and the attitude of their friends toward academic effort.

Linkages between the school and the community are also important. Parents will be more eager to monitor and support teaching if they feel they can influence how the school is run – many successful schools draw on parents for school boards, for staffing and supporting extracurricular programmes, as well as for providing funds for equipment that is not accounted for in the normal budget. Communities help the young outside schools, whether it is through preschool learning, summer jobs, or watching out for, and counseling, teenagers who might stray. Equally, teachers, coming from the community, can work to build alternative local social supports for students whose families are broken. Schools are also an important focal point for parents to build mutual friendships, as they are drawn together in a common endeavour.

The community shapes the views of its members about one another, so as to encourage mutual support. The elderly are a store of knowledge and have experiences and wisdom that can be very important in guiding the community. Nevertheless, in environments where reproductive capabilities matter enormously or much of the work is physically taxing, the elderly may be a dispensable burden. To give the elderly an incentive to share their wisdom, even while protecting their position, the socialisation process often inculcates respect for age. In modern South Indian Brahmin marriages and coming-of-age ceremonies, the elderly have an important position as they guide the young on the specific rituals to be followed. The young signal their acceptance of the natural order by repeatedly prostrating themselves before anyone older, asking for their blessings. Rank or position in the outside world is immaterial in determining who prostrates themselves before whom – all that matters is age. More generally, communities may allocate authority and power in ways that have nothing to do with economic capability, but help keep the community together.

Creating Binding Social Relationships

In close-knit communities, few transactions are explicit exchanges of broadly equal values. A mother nurses her child with no thought of sending a bill for services rendered, while we ply dinner guests with food and wine with no concern of when they will reciprocate. As ties get weaker in the community, more reciprocity is expected, but usually in such a way that the original gesture is never fully reciprocated so as to ‘close the account’.

American anthropologist Laura Bohannan spent years working with the Tiv people of Northern Nigeria. When she arrived to study the community, she was inundated with gifts by the very poor villagers – a common experience for guests in traditional societies. Not wanting to appear rude, she accepted them but was eventually taught the appropriate etiquette by the headman’s wife, who told her to ‘stop wandering aimlessly about the countryside and start calling to return the gifts’ she had received. Bohannon concluded:

‘What had been given must be returned, and at the appropriate time – in most cases, within two market weeks. For more valuable gifts, like livestock, one should wait until the giver is in sudden need and then offer financial aid. In the absence of banks, large presents of this sort are one way of saving…. I couldn’t remember [who gave what]; I didn’t think anyone could. But they did, and I watched with amazed admiration as Udama [the headman’s wife] dispensed handfuls of okra, the odd tenth-penny and other bits in an endless circle of gifts in which no one ever handed over the precise value of the object last received but in which, over months, the total exchange was never more than a penny in anyone’s favour.’ [6]

Gifts among the Tiv, as in most societies, serve to strengthen social bonds. That a gift is not returned in exact and equal measure prevents gift exchange from becoming a market transaction. Indeed, the very point is that nothing is demanded in return by the giver – social ties are built only when the giver seemingly forgets the gift as soon as it is given. Yet someone who only receives and never gives is quickly ostracised, hence the advice to return the gifts. Relationships are built not just by offering gifts but also by offering services. As Bohannan sat with neighbours assisting a woman’s childbirth, she reflected:

‘I also remembered that my great-grandmother had her first child alone with her husband on the frontier; in her diary, she had longed for another woman then…. More generally, though, I could see that where we multiplied specialists and services, these people multiplied personal relationship …’

In small communities where there are few specialists to provide services, neighbours fill in the gaps. For example, in Amish communities in rural Pennsylvania, everyone comes together in ‘barn raisings’ to build a barn for someone in the community. It is as much a community celebration as collective work. Such actions broaden the areas of interaction and help deepen relationships within the community. Indeed, every transaction within a community, whether economic or not, is just the most recent link in a set of cross-linked block chains which stretch back into the past, and likely will well into the future.

The ties within a community enable it to act as a support of last resort. When all is lost, we can always return to our family or village, where we will be helped because of who we are rather than what we can pay or what we have accomplished. A study finds that 20 per cent of households within a caste group in India in 1999 sent or received transfers of money.[7] The transfers amounted to between 20 and 40 per cent of the receiving household’s annual income. Each sending household sent between 5 to 7 per cent of its annual income, implying a number of them combined to help a household that had major contingencies like illness or marriage. Even with modern sources of social insurance such as unemployment benefits and pensions, the community is critical in filling holes that are left by the formal government and market systems.

Facilitating Transactions

Communities facilitate internal trading by monitoring behavior and ostracising defaulters, cutting them off from further transactions and community support.[8] Some embed differential treatment of insiders and outsiders into their norms. Anthropologist Douglas Oliver observed that to the Siuai of Solomon Islands, mankind consists of relatives and strangers. ‘Transactions with relatives ought to be carried out in a spirit devoid of commerciality.’ With few exceptions, however, ‘persons who live far away are not relatives and can only be enemies … One interacts with them only to buy and sell – utilising hard bargaining and deceit to make as much profit from such transactions as possible.’[9] With such an attitude, it would take a particularly confident outsider to contemplate trading with the Siuai, ensuring outside trades would be few and far between. But that may be the point! Parochial as the attitude may seem, it fortifies the community by strengthening within-community trade and limiting opportunities for members to stray outside.

Encouraging Favours and Resolving Conflicts

Bonds between members are obviously stronger if they grow up together, undergo common socialisation processes and rites of passage, and share common values and traditions. However, bonds can also build between members of a community in a more modern setting where they come together only in adulthood. Indeed, despite having access to a modern legal system, neighbours may rely on community norms to resolve potential conflict because it is cheaper.

Robert Ellikson, a legal scholar at Yale University, studied ranchers in Shasta County in Northern California and found that their community had developed a variety of unwritten norms to deal with various frictions. For example, cattle from one ranch might trespass onto another rancher’s land. If that rancher discovered an animal wearing someone else’s brand, he would inform the owner. The owner, though, might take weeks to pick up his animal in a collective roundup – it is too costly to go fetch each animal as it strays. In the meantime, the rancher would incur costs of hundreds of dollars for feeding the trespassing cattle. Nevertheless, he typically did not charge the owner for this.

Ellikson conjectures this is because in the thinly populated rural areas of the county, neighbours expect to interact with one another on multiple dimensions such as fence repair, water supply, and staffing the volunteer fire station, and these interactions will extend far into the future. Any ‘trespass dispute with a neighbour is almost certain to be but one thread in the rich fabric of a continuing relationship.’ Therefore, most residents expect giving and receiving to balance out in the long run – a shortfall in the trespass account will be offset by a surplus in the fence repair account.

Accounts need not balance over time. When a transfer is necessary to square unbalanced accounts, neighbours in Shasta County prefer using in-kind payments, not money, for the latter is thought ‘unneighbourly’: If one’s goat eats a neighbour’s plants, the neighbourly thing to do would be to replant them, not offer money. Indeed, when one of the ranchers paid to settle a trespass dispute, others rebuked him for setting an unfortunate precedent.[10] The point is that neighbours prefer to keep an ongoing cooperative relationship rather than end it through ‘cold hard cash’, which can signal an arm’s-length dealing and poison the atmosphere. It is the web of credit and debit accounts within Shasta County ranchers, settled with favours rather than with money so that no one quite knows what the balance is, that seems to tie the community together.

In every such community, there will be potential deviants, who are happy to take but will not give. Ellikson describes a rising set of penalties for defaulters, starting with adverse gossip within the close community. A besmirched reputation is enough to stop the flow of favours, so most ranchers are very careful not just about adhering to the norms but about being seen to be adhering to the norms. If the deviant does not really care about his good name, aggrieved ranchers may take sterner action like killing the trespassing animals after giving the owner due warning, or reporting the owner to county authorities. While disputes are resolved under the shadow of the law, legal remedies are rarely invoked, and even then, typically against outsiders. As one rancher put it, ‘Being good neighbours means no lawsuits.’[11] More generally, as we will see, communities can be diminished by the intrusion of the state, and it is not surprising that Shasta County tries to avoid relying on it.

THE VALUE OF COMMUNITY

It is easy to see why the community is so appealing. Apart from contributing to our sense of who we are, a richer range of transactions can be undertaken within the community than would be possible if everything had to be contractual and strictly enforced by the law. The record of what one does for the community continues to be visible in the community, and it does not vanish into an anonymous marketplace. This leads to greater pride, ownership, and responsibility. The community comes together to raise its young and to support its weak, elderly, and unlucky. Because of its proximity, and the degree of information it receives, the community can tailor help to the specific needs of the situation. It also recognises freeloaders far better than any distant government could and can shut down their benefits. As a result, given any quantity of available resources, it can offer a far-higher level of benefits to the truly needy. Communities therefore aid the individual, preventing them from drifting – untaught, unaided, and unanchored – in life.

The work of economic theorists like Oliver Hart, who won the Nobel Prize in Economics in 2016, offers a related explanation for the economic value of communities. The real world is plagued by the problem of incomplete contracts. We cannot fully anticipate what will happen in the future, and even if we can, we do not have the ability to prove who did what, and when, to the satisfaction of a court of law. We cannot thus write the full range of arm’s-length contracts that would be necessary to deal with all the problems that might arise in real life. For instance, to deal with the problem of stray cattle with explicit arm’s-length contracts, every rancher would have to contract with every other rancher on what ought to be done if his cattle strays, as well as on the necessary payments for services rendered. With little ability to verify when the cattle wondered off the ranch, or what the quality of their treatment was in the hands of the rancher who found them, lawsuits could proliferate. The system of implicit community responsibility and enforcement might be far more effective in protecting cattle and minimising transactions costs than using explicit contracts and the legal system. Communities thus can be more than the sum of individuals who compose them.

Finally, an important modern function of communities is to give the individual in large countries some political influence over the way they are governed, and thus a sense of control over their lives, as well as a sense of public responsibility. Well-structured countries decentralise a lot of decisions to local community government. To the extent that individuals can organise collective political action within the community more easily, it affords them a vehicle to affect issues on a national stage. The community then magnifies the power of the individual. We will return to the political role of the community later in the book.

DYSFUNCTIONAL COMMUNITIES

We have seen what functional communities do. Consider now a classic picture of a dysfunctional community and what it does not do. Dysfunctional communities in developed countries can be virtual war zones, with widespread drug addiction, crime, failing schools, and broken families. Who would expect significant public engagement if even leaving home is dangerous? This is why the Pilsen community we discussed in the Preface set about tackling crime as the first step in community revival. However, dysfunctional communities are present in even fairly safe areas around the world.

In the mid-1950s, social anthropologist Edward Banfield spent nearly a year studying a poor village in Southern Italy, to which he gave a fictitious name, Montegrano. The extent of underdevelopment of the village can be gauged by the fact that many of the inhabitants were illiterate and did not have toilets with running water. The village remained underdeveloped even in an Italy that was then undergoing a miraculous economic transformation, in part, as Banfield argues, because of ‘the inability of the villagers to act together for their common good’.[12] Anyone who has been to dysfunctional communities around the world will recognise some of Montegrano in those communities.

The main occupation in Montegrano was agriculture, but with limited untilled land and small land holdings, it was unlikely that peasant families would prosper by staying in agriculture. Even so, the main path of upward mobility for children, education, was largely blocked. Only five grades of school were taught in the village, the schools were poorly equipped, teachers poorly paid, and attendance, both by students and teachers, was irregular. Moreover, ‘After finishing the fifth grade some students can barely read or write or do simple sums … According to a Montegrano school official, one-third of the [school] graduates are illiterate several years after graduation.’[13] Many children did not attend schools regularly, and some farm people sent their children to school willingly only so long as they were too young to work in the fields.

An engineer from Northern Italy, who was shocked at the lack of professionalism among teachers in Montegrano, perhaps best captured what was wrong: He noted that during the summer vacation, a teacher from more prosperous Northern Italy might hold informal classes, take children for walks into the country and explain a bit about nature, or even go on picnics. In contrast, teachers in Montegrano spent their summers ‘loafing in the piazza’, and did not speak to their students when they saw them. The teachers simply did not care if their students learned anything.[14]

Apathy was evident elsewhere too. There were no organised voluntary charities in the village. An order of nuns from outside the village maintained an orphanage for little girls in a crumbling monastery, but even though girls from local families were at the orphanage, ‘none of the many half-employed stone masons has ever given a day’s work to its repair’.[15] There was not enough food for the children, ‘but no peasant or land proprietor ha[d] ever given a young pig to the orphanage.’[16]

The nearest hospital was five hours away by car, and few villagers could afford the trip. There was no organised effort to bring a hospital nearby, despite villagers complaining for years about the lack of access to medical facilities. Stopgap measures to improve access to education and health care, such as rescheduling public bus timings to transport village children to schools elsewhere, or funding an ambulance to carry emergency cases from the area to the hospital, were simply not considered.

A functional community would have put pressure on the local government to improve public services, failing which volunteers would have gathered to undertake the task. While Montegrano had an elected mayor and council, decisions ‘even to buy an ashtray’ were taken by the prefect, a member of the civil service sitting in Potenza, the nearest large town.[17] Similarly, the director of schools reported directly to Potenza, public works were not under the purview of local government, and the police were under the Ministry of Justice in Rome. Too few important decisions were taken locally, a problem we will discuss later in the book, but even so, villagers did not even try to influence them.

The problem in Montegrano, as Banfield argues, was the extreme distrust between villagers, their worry about losing relative social position if they helped someone else improve their lot, and their corrosive envy of those who did succeed. Given this attitude, anyone who undertook a public-spirited action felt they incurred the full costs of acting, would probably receive only a small part of the public benefits, and would feel diminished by the public benefits that went to others. As one teacher explained, not only was there little public spirit, but many people positively wanted to prevent others from getting ahead.[18] Such public apathy explains why voluntary efforts to supply public services – for example, masons repairing the monastery – simply did not emerge.

There are a variety of reasons why these attitudes exist in communities. When economic opportunity is very limited, economic activity might be seen as zero-sum – your gain comes at the expense of mine. The problem is exacerbated when families are at risk of slipping in social status, from the barely self-sufficient but still respectable to the ‘deplorable’, who are dependent on others for subsistence. With few savings and little wealth, many peasants were just one hailstorm or one pig’s unfortunate death away from a winter of deprivation or worse. While families were willing to help one another tide over temporary misfortune, more general public spirit required a degree of comfort with their economic situation that they simply did not have. Given the difficulty of staying afloat economically, villagers’ focus was on providing for their immediate family rather than maintaining a broader public spirit.

This inward focus may actually do public harm. A common example of what Banfield calls ‘amoral familism’ is visible in many developing countries, where people keep their houses spotlessly clean, but unceremoniously dump the garbage collected inside on the street outside. The ultimately self-defeating effects of having unclean and unhygienic public spaces surrounding clean homes can only be explained by extreme public apathy, a fundamental characteristic of dysfunctional communities.

The state, despite being recognisably apathetic, distant, and nonfunctional itself, nevertheless dampened initiative in Montegrano. The faint hope that the government will dig a latrine, pave a road, or discipline school teachers can prevent the local population from organising to do so. In frontier towns in the United States, the community raised a barn or built a road itself, knowing there was no one else who would do it. In dysfunctional communities where the government is closer, the misplaced expectation that the ghost of the inefficient government will eventually appear and do the job crowds out what little private initiative there is.

WHEN DO COMMUNITIES WORK AND WHEN DO THEY NOT?

Communities can be fragile even without becoming dysfunctional. They tend to work best when they are small and have little competition. Community relationships are built when members have limited choices, both at a point in time and over time. Relationships, and thus communities, become more fragile when the available set of choices expands, as when communities grow or when the outside market starts offering more opportunities to community members. Communities can also distort decisions, reducing the incentives for individuals to move, change, or adapt. While this may be the right individual choice, when many members make such choices it can drag down a community.

Too Many Alternatives

Mitchell Petersen of Northwestern University and I were interested in uncovering the effects of the greater availability of potential financial partners on the strength of relationships.[19] We examined the relationships between small firms and their banks. Small firms typically find it hard to get finance, and young small firms especially so. Most economic theories would suggest that in areas with greater bank competition, young small firms would be better off.

Interestingly, we did not find this. Instead, in areas in the United States served by fewer banks, and hence with a less competitive banking market, we found small young firms got more bank loans, and at lower interest rates than similar small young firms in areas with many more banks. Importantly, they also seemed to pay back for this help. As the young firms aged, the interest rate they paid on their borrowings moved up faster in areas with few banks, with older firms paying more in such areas than in areas with more competitive banks.

Why were banks more willing to help out young firms in areas where firms had less choice of banking partners? The answer seemed to be that they knew they could build stronger relationships. As in the community relationships described above, a banking relationship is based on give and take over time. Lending to untried young firms is costly because even a small loan requires a fair amount of due diligence by the banker, and the size of the loan does not allow the bank to recoup the cost of the effort invested quickly. Moreover, many small firms fail, adding further to the bank’s costs as such loans have to be written off. A bank therefore takes a chance on an untried young firm only if it is reasonably confident the firm will survive, grow, and give it more profitable business in the future.

In areas with many banks, a successful firm could always renege on its implicit promise to the bank that helped it early on, by replacing it with a new banking partner at better terms. In areas with few other banks, however, the successful firm would likely stay with its original banker because of the lack of choice, and thus would compensate the bank with additional profitable business for the risk the bank took when the firm was young. A bank in such an area, being more confident in the (forced) durability of the relationship, would then be more eager to support young firms.

Thus, relationships seem to be stronger when the members of the community have fewer alternatives, for it gives the members confidence that they will stay mutually committed. An interesting corollary is that communities within a larger economy that are partially ostracised by others may flourish because members build stronger ties within the community. For instance, a disproportionate number of entrepreneurs during England’s Industrial Revolution were nonconformists such as Unitarians and Quakers, who were excluded from civil or military office and from Oxford or Cambridge University.[20] The silver lining may have been that, given their exclusion from the larger community, nonconformists trusted one another more to continue maintaining business ties, with marriages eventually cementing the community links that provided initial business finance and business partners. Not only was entrepreneurship one of the few attractive career outlets that was not proscribed to capable Quaker youth, many a budding entrepreneur got help from others in the community as he started out.

In sum, in a small community, not only am I assured that those I help will stay committed to me, but I also know if I don’t help someone in deep trouble, my community may shrink and leave me worse off. In a small community, therefore, everyone has a stake in everyone else’s well-being. We are spoiled for choice as the community grows, which could hurt the community.[21]

Relationships also work better if partners interact over multiple activities – if one’s neighbour is not just a source of the odd gardening tool but also helps deliver our child, we are likely to have stronger bonds. However, this requires the community not to have specialists, else most of us would prefer our child be delivered by a professional midwife or gynecologist. There is no point specialising as a midwife if one is to serve a community with only a handful of women of childbearing age, but it makes more sense if there are hundreds – as Adam Smith famously wrote, ‘the division of labour is limited by the extent of the market’. As the community grows larger, therefore, we can call the professional midwife when a child is being born and the professional fire service when a cat is stuck up a tree, instead of our neighbour. Members have more choice, and the quality of goods and services they have access to increases, but the breadth of interactions that take place between members narrows. This social distancing or alienation once again diminishes the strength of relationships and the value of community.

Members could try to preserve a sense of community as it grows larger and more anonymous, urging everyone to take into account community benefits in deciding whether to transact locally or in the larger marketplace. They then run into the free-rider problem. We may all benefit from having a local bookstore, where we can browse through books before buying, and meet for coffee or for book events. It may well be that the associated benefits of building community through purchases from the local bookstore outweigh the lower price from ordering more cheaply online. However, if everyone else does their purchasing locally, the bookstore survives, leaving me free to cheat and patronise the cheaper online bookseller. The anonymity of a larger community will make individual transactions harder to police. When everyone acts in a rational self-interested way, the neighbourhood bookstore closes down, to the detriment of all.

Too Little Incentive to Change

We have just seen that self-interested people do not take into account the loss of benefits to community health when they transact outside the community. Equally problematic is when they rely overly on community support when they make individual decisions, staying too long within the community when the outside makes more sense. One situation where such incentives may be at work is when an important source of livelihood in the community is threatened by technological change or trade. A well-documented tragedy of the Industrial Revolution in England is the fate of the handloom weavers.[22]

The automation of spinning toward the end of the eighteenth century meant that there was much more yarn available to be woven. Automated power looms were only slowly being introduced, so there was strong demand for the labour of handloom weavers to weave the now abundantly available yarn into cloth. Unfortunately, the writing was on the wall – these jobs would be automated also. Indeed, because it was costly to let expensive power looms lie idle, the handloom weavers were already the first to be deprived of work when business slowed. Nevertheless, even as wages in handloom weaving fell as automation and the entry of workers created a labour surplus, the numbers joining the handloom weaving sector continued to increase. Eventually many ended up unemployed and destitute. Why did so many workers continue to stay in, or join, an industry that was so clearly doomed?

We will see such behavior again in modern United States. The explanation cannot be disassociated from community. Handloom weaving meant following the traditional family occupation, staying at home in the village with family and community close by, and enjoying all the benefits of community support. Changing jobs would mean moving to a dirty slum in a town and working in a hot, noisy factory. For the individual household that moved, this would have also meant foregoing the support the community could offer, and essentially tearing up all the implicit claims they had on it. Staying, even if the likelihood of job loss was high, was made less unpleasant by the prospect of community support.

As the entire handloom weaving industry collapsed, though, the weaver communities were severely weakened and unable to provide the support that was expected of them. Destitute unemployed weavers were forced to petition for public support from the government, which never came – in fact, the Poor Act in England was reformed in 1832 to tighten the conditions of eligibility for public relief.[23] While it would not be fair to place the entire burden of this tragedy on the community, it is reasonable to conclude that the presence of the community can distort the decisions of its individual members. When trade and technological change affect many members of the community, their suboptimal individual decisions can end up dragging the community down with them as they place too much of a burden on it.

THE COSTS OF INSULAR COMMUNITIES

Communities through history have understood how detrimental the free and unconstrained choices of their members can be to community survival. For much of history, this did not matter because people had few alternatives, and change was slow. At times of great change, however, communities have had to react. Some of their actions may have made the communities much less useful in promoting social well-being.

Take, for example, the problem of excess outside choice that we discussed earlier. Most obviously, communities can prohibit or restrict contacts between their members and the outside, especially if such contacts can infuse new and uncomfortable ideas or make members more economically independent of the community. As we will see in the next chapter, feudalism was an example of enforced community, and was perpetuated by severe restrictions on what people could do.

Such restrictions are not imposed solely to protect the community, they also protect the powerful in the community against challenge and the community from desirable change. Ellen Barry of the New York Times followed the travails of a group of women from the Nats community in Meerut, a few miles from New Delhi.[24] During the wedding season, the community men worked as musicians in wedding bands, but begging was the traditional off-season occupation for the community. As India started exporting buffalo meat in large quantities, some women started to work in a nearby meat-processing factory, and earned considerably more than their husbands. With the women contributing to family finances, and reducing the extortionate stranglehold of moneylenders, the male elders of the caste, some of whom not coincidentally were moneylenders, struck back. They decreed that the women should stop work, ostensibly so that they would not be exposed to the sexual advances of outside men.

The real reason, Barry surmised, was that the women’s earnings had begun to undermine the existing order. When some of the women refused to obey the decree, they were ostracised by the community. Of course, when community members want to break free, ostracism may have little punitive effect, so it was followed by violence. The women were forced to appeal to the police and the judiciary to protect them, as well as to ensure their constitutional right to work. In older India, neither would the job opportunity have arisen nor would the legal system be open to helping them. Markets and the state do open up the community, reducing the extent to which it can become oppressive.

In addition to remaining small to build relationships, the community may also need to remain small if it is to share information effectively.[25] Apart from the costs of foregone growth, information sharing has its downsides. The community can be very intrusive and cloying, poking its nose in members’ private affairs. Gossip can be helpful in straightening out aberrant behavior, but it can also be mean, hurtful, and intolerant of deviance from age-old traditions. Transparency can highlight budding problems, but those in the community fishbowl, naked to the view of all, may be civil in public while hiding seething resentment. By comparison, the anonymity of the city can be liberating, even though it distances us from social relationships.

The pressure in some communities to stay small and only transact internally can also come at some cost to the broader system. Medieval Chinese master craftsmen typically found apprentices within the family or the close-knit clan. In contrast, the guild system in Europe allowed masters to take on apprentices from almost anywhere, and apprentices, on becoming masters, similarly could move to their hometowns to set up their workshops. According to economic historians de la Croix, Doepke, and Mokyr, a consequence of the looser guild structure in Europe was that technical knowledge was shared widely, improved upon, and shared again.[26] In contrast, it remained relatively stagnant when confined within the clan in China. They argue that this can explain the vast improvements in Europe between 1500 and 1750 in a variety of technical areas, such as watchmaking, relative to China. It is a lesson that we will take to modern times when we examine firms and patent rights later in the book.

Communities may also try and hold together by overemphasising traditions as the source of the community’s strengths. In doing so, the community risks making members suspicious of the choices presented by the modern world, allowing them to become trapped by the past. This is particularly problematic in matters of science. Economic historian Joel Mokyr argues that a major spur to the scientific discoveries in the seventeenth century was the realisation that Aristotle’s scientific observations were often wrong.[27] Equally energizing for scientific progress was the comfort that contemporary scientists like Galileo, Newton, and Leibnitz had extended the boundaries of knowledge far beyond what was contained in the ancient texts, and there was nothing extraordinary or eternal about the classics. This led scholars to challenge old knowledge in every area, breaking from their earlier conformism. In contrast, centres of Islamic learning, perhaps to promote the commonality and thus cohesiveness of historic Islamic thought in a rapidly expanding and disparate community, turned their gaze backward. Islamic scholars, whose predecessors had kept scientific knowledge alive and expanding during Europe’s Dark Ages, started studying older Islamic texts to uncover their eternal verities, and contributed little to the progress of science from the thirteenth century onward.

CONCLUSION

Although communities can be supportive, they are effective in special circumstances. Either community members are socialised to be concerned about the greater utility of the community and its members relative to their own – typically true of groups that grow up together or are ethnically homogenous – or the community needs some surplus value (what economists term ‘rents’) embedded in relationships for members to find cooperation worthwhile. As we saw with banking relationships, arguably the most important problem the community faces is the centrifugal pull of the outside on community members – the competition that emanates from the outside world erodes rents within the community. Ideally, the community would offset that centrifugal pull by the centripetal attraction of the warmth of its relationships and the noncontractual support it provides. Indeed, the point of inclusive localism, as we will see, is to create enough benefits through proximity that the community can afford to be inclusive. Nevertheless, the human desire to protect its valuable relationships and to create new ones by limiting competition and the pull of the outside, will be a recurrent theme throughout the book.

PART I

HOW THE PILLARS EMERGED

There are ninety and nine who live and die

In want and hunger and cold

That one may live in luxury

And be wrapped in a silken fold

The ninety and nine in hovels bare

The one in a palace with riches rare…

And the one owns cities, and houses and lands,

And the ninety nine have empty hands.

PUBLISHED IN THE FARMERS’ ALLIANCE, JULY 31, 1889, AT THE TIME OF THE POPULIST REVOLT IN THE UNITED STATES

In the Introduction, we explored some of the benefits of the community, the third pillar in our narrative, and also saw some of its downsides. In the next four chapters, we go back in history to trace how the three pillars we see today emerged from the original single pillar, the community. We will see the functions of each pillar and the interrelationships between them when society was, arguably, simpler. This will help us understand our current challenges as we recognise in today’s problems echoes from history. Also, we will see that pillars waxed and waned in strength through history, creating disequilibria. Society eventually adapted to restore balance. As we face another period of disequilibrium today, history should give us some confidence that we will find answers.

We start in Chapter 1 with the archetypal medieval community, the European feudal manor. The most valuable asset at that time, land, was rarely sold, since it was tied to a family or clan rather than an individual, and land rights were based on customs that involved feudal rights and obligations rather than explicit ownership. Goods were largely exchanged within the manor. The lord of the manor governed the community, adjudicating disputes and meting out justice. Thus, for all practical purposes, the community also contained the other two pillars. We use the quintessential market transaction, debt, as a focal point, and trace how both the state and markets separated from the feudal community over time. We will also follow changing public and scholarly attitudes towards business and markets, and see they have not been static. Instead, they often mirrored the economic and political necessities of the time, as they do today.

With the rise of the nation state, the state pillar was in ascendance. We turn in Chapter 2 to the emerging nation-state in England, and see how competitive markets helped England solve a fundamental conundrum – how the state can obtain a monopoly of military power within the country, and yet give up its powers to act arbitrarily and outside the law. This is essential for markets to be confident that private property is protected. We will see the importance of an efficient commercially-minded gentry as well as independent businesspersons in aggregating power through Parliament and imposing constitutional checks on the monarchy. Once the state was constitutionally limited, the way was open for truly competitive markets – individuals no longer needed the anti-competitive feudal structures such as guilds that also served to protect them against the state. At the same time, both widely-held private property as well as competitive markets were necessary to create an independent private sector that could protect property and constrain the state. In sum, the constitutionally limited state freed markets and free markets limited the state.

Once the markets were free of the fear of expropriation by the state, they flourished. As we will see in Chapter 3, the market pillar was dominant as countries experienced the First Industrial Revolution but often to the detriment of the community. The fight for broader suffrage was, in many ways, a fight by the community for more democratic power, this time to protect labour, not just physical property. The empowered community then, through movements like those of the Populists and the Progressives in the United States around the turn of the nineteenth century, played its role in restoring the balance by pressing the state to keep markets competitive and opportunity alive for the many.

The democratic community may not always want markets. In Chapter 4, we will outline three situations when the community does not push for competitive markets – when market players or practices are deemed illegitimate and the state seems a better alternative, when the state is weak and the community is easily bribed to stay apathetic, and when neither the state nor the community offer people the capabilities and the support they need to participate in volatile, changing markets. For people to desire markets, an effective state together with an engaged community have to create mechanisms that will provide people the capabilities and support that will allow them to benefit from markets. We will see how the balance came together in the liberal market democracies that emerged across the developed world by the early twentieth century. We will cover a thousand years of the evolution of the pillars in four chapters – a little too fast for the historians, but just right for our purpose, which is to give a sense of what problems they solved.

History’s lessons are important. They will give us a sense of why each pillar matters and how the pillars fit together to produce the liberal market economy. Patterns of their interaction reproduce, not exactly but recognisably. Nevertheless, readers who want to jump ahead to recent times might skim through Part I and go to Part II, where we move quickly through the post World War II–era to explain the genesis of today’s problems. They could then come back to Part I for a historical perspective.

## [1]. TOLERATING AVARICE

In this chapter, we will see how the markets and the state separated from the medieval manor community and became powerful pillars in their own right. We will follow these developments through the use of the quintessential market contract: debt. The Catholic Church will play a cameo role in this story, initially filling the vacuum left by the absence of a strong state, then competing with the state to both protect and exploit people. Crucially, though, for our narrative, the Church managed to stand up to the state, armed only with the power of religion. It established the idea that there was a higher legitimacy that constrained state actions, over and above temporal power. As we will see, this was an important step toward a constitutionally limited state, which in turn was necessary for markets to have full play.

THE DEBT CONTRACT

Unlike the favours we have been discussing between members of a community, a loan contract is an explicit commitment by a borrower to repay the loaned amount with interest at a prespecified time, failing which the lender will be able to use the force of the law to recover the value lent. Typically, she will do so by seizing pledged collateral. If the security offered by the borrower is valuable – such as a farmer borrowing against his land – the lender need not know very much about the borrower or monitor his activity closely. By making terms explicit, the debt contract frees the lender from dependence on the whims or fortunes of the borrower. No longer is it the borrower’s choice whether to repay and when to do so – he must pay on the contract’s maturity or face the stipulated penalties, which in some societies were as harsh as slavery or death. Since the debt contract is written down, it is not dependent on the frailty of human or community memory. Favours can be forgotten – debt cannot.

Debt is thus an arm’s-length exchange of money for interest, untrammelled by the need to maintain social ties. This can draw in lenders from outside the community. In fact, such lenders may be the best at getting repaid because they will not sympathise with a borrower who has fallen on hard times, unlike a lender from within the community. Shylock, who hated Antonio, Shakespeare’s merchant of Venice, was, in a sense, the ideal lender, since he was perfectly willing to take his pound of Antonio’s flesh if Antonio did not repay the debt. Because Antonio then had every incentive to repay, Shylock was willing to lend.

These attributes of debt – that it is explicit, often secured by collateral, and impersonal – seem to favour the lender. They also make it much easier, though, for a potential borrower to get a loan at a low interest rate in competitive environments – somewhat paradoxically, the harsher the debt contract and the more it seems weighted in favour of the lender, the greater and broader the borrower’s access to finance. If, in contrast, sympathetic courts were to suspend the lender’s power to recover whenever the borrower was in difficulty, lenders would not be eager to lend to anyone who was even moderately risky, and lending would dry up. The few loans that would still be made to risky borrowers would be at sky-high interest rates. So it is from the very harshness of the debt contract, and the lender’s ability and willingness to enforce it, that the borrower gets easy access to funds. None of this is to say that borrowing is appropriate for everyone who wants money, or that debt forgiveness is bad, only that the debt contract is fit for its purpose.

In the relationships we have discussed so far, one member of the community does a favour to another without the expectation she will be repaid in full measure. In the typical debt contract, the terms including the interest rate are calculated so that both sides are satisfied if the contract is adhered to, even if they never see each other again. A relationship leaves possibilities open-ended; the debt contract calculates them to closure. A relationship requires parties to have some empathy for each other or some sense they are part of a larger, longer-term whole; the debt contract is entirely self-contained. It is in these senses that the debt contract represents the quintessential individualistic arm’s-length market transaction.

Despite the usefulness of debt, lending for interest, otherwise known as usury, has been proscribed by many religions and cultures. Usury laws capping interest rates prevent the equalisation of benefits to both borrower and lender. The lender gets less than what he might obtain in a free market. Why did such laws emerge?

THE PROHIBITION ON USURY

Societies have often prohibited lending at more than a specified moderate rate of interest. The Arthashastra, attributed to Indian Emperor Chandragupta Maurya’s adviser, Kautilya, and written around 300 BCE, has detailed prescriptions on the maximum rate of interest that can be charged for different kinds of loans. The ceiling was 1 1/4 per cent per month or 15 per cent per year for ordinary loans to people, intended to finance consumption or emergency needs.[1] It went up to 5 per cent per month for ordinary commercial loans, 10 per cent per month for riskier commercial transactions that involved travel through forests, and 20 per cent per month for trade by sea. The only exception to these limits was in regions where the king was unable to guarantee security, where judges were asked to take into account customary practices among debtors and creditors. Thus, ancient India recognised a distinction between consumption loans and loans taken to fund profitable commerce, with lower ceilings on interest charged on the former. It also saw the need for the lender to receive a higher interest rate when the commercial enterprise was riskier.

The Old Testament was much less tolerant of usury. For instance, according to Exodus 22:25, ‘If thou lend money to any of my people that is poor that dwelleth with thee: thou shalt not be hard upon them as an extortioner, nor oppress them with usuries.’ Elsewhere in the Old Testament, though, there is an exception – strangers. In Deuteronomy 23:19–20: ‘Thou shalt not lend upon usury to thy brother; usury of money, usury of victuals, usury of anything that is lent upon usury. Unto a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury.’

Is the payment of interest unjustified compensation? After all, the lender has to postpone her own use of the money – think of all those middle-aged people investing money in a debt mutual fund for their old age, which the fund then lends to firms. Postponed gratification, as well as the loss of convenience in not having the money at hand for emergencies, requires some compensation. So too does any cost of preparing the loan document, checking the borrower’s credentials, and administering the loan. The lender also takes the risk the borrower may not repay, or may repay only partially, despite all the safeguards built into debt. So she also needs compensation for the risk of default. Finally, the lender’s use for money, as well as her ability to buy goods with it when she gets repaid, may be very different from today. This is another risk she bears.

The economically defensible interest rate therefore includes the time value for money plus transactions costs for making the loan plus the compensation to the lender for the risks she takes. The final piece that is tacked on is the lender’s profit, based on how pressing the borrower’s need is and what the alternative sources of loans are. So why would the ancient Hebrews prevent lenders from getting what modern economists think is their legitimate due? The answer relates to three factors: the size of the community, the condition of the borrower, and the extent of competition between potential lenders.

THE RATIONALE FOR PROSCRIBING USURY

In biblical times in Palestine, tribes were small, people poor, and the occasional borrower needed money typically to buy food or shelter for survival. The prohibition on usury within the community essentially meant the members of the community insured one another against adversity. If one tribesman’s goats died accidentally, he could go to others who were not similarly afflicted for help while he rebuilt his herd, promising to repay the favour when his luck improved.

A prohibition on taking interest would have a number of beneficial effects here. When people are living close to the edge, they are willing to promise anything for their family’s survival. If the community is poor and only a few have resources to spare at any given time, those few would then have tremendous bargaining power over the needy. If there were no prohibition on charging exorbitant interest, a temporary setback to some members of the tribe could lead them to become permanently indebted and thus enslaved to other luckier members. Over time, the enslaved would have little reason to work, the tribe would become even more impoverished, and conflict would increase.

In contrast, though, if the charging of interest were limited or even prohibited, the better-off members would have little profitable use for surplus resources. They would be forced to help out proximate neighbours or kin with interest-free loans, thus accumulating favours they could draw on when they themselves were hit with adversity. Those on the verge of starvation would have much more use for the shekel saved in interest than the well-fed lender.[2] Moreover, in a small tribe, helping close tribe members survive would also be a matter of self-interest. These would be the people one would trade and work with over time. The bonds of friendship aside, if one’s trusted associates perished in hard times, one would have to build relationships with unfamiliar others, a potentially costly endeavour. Given the tribesmen’s choice between freely given mutual help and debt bondage, with uncertainty about who would come out as master and who would be enslaved, perhaps it is not surprising that they might have chosen to prohibit the latter. In a sense, therefore, the prohibition on usury created a rent, or surplus – the interest that could not be charged – that would be shared within the community to strengthen bonds.

Of course, a lender could get around the usury prohibition by disguising interest; for instance, a lender could finance the unlucky tribesman’s purchase of additional goats but demand milk every day in lieu of interest. This is where religion came in. Knowing that God saw what the tribal authorities might overlook, in an age when the fate of the soul was more important than earthly existence, the fear of retribution in afterlife played an effective role in ensuring the usury prohibition was respected in letter and spirit.

The prohibition on charging interest thus helped strengthen communal bonds and mutual support in small poor communities where anyone could be hit by adversity, and the identities of those in need fluctuated almost randomly over time. To be your brother’s keeper, to practice a kind of communism, made sense.

The prohibition was also a form of early consumer protection vis-à-vis outside lenders. With the poor borrower not knowing how to read, having a very rudimentary understanding of interest, and also often being in a position of deep distress, the possibility that dispassionate lenders from outside the community could take advantage of him was substantial. Better, socially conscious thinkers would have argued, to force the community to take responsibility for the poor than to deliver them into the clutches of the moneylender. Indeed, all these reasons also played out in the Church’s attack on usury in Europe in the Middle Ages.

FEUDALISM AND THE CHURCH’S ATTACK ON USURY

In Europe, from the early Middle Ages till about the eleventh century CE, the Church frowned upon the charging of interest on loans but did not prosecute moneylending as a sin.[3] However, from about the middle of the eleventh century, the Church moved aggressively to curb usury, regarding any interest as a sin, prohibited by the Bible. The usurer had to repay all interest received during his life in full before he could aspire for salvation. The attempts to suppress usury reached their apex in the Church Councils of Lyon in 1274 and Vienna in 1312. The punishment for moneylenders included not only refusal of confession, absolution, or burial in hallowed ground – terrible penalties in those times of deep faith – but also excommunication of rulers or magistrates of states that permitted usury. The economic historian Richard Tawney writes about ‘innumerable fables of the usurer who was prematurely carried to hell, or whose money turned to withered leaves in his strong box or who … on entering a church to be married, was crushed by a stone figure falling from a porch, which proved by the grace of God, to be a carving of another usurer and his money-bags being carried off by the devil …’ [4]

What accounted for the Church’s greater zeal in enforcing the ban on usury from the eleventh century onward? And why did it become far less passionate about rooting out the usurer from the late fourteenth century onward? An understanding of these shifts will give us a better sense of why attitudes toward markets change. First, though, we need to understand the quintessential community in those times in Europe: the feudal manor.

The Feudal Community

Under feudalism, everyone except the king held his share of land in trust from his overlord. Because land, the principal source of value, was not freely saleable, it was allocated to trusted supporters. In return for the use of the land and the overlord’s protection, the vassal swore fealty to the overlord and paid him in kind. If the vassal was capable of fighting, payment was through military service; if he was a peasant, payment was through produce from the land or labour. In a sense, feudal obligations and relationships arose from the land and the produce it generated, neither of which could be marketed.

Feudalism in Europe reached its zenith as the Muslim expansion from the seventh century onward shut off Europe’s access to traditional overseas markets. The proliferation of little principalities as well as banditry reduced the size of markets and increased the cost of transporting goods for trade.[5] With little to buy, market transactions and the use of money diminished, and feudal relationships proliferated.

The feudal manor was thus a closed, hierarchical community, producing much of what it consumed. The peasant’s land holdings were typically in the form of strips in two or three large open fields, intermingled with those of his neighbours. Each peasant followed the same rotation of crops as the others, and had free access to common pastures and woods where each peasant had grazing rights for a certain number of cattle, sheep, or pigs, as well as the right to collect firewood. All this required a fair amount of coordination and give-and-take (the strips were not separated by fences and the commons were open to all in the manor), which required building consensus in the community.

Each peasant had enough to ensure a subsistence existence. There was little incentive to produce more, since there was not much of a market to sell the surplus in.[6] Because the peasant was tied to the land, though, the feudal community was stable, albeit poor. As one historian noted, ‘Most men have never seen more than a hundred separate individuals in the course of their whole lives, where most households live by tilling their great-grandfather’s fields with their great-grandfather’s plough.’[7]

The Commercial Revolution

The nonmonetary feudal economy did relatively well when there were few trading opportunities. Over time, though, Europe learned to trade with, and through, the Muslim lands. Moreover, demand for agricultural products from the growing towns, as well as travel routes that were safer from brigands, helped the revival of trade and commerce. Feudal lords now not only had the opportunity to convert the manor’s produce into money, the money could buy an increasing variety of goods. The growing attraction of producing for, and consuming from, the market did not sit well with traditional feudal practice.

For key to the feudal system was that the individual did not own the land outright; instead, the peasant managed it while he was able-bodied and passed the management on to his kin when he could no longer manage.[8] Everyone in the family had customary rights to the land, which made those rights difficult to sell or turn over. In turn, this ensured that a long-lived community built around that land, but productivity was generally low, since a farmer’s kin were not necessarily good farmers. In fact, the absence of a market protected the peasant – his low productivity hurt his household’s production, but did not jeopardize his right to farm land.

As feudal lords became more attracted to monetary income, and as land became easier to sell, this changed. In order to enhance production, the feudal lord had to be able to transfer land to more productive tenants or owners. In England, soon after the turn of the millennium, the courts started overlooking the customary rights of kin, making freehold land easier to bequeath or sell.[9] Even tenancy that was tied in with feudal obligations, known as copyhold tenancy, became better defined and easier to transfer over time.[10] Scholars argue over whether there was a dramatic change in the legal treatment of property, or whether England was intrinsically more favourable to sales. Whatever the reason, the interests of the Church also lay in freeing property from customary entanglements. If the rights of inheritance, for example, narrowed to direct relatives rather than residing with all kin, land would be easier to bequeath to third parties or to sell. And a primary beneficiary of bequests to third parties was the Church. An elderly childless widow or widower could easily be persuaded that their route to salvation lay in willing the bulk of their property to the Church. Even if they were not persuadable, often the only one who could write down a will or hear last orders was the not entirely disinterested parish priest.[11]

The net effect of a freer land market was that less-productive peasants had an incentive to sell or were strong-armed into doing so, often to larger landowners who had surplus cash, and who could farm the combined land more profitably. Land holdings became more concentrated in fewer hands but agriculture also became more productive. Unfortunately, a number of peasants were forced into marginal holdings or entirely out of the manorial community as they sold, or were evicted from, the land that tied them to it. At the bottom, holdings became smaller as the size of the peasant family grew. As the small peasant’s holdings were subdivided and average incomes fell, a growing number of second and third sons had to fend for themselves outside the feudal manor. The expansion of the market, as is sometimes its wont, resulted in growing inequality.

These were therefore extremely difficult times for many European peasants, especially those who no longer had the protection of the manorial community. Average incomes were not only barely above the level needed for subsistence but also were highly variable over time.[12] The failure of a harvest or the death of livestock were not infrequent events. One estimate suggests that even the relatively wealthy English peasant could expect to face serious calamity every thirteen years.[13] Some work did open up outside farming, especially in the growing towns where merchants and artisans prospered, but it was rarely enough.

Despite their low and highly variable incomes, death by starvation was surprisingly rare among the peasantry. The reason was simple: informal community support within the manor for those who still belonged to one, and formal charitable institutions run by the Church, such as almshouses, leper houses, pilgrim centers, educational institutions, and monastic hospitals, for those outside the manor, constituted a social safety net. Harder times for the poor explain why the Church became more aggressive in its fight against usury.[14]

Usury prohibitions limited the profits that anyone with excess wealth could make by lending to those in difficulty. At the same time, a lender faced a loss of social status and even excommunication if he was condemned as a usurer. Perhaps the businessman was willing to take this risk when young. As he grew older and came closer to the feared inevitable meeting with his Maker, the graphic pictures painted by the clergy of the torments that awaited him in hell were an increasing source of worry. The prohibition on usury thus helped channel the wealth of the rich away from making usurious consumption loans and toward helping poorer unfortunates. Such help could be given informally, or formally through charitable donations to the Church. As in the Hebrew tribes, the prohibition on usury suppressed the market in favour of the community. Thus as the commercialisation of agriculture created greater numbers of the poor, the Church took their side by restricting the debt market.

The Church’s actions were also not unrelated to the political battles it was fighting at that time with the secular authorities. The reforms initiated by Pope Gregory VII in 1075 – the so-called Papal Revolution – attempted to separate the Church from the feudal hierarchy, especially the domination of the Holy Roman Emperor.[15] The details of the conflict, which culminated in the victory of the Church, need not concern us but some aspects are important. In order to attract support for their cause, Church scholars systematised and rationalised the Church’s vast legal traditions. A comprehensive body of canon law emerged, which could now guide ecclesiastical courts, and which helped reaffirm that all Catholic authorities, including the powerful emperor, were constrained by a higher, principle-based, law. Furthermore, in response to competition from the now-more-reliable ecclesiastical courts governed by canon law, feudal rulers developed their own legal system.

Both the Church and the ruler competed to offer better justice to attract plaintiffs into their courts. Since the poor and the powerless benefited disproportionately from the law, courts consequently became more sympathetic to their problems. Better-enforced usury prohibitions became one element of that competition.

The Church’s actions thus had mixed effects on the poor peasant. The Church may have helped make property more alienable in order to expand its own wealth.[16] Easier alienability allowed feudal lords to move unproductive peasants off their land, rendering them destitute. However, the Church was probably also motivated by the welfare of these very same peasants and concerned about the stability of the community when it banned usury and exploitative market transactions. And it did use some of the wealth it accumulated to provide charity to the destitute.

The Intellectual Support for the Ban on Usury

The Church could appeal to a long line of thinkers, past and present, for support for the ban on usury. The Greek philosopher Aristotle, who was being rediscovered in this period, was firmly against interest on loans. He saw the production of goods to satisfy physical wants such as food and clothing as useful economic activity. Farming, the raising of livestock, and manufacturing were all productive. In contrast, trade, which simply exchanged goods for one another; hire, which lent out goods for money; and usury, which lent out money for money, produced nothing that satisfied physical wants. Of the three, ‘The most hated sort, and with the greatest reason, is usury, which makes a gain out of money itself, and not from its natural use of it. For money was intended to be used in exchange, but not to increase at interest.’[17]

St Augustine, a guiding light of the early Church, similarly warned about the three sins of fallen men: the lust for power, sexual lust, and the lust for money. Of these, he was most ambivalent about the lust for power, which if accompanied by a sense of civic duty and honor, could protect the community against external attack.[18] He also discussed in his startlingly frank Confessions how his private desires such as sex – as a young man, he was sexually active, and later, he lived with a mistress who bore him a son – came in the way of his relationship with God. Here too he seemed to be ambiguous, if not understanding. About the lust for money, though, he was clear in his condemnation.

Drawing on such sources, Church scholars in the Middle Ages concluded that trade or enterprise was necessary but perilous to the soul. The businessman could always be tempted to hanker after excess profit by charging more than the just price – the price that provided adequate income for the seller to maintain his station in life. This constituted avarice, a deadly sin. Working hard to enhance profits was clearly not in accordance with medieval thinking. Worse still was finance, which ‘if not immoral, was at best sordid, at worst disreputable.’[19] These strongly Aristotelian attitudes, which still dominate many societies today, reflected a suspicion of the middleman. They were thought to make money not by adding intrinsic value to the traded item, but by moving goods or money to areas of shortage, or even, many believed, by creating the shortage in the first place.

WHY THE CHURCH BECAME MORE TOLERANT OF USURY

Important developments eventually moderated Church hostility toward business and finance in Europe. The Black Death, a plague more deadly than any before in Europe’s recorded history, did much to shake the distribution of income and social structures. There were now relatively fewer poor to protect. Moreover, commercial activity also picked up; the development of new military technologies led to larger states, and therefore larger, safer, internal markets. There was consequently more opportunity to trade. Lending to businesses to finance trade increased. With the state also demanding loans to finance its larger spending, lending did not seem so exploitative – it was no longer primarily consumption loans to the poor untutored peasant but rather loans to financially sophisticated borrowers (as the modern parlance goes). Furthermore, it was less important for the Church to protect the borrower as more of the wealthy competed to lend. Also, the Church itself became an important usurer as it lent out the enormous wealth it had accumulated following the Papal Revolution.

Eventually, the Church’s wealth made it a target for the state. As critics attacked the Church during the Protestant Reformation, monarchs seized an opportunity to cut the Church down to size, and it was rarely a factor in governance again.

The Black Death

In October 1347, twelve Genoese trading ships docked at the Sicilian port of Messina after a long journey through the Black Sea. Many of the sailors on board were dead, covered with black boils that gave the illness its name, the Black Death. The Sicilian authorities ordered the ‘death ships’ out of the harbor, but it was too late. Over the next five years, and over the course of subsequent recurrences, the bubonic plague pandemic would wipe out an estimated third of Europe’s population.

The humanitarian catastrophe had a thin silver lining. The lucky peasantry that survived the Black Death now could farm much larger land holdings, could concentrate on better land, and were thus significantly richer. For instance, in 1341 in the English village of Stoughton, 52 per cent of landholdings were eleven acres or less. By 1477, only 16 per cent were that size, with 58 per cent of holdings larger than thirty acres.[20] With many in the community becoming more prosperous, life became less precarious, and the need for emergency consumption loans and Church charity diminished.

The poor were still around, albeit fewer in number. Fortunately, with more people possessing surplus resources, competition to lend to those in adversity increased. With vast tracts of now-untilled land as well as commercial opportunities in towns beckoning the poor, the extremes in bargaining power that might have led to debt bondage no longer prevailed. Indeed, across much of Western Europe, the Black Death precipitated the end of serfdom.[21] Greater prosperity and competition to lend that prosperity now diminished the old rationales for prohibiting usury.

As we will see throughout the book, natural or economic catastrophes and technological progress are the big drivers of societal change. After the Black Death, technological progress took over. Francis Bacon, the seventeenth-century courtier and philosopher, saw gunpowder, printing, and the compass as the three greatest inventions known to man.[22] Their arrival in the West played a part in the expansion of markets, and the further weakening of the feudal community as well as the Catholic Church. They also heralded the rise of the nation-state, a key player in our narrative.

CANNONS AND INTERNAL COMMERCE

In feudal Europe around the turn of the first millennium, all that it seemed to take to create a self-sufficient political entity – it would be too much to call this a state – were fortified walls and a retinue of armed men. Indeed, often the first use of the independent taxation authority a town received was to build a strong wall – a policy that still appeals to some of our politicians.[23] In the fourteenth century, by some counts there were over one thousand separate political entities in Europe.[24] Each entity levied its own duties, taxes, and tolls, especially on goods crossing its borders, which increased the cost of transporting goods over long distances. These were just the legal impediments to commercial traffic; entrepreneurial lords could indulge in their own banditry, while sea captains could engage in piracy. If you drive alongside the Rhine near Frankfurt today, you will see the castles of the original robber barons at regular intervals, though today they only relieve tourists of their money, and in a far more civilised way than in the past. All these impediments ensured that the size of the market any producer could safely and profitably access was quite small – often only within the borders of the little political entity he resided in.

The cannon changed everything. The Chinese invented gunpowder, but it was the Europeans who fully discovered and developed its destructive potential. At the battle of Crecy in 1346, English bowmen used small bombards, which, primed with gunpowder, shot little iron balls to frighten enemy horses.[25] A hundred years later, massive siege cannons could demolish even the strongest fortifications. Techniques of fortifying changed in response, so the net effect of the cannon was to increase both the cost of attack and of defense.

Military techniques also changed. Cannonballs and musket fire could slaughter charging armored knights on horseback. However, muskets took time to reload, which meant an experienced musketeer even in the beginning of the seventeenth century could shoot a round only once every two minutes.[26] Against a cavalry charge, this meant essentially only one shot between the enemy coming into range and the commencement of hand-to-hand combat. The tactical solution was to have musketeers drawn up in long parallel lines, with the first line firing then stepping behind the second to reload, and so on, so that near-continuous volleys of fire could be directed at the enemy. To be effective, the army needed many more recruits with substantial drilling and discipline, which meant a large standing army.[27] The size of armies of some states increased tenfold between 1500 and 1700.[28]

To afford both cannonry and an army, any political entity required a larger catchment area, both to find peasant recruits and to find taxes to pay their bills. Little political entities no longer had the population nor could afford the minimum necessary expenditure. The average size of the state increased as entrepreneurial rulers started integrating smaller entities in the fifteenth century, and by the end of the century, the number of entities had halved to around five hundred. By 1900, these were down to twenty-five or so.[29]

The expansion in the size of the political state also meant an expansion in the size of its domestic market. Monarchs increasingly obtained monopoly control over violence within their country by controlling the powerful landed magnates, a subject we will explore in greater detail in the next chapter. They also suppressed the entrepreneurial robber barons and pirates, making trade routes safe.

This meant that producers could sell in the entire national market. Moreover, in the thirteenth and fourteenth centuries, aids to navigation like the dry compass and the astrolabe, coupled with new technologies in ships such as multiple masts with lateen sails and the sternpost-mounted rudder, which improved ship maneuverability and stability, meant ships no longer had to hug the coast, and could venture much farther out at lower risk. This expanded trade, and thus added to the size of the accessible market. With larger available markets, producers could specialise, as well as raise the scale of their production, thus reducing unit costs of production. As the prices at which they were willing to sell fell, demand for goods increased.

In sum, political consolidation led to economic integration. When combined with maritime technological innovation that allowed trade with more distant land, producers could now exploit economies of scale. European production of crafts and manufactured goods, centered in towns and cities, expanded. And as markets delivered all manner of goods, the manor too specialised, with some focusing on cash crops like grapes, transformed into wine, instead of the earlier emphasis on necessities like cereals – for cereals could now be bought with the money obtained from selling wine.[30]

The increase in production and trade played an important role in weakening the case against usury. A master craftsman or merchant wanting to borrow to finance an expansion in his business or trade was not in the sympathetic position of an illiterate peasant living at the margin of starvation. As the community turned from consumption loans to small production or trade loans, public attitudes toward usury became more favourable. After all, it seemed only fair that those who sought commercial loans to make profits should pay a share of their profit out as interest.

THE POWERFUL INTERESTS

Moreover, the monarch was now an interested party. With the increase in the expense of fighting wars, he needed additional sources of revenue. The merchants, artisans, and moneylenders in the growing towns could be taxed, but yet more tax revenue could be obtained if they were freed somewhat from Church regulations concerning the just price at which transactions could be done or the interest that could be charged, and allowed to make larger taxable profits.

Furthermore, when rulers still needed funds after squeezing all they could out of the taxpayer, debasing the currency, and seizing the estates of weak lords, they had to make their way to the moneylender. There was always a danger that the king could turn on his lenders, labeling them usurers and refusing to repay. The few who did lend did so at high rates. They kept the impecunious monarch on a tight leash so that if he defaulted, he risked shutting off further recourse to loans, which might especially weaken his ability to fight off his enemies. So monarchs repaid enough to keep the loan spigot open, and were inclined to look for ways to permit such lending.

There was also a mighty potential lender: the Church itself. It had become rich, in part because of the way it had shaped rules governing usury and inheritance. Church treasuries were full of reliquaries, candlesticks, and vessels made of precious metals, which not only increased the grandeur of Church services, but also could easily be melted down, coined, and loaned. The French historian Henri Pirenne asserts that ‘the Church was the indispensable moneylender of the period.’[31]

With both monarchs and the Church administration inclined to allow some borrowing and lending, ways had to be found. Many in the Church were not comfortable with violating what they believed was a Scriptural ban. Financial innovation helped satisfy those in the Church looking for a fig leaf that the letter of the interest prohibition was not breached. For example, bills of exchange allowed a borrower to pay interest to a lender provided the borrowing was done in one currency and repayment in the other. The interest payment was hidden in the rate at which one currency was exchanged for the other, but could also be justified as a compensation for the exchange rate risk the lender bore.[32]

Similarly, the Church, following Roman law, allowed a penalty imposed for late payment, poena detentori. It was then a simple matter to lend with a fixed date for repayment and an implicit agreement that the borrower would not repay by that day. When he paid a few days later, a penalty was tacked on, which surprisingly approximated the market interest that ordinarily would have been charged by less conscientious lenders! When there is a will, the market finds a way around impediments; financial innovation helped finesse the Scriptures, much as it helps aggressive financiers avoid regulations today.

THE STATE MOVES AGAINST THE CHURCH

Not only was the Catholic Church inclined to turn a blind eye to some types of lending, it was becoming weaker politically once again. Its pronouncements, including on usury, began to carry less weight. The Church’s wealth made it an attractive target for monarchs. They preferred their subjects’ wealth to stay within their control rather than be transferred into the hands of a distant, and possibly antagonistic, Rome.[33]

Much as social media today has allowed politicians to reach people directly, bypassing the filters of the mainstream press, Gutenberg’s movable-type printing press allowed critics of the Church, abetted by the local prince, to gain direct access to the masses. The reduced cost of printing pamphlets, as well as the spread of literacy, especially among the growing business community, ensured that the Church could be challenged and the arguments would reach many more people than in the past. Indeed, conservatives at that time warned that ‘printed books and broadsheets would undermine religious authority, demean the work of scholars and scribes, and spread sedition and debauchery.’[34] They were right! For instance, over three hundred thousand copies of Martin Luther’s theses against the Catholic Church were circulated between 1517 and 1520, something that would not have been possible without the press.[35]

Additional pressure for reform came from secular law and secular courts that increasingly competed with the Church to try usury cases. Over time, though, as commercial and state activity necessitated the charging of interest, secular courts became willing to enforce loan contracts, especially when interest rates were moderate. French and English monarchs adopted the legal fiction that their moneylenders, both lay and clergy, were to be considered Jews for legal purposes, and came under secular law courts.[36] Judges, however, needed more than workarounds. Scholarly arguments were made to support the practical judgments of secular courts. As monarchs grew more powerful and independent of the Church, this meant more protection to usury.

As selective violations of usury prohibitions, such as royal or commercial borrowing as well as Church lending, increased, usury prohibitions became ever more difficult to justify as a purely religious matter. As the historian Richard Tawney has argued, the religious arguments for the prohibition on usury, by their very nature as moral arguments, had to apply universally, even though they were meant primarily for consumption loans to the poor. With the emerging range of new, seemingly defensible, reasons for lending at interest, the Church faced questions about how general the religious arguments really were.[37]

THE CHURCH REFORMS ITS ATTITUDES TOWARD BUSINESS AND INTEREST

As the Reformation swept across Europe, scholars proposed new doctrines to rationalise the expanding markets and growing prosperity, as well as the needs of the emerging powerful monarchs. Perhaps the most important of these from a commercial perspective was the sixteenth-century French theologian and pastor John Calvin, who fled Catholic France for the Swiss city of Geneva, where he became extremely influential. Indeed, in The Protestant Ethic and the Spirit of Capitalism, the German social historian Max Weber attributed the rise of the archetypal capitalist to the teachings of John Calvin.

In Weber’s view, the true capitalist is not the flamboyant gambler who risks all or the unscrupulous speculator who wheedles his way to riches, but the temperate, reliable, hardworking businessman, ‘with strictly bourgeois opinions and principles’.[38] The essence of modern capitalism is the steady accumulation of wealth, not because of the pleasures it can buy or the material needs it can satisfy, but for its own sake. Indeed, far from unbridled greed and debauchery, rational capitalism combines a single-minded focus on accumulation with a frugal lifestyle. What Calvin did for capitalism, according to Weber, was to provide it a moral legitimacy in a world where avarice was a sin.

Calvin emphasised the notion of calling, or predestination – that God has chosen some to be saved from damnation, and that their moral obligation is to do their duty in the world. Rather than abandoning the world, as was the Catholic monastic ideal, one had to embrace it. The practising Calvinist had to have faith that he was one of the chosen, and had to demonstrate this faith through worldly activity. Business success was a sign of being one of the elect. Therefore, the accumulation of wealth was no longer to be condemned as avarice, but instead celebrated. Indeed, it was condemned only if wealth was spent on luxuries and high living – not only did conspicuous consumption reduce the savings necessary for investment, but it was also a waste of time, detracting from man’s true calling. The Calvinist vision of capitalist society was austere – and Geneva under the Calvinists was a harsh dull place – but it gave the single-minded entrepreneur a moral compass and justification that he did not have before. Various Protestant sects influenced by Calvinism then spread to Scotland, the Netherlands, and England, and thence to New England in the United States.

Calvin’s views on usury were consistent with his arguments about business. He maintained that the arguments against usury in the Old Testament were so that ‘mutual and brotherly affection should prevail among the Israelites’, so that they could trade conveniently among one another without conflict.[39] It was an argument for a different age and different community circumstances, and could not be deemed universal – even in the Old Testament, usury had been permitted to strangers. Therefore, usury was permissible ‘if it is not injurious to one’s brother’.

Taking on Aristotle, Calvin asserted that money was barren only if unused. If used productively – invested in land or trade – the borrower is not defrauded when he pays a portion of his profits for the use of money. Thus all interest need not be condemned for otherwise ‘we would impose tighter fetters on the conscience than God himself’.[40] Nor, Calvin argued, do the Scriptures prohibit a reasonable charge for money. Observing that the Hebrew word for interest, neshek, meant ‘to bite’, Calvin argued that the Bible prohibits only ‘biting’ interest, which oppresses the poor.[41]

So while Calvin’s theology sanctified the pursuit of wealth and removed the associated taint of avarice, it also created a space for saving and lending at moderate interest rates. Such a positive interest rate was necessary to give the accumulative capitalist the incentive to be ascetic in his spending and save. It was also a pragmatic recognition that the needs of capitalistic business differed from those of the penurious household. While urging continued protections for the poor, Calvin opened the way for ordinary business lending.

Weber argues that Calvin also paved the way for the rise of capitalism. Instead, Calvinism may simply have been a rationalisation and legitimisation of emerging business practices rather than the wellspring for capitalism. Nevertheless, by transforming business from a furtive activity done in dark corners hidden from religious authorities to one that was publicly praiseworthy and indeed a route to salvation, Calvinism did much to encourage the further growth of business. Calvin may have imbued the bourgeoisie of Western Europe in the sixteenth century with a sense of being chosen and predestined, much as Marx anointed the proletariat of the nineteenth century.[42]

In sum, from about the middle of the fourteenth century, the Church’s attitude toward usury softened, probably as much by necessity as by conviction.[43] Usurers were allowed to be buried once again in church graveyards, and various kinds of contracts involving interest were declared non-usurious, with only excessive interest being deemed sinful. While the Church’s views of business were not irrelevant after the Reformation, its influence certainly diminished greatly.

Moreover, religion was no longer a significant unifying national force in the emerging Western European nation-states – some nations had both sizable Catholic and Protestant populations, while nations with predominantly Catholic populations needed an identity that differentiated them from co-religionists elsewhere. As we will see in the next chapter, a new form of devotion, nationalism, started edging out religious zeal across Europe. It too would affect attitudes toward business and finance, as well as the community.

CONCLUSION

Around the end of the first millennium in the Common Era, commerce and finance started stirring once again in Europe. As monetary transactions started undermining the stability of the feudal community, the community via the Church struck back and imposed severe limitations on the behaviour permitted in finance and goods markets. Over time, and as both the unifying power of the monarch and the size of the market grew, some of the restrictions on business and finance started impinging on economic activity as well as on the monarch’s finances. The antibusiness scholarly ideology protecting the feudal community and constraining the market gave way to a more tolerant view, which gave individuals greater freedom to transact – the dominant scholarly view changed with public need, as it invariably does, even though theoretical reasoning is not supposed to have such flexibility! Trade, land sales, and debt weakened reciprocal feudal obligations and replaced them with market transactions. The state and the market grew together, even as the feudal community weakened.

The Church’s power also declined, leaving the nation-state in ascendancy. However, its period of power had served a purpose – to push the state, at least in some parts of Western Europe, to acknowledge the possibility of a higher law, and to prod it into developing a more rational legal system. Two struggles now became more salient. One was the struggle for supremacy within a country as the king attempted to subdue the few powerful landed magnates who had the ability to match the king’s military spending. An equally fierce struggle was between the emerging nation-states in Europe, as each tried to establish its dominance over others. These two struggles were the crucibles in which the constitutionally limited state and modern markets were forged.[44]

## [2]. THE RISE OF THE STRONG BUT LIMITED STATE

In the last chapter, we saw how new military technologies such as siege cannons developed to overcome traditional fortifications and unify territories. No longer could every town or manor stand up to the king’s men simply because it had strong walls. (I will use ‘king’, since they were mostly kings, with due apologies to queens like Mary Tudor and Elizabeth I.) The emerging nation-state’s military power was too much for the traditional feudal community and broke its protections down. The centralising of governance powers had begun, though limited by the difficulty of governance at a distance in times when the fastest means of communication was through bonfires or via riders on horseback.

The nation-state still had to accomplish at least three tasks before it came to even remotely resemble today’s strong state. The first was for the king to obtain a monopoly of military power within his territory so that it was a unified whole with a common market. To do this, he had to suppress the large magnates – the domestic dukes and princes – who had the lands and revenues to rival his military power. We will see that this took different forms, but in England, it was achieved through direct confiscation as well as, interestingly, through competition in markets.

The second task was to create an identity that would replace religion – since religion did not distinguish one nation-state from another in Europe. That identity had to give people a sense of larger purpose. Increasingly, an identity that suited many requirements, including the king’s need to lead a unified country, was identification with the nation.

Even after unifying the land under his power, the king faced external threats. Some European country was always trying to establish supremacy – first Spain, then France, and in modern times, Germany and Russia. Any European country risked subjugation if it was not militarily powerful. As his feudal vassals’ obligations to supply arms and men waned with the demise of feudalism, the king needed money to maintain a strong military to defend the country against these external threats. Much of the subsequent development of the state can be seen as a consequence of steps taken to enhance its ability to raise revenues – the third task.

The nation-state that emerged had somewhat contradictory powers. It was strong in its ability to defend itself against external enemies and defeat internal threats to the state, yet it was compelled to respect the private property rights of its citizens. The constitutionally limited state was an important milestone in the path towards free markets. The security of private property did away with the need for private players to protect themselves through anti-competitive medieval business associations, such as guilds. It allowed them to compete as individuals. Greater competition raised efficiency and output, increasing the economic power of the nation-state that could foster it. The markets pillar and the state pillar now fortified each other.

Since different nation-states went through these developments in different ways, and my intent is to illustrate, not be exhaustive, I will focus on the path England followed, primarily because it was the first large nation-state with a constitutionally limited government. The process of stabilising governance in the English nation-state took the Crown over two hundred years, spanned the reigns of two houses – the Tudors and the Stuarts – and involved substantial amounts of chance. Even though England’s path to constitutionally limited government and freer markets was unplanned and idiosyncratic, through war it imposed competitive pressures on other European countries to change if they wanted to survive. Eventually, many reached the same endpoint, albeit in their own ways.

THE DECLINE OF THE MAGNATES

As we have seen, the new military technologies required scale. At the outset of nation building, the monarch was not personally much wealthier than the most powerful of the landed aristocracy. He needed to build his own power as well as reduce theirs. In the process of eliminating the threat of the high aristocracy, the English king unleashed market forces that would help create entities that would eventually curtail his own freedom of action. Interestingly, as the king lost the ability to act willfully and outside the law, as his identity was submerged in the broader apparatus of the state, the state’s access to financing from its citizens increased. It could now expand in ways, such as maintaining a large army, which would earlier have raised public apprehension about the monarch’s intentions. Somewhat paradoxically, the limited state became strong and improved its capabilities even while bolstering the confidence of the citizenry in the security of their property. Let us see how this happened.[1]

Henry VII, the first Tudor monarch, was the last king of England to win his crown on the battlefield in 1485. There were others who had some right to the throne, so Henry’s claim to be monarch other than by ‘right of conquest’ was questionable, at best. From the outset, therefore, the Tudors had to dominate other aristocrats through sheer power. This was not a simple or quick task, and spanned the reigns of successive monarchs.

The monarch’s problem was complicated in two different ways. First, the landed aristocracy had built militias out of their armed servants, and could also summon their vassals and tenants to fight for them. Even as Henry VII passed a series of Acts asserting that the prime loyalty of every subject was first to the Crown and only then to his lord, feudal tradition militated otherwise.[2] The monarch only had control over a small militia, and was otherwise reliant on conscription. This meant that in any emergency requiring a prompt response, such as an internal rebellion by one of the lords, he needed the help of the other lords to defeat it. Second, the king did not have a large bureaucracy to collect taxes. He depended on the high lords to collect and pass taxes on to the royal treasury. With the king so dependent on the aristocrats, he simply could not take them all on at the same time.

Time and infertility were on the king’s side. He had no need to create powerful new aristocrats, and indeed no dukes were created by the Tudors.[3] Furthermore, because some lords did not have male children, which was not an infrequent occurrence, existing houses came to an end. Through such means, Henry VII doubled his revenues from Crown lands.[4] Individual rebellious lords could also be picked off, convicted of treason, and executed, as was the duke of Buckingham by Henry’s son, Henry VIII, and their lands seized by the Crown. Nevertheless, what really clipped the wings of the landed aristocracy was more indirect and perhaps unintended – the dissolution of monasteries and the great price inflation of the sixteenth century.

THE DISSOLUTION OF THE MONASTERIES AND THE RISE OF THE GENTRY

The Tudors were hungry for land, and looked for easy targets. After Henry VIII broke with the Pope over his marriage to Anne Boleyn, he turned his attention to the Church’s wealth in its various monasteries, which had grown substantially since the Gregorian reforms. Monastery property had two attractions. First, it was unprotected by armed men, unlike the land of the magnates. Many monasteries had also grown complacent and neglected their duties toward the needy. As a result, they enjoyed only modest public support. Second, and perhaps more important, monastery land was poorly managed, which attracted the attention of the capable, who felt they could do a better job using the latest methods of agricultural management.[5] So when Henry VIII seized monastery property, giving abbots and abbesses the choice between being accused of treason, convicted, and put to death cruelly (they needed to be convicted because only the property of traitors went legally to the Crown), or ceding property ‘voluntarily’ to the Crown, most made the obvious choice, and few among the public protested.

The seized property was soon sold, as the king needed funds to fight wars. Those who bought the land were primarily local moderately wealthy land owners – the local gentry. These were typically minor nobility, who did not have the vast land holdings the aristocracy had, but owned more land than well-to-do peasants. The landed high aristocracy were only a few dozen, while the gentry numbered in the thousands. The gentry had made their money managing their own properties well. They could bring their expertise to the new properties, especially because they knew local conditions and were closer to the land than the landed magnates. Since land ownership was the route to social status in those times, successful wealthy town-dwellers such as merchants and lawyers also bought land so that they could rise to the status of country gentlemen.

These men improved the management of the land they bought; including bringing unused land into cultivation; ending unproductive traditional techniques such as leaving one out of two fields fallow instead of one out of three; and appropriating customary-use common areas by enclosing them, and shifting them into more lucrative sheep rearing. Rather than continue with the feudal practice of demanding unpaid labour from tenants, which was anyway grudgingly given, these ‘new’ men instead hired labour directly for commercial wages. They raised rents on existing tenants commensurate with the commutation of labour obligations and the increased incomes from the more productive land. Not all were successful in making a go of land management, but the unsuccessful sold out to others who were more expert. At any rate, land management improved substantially, increasing agricultural output. Some economic historians argue that England’s prosperity in Elizabethan times was in substantial part due to higher national income growth resulting from the seized lands.[6]

Importantly, the successful country gentlemen, both old and new, went on to acquire more land. Some of the richer gentry came to own as much as the poorer aristocrats. Furthermore, because many of the high lords were not particularly good managers – after all, they and their ancestors had established their prowess on the battlefield, not in estate management – the incomes of the richer gentry far exceeded that of the poorer aristocracy. For crops that had a national market, the more efficient cheaper production from the gentry lowered prices and thus aristocratic incomes. The old guard was at risk of being blown away by the gales of competition.

The aristocracy, who no longer could distinguish themselves easily from lesser mortals based on land ownership or income, found new grounds for differentiation. What distinguished them from the nouveau-riche Calvinist gentry was their lavish entertainment and the liberal hospitality they showered on guests who passed their social threshold, their free-spending enjoyment of fashion, art, and architecture, and their sympathetic treatment of unproductive customary tenants paying low rents. These were exactly the wrong elements to distinguish themselves by as prices started rising.

THE GREAT INFLATION

The gold and silver flowing into Europe in the sixteenth century from its colonies in Africa and Asia first, then the Americas, raised prices of goods, as the growth in their production did not keep pace with the growth of coined precious metal. For the aristocracy, the tremendous increase in spending that was necessary to keep up their lifestyle and their army of retainers collided with the stagnant tenant rents that noblesse oblige demanded of them. Something had to give. For those who could not bring themselves to manage their lands commercially, it meant land sales and further decline – until some social-climbing wealthy merchant or member of the gentry could be persuaded to underwrite the aristocratic expenditure in return for a status-enhancing marriage alliance. For those who wanted to maintain their distance from the arrivistes, there was no alternative to moving to new techniques of agricultural production, raising rents on tenants who could cope, and terminating the tenancy of those who could not, for more capable ones who could.

The demands of the market – the competition from the gentry accentuated by the great inflation – thus killed the capacity of the aristocratic lord to look out for his tenant and see him through difficulty, the essence of the feudal obligation. At the same time, it also killed any loyalty the tenant might have had to his lord.[7] Transactions were now on strictly commercial terms – the market, by competing away the rents on aristocratic estates, once again had eroded community ties. No longer would tenants flock to their lord’s banner in times of military need. For the monarch, this was a distinct relief, since his army was based far more on recruits drafted for a wage than on loyal feudal retainers.[8]

The king also undermined the landed aristocracy in matters of local governance. As the gentry grew more prominent, the monarchy appointed them as justices of peace to judge small claims and local cases, as sheriffs, and as tax and military draft commissioners. These positions were unpaid, but offered their occupants prestige and local influence. And they became essential to administering local justice as well as collecting taxes and administering services for the poor. As one historian put it, ‘the gentry were essential to the power of the king, but he was not essential to theirs.’[9]

THE POWER OF THE GENTRY

All this meant that even though the aristocracy had been undermined, as had the Church before it, the monarchy did not have absolute power; a new power, the gentry, now stood in the way. The king was vastly more powerful than any single member of the gentry, but he could not treat them like Henry VIII treated the monasteries. Unlike the poorly managed monastery land, the gentry used their superior knowledge of farming and the locality to manage their land productively. There were no unrealised bonanzas that could be obtained through expropriation.[10] It made far more sense for the king to tax the gentry regularly than to expropriate some of them and risk upsetting an entire class. Ironically, one of the most infamous violations of property rights in history, the expropriation of the monasteries, had strengthened property rights by moving land into the most productive hands. With the markets having done much of the work, courts and their judgments soon established property rights over land more firmly, eliminating the last vestiges of feudal constraints on property ownership and transfers, while protecting contractual ownership and tenancy rights.[11]

The gentry also dominated the House of Commons in Parliament, an institution whose purpose we will describe shortly. It offered them a venue to coordinate their actions if they perceived any threat from the monarch such as moves toward expropriation or levying additional unapproved taxes. With their limited individual influence, they preferred an arm’s-length rule by law that would protect all of them. They were collectively wealthy – a peer ruefully noted in 1628 that the House of Commons could buy up the Lords thrice over – so together, they could influence the nature of those laws.[12] And they were closer to their tenants than the great lords were, and thus could command more of the much-diminished sense of loyalty in their locality than either the great lord or the king. The gentry, not the landed magnates, thus became the primary source of possible opposition to the Stuart kings.

As an aside, the belief that widely distributed property leads to better security of property and stronger constraints on the state has a long tradition. Some societies set maximum limits on the amount of land anyone could own so that it would be distributed widely. The Roman Republic had an agrarian law that limited how much land any one person could own, which of course was breached as it progressed toward empire. In his treatise, Oceana, James Harrington, a writer in seventeenth-century England, argued that ownership of property was the source of all power, and the group that had the most property dominated government.[13] Influenced by Harrington, Jefferson’s draft constitution for Virginia, written in 1776, required that each adult have fifty acres of land. The minimum limit would ensure that the owner would be reasonably prosperous and independent – if not quite a member of the gentry.[14] Yet we have seen, it is not just how land is distributed, the efficiency of owners also makes a difference – the inefficient monasteries were not powerful while the gentry were. The vibrant land market had the dual effect of moving land into the hands of the efficient and, through their competition, eliminating the last vestiges of the feudal community such as the loyal but inefficient hereditary tenancy. Such arrangements were sustainable only when competition was muted.

THE TOWNS, GUILDS, AND MONOPOLIES …

Even as they were suppressing the landed magnates domestically, monarchs continued to face external threats, which was the source of their perennial problem, their need for funds. The competition with other European nations for political supremacy was bloody and never-ending. Whenever any state became strong enough to potentially acquire an enduring advantage, the other states banded together to defeat its quest for domination and achieve a new balance of power.[15] Yet dreams of supremacy never faded.

Any money the monarch could access to fund his military machine, whether through borrowing or tax revenues, ultimately was supported by economic production. So competition between states for supremacy, in the long run, would favour states that had stronger economies with which to sustain their war machines. Every country faced steady pressure from the outside to beef up its economic capabilities, else risk subjugation.

It was not just enough to produce more – the monarch had to be able to collect his share in taxes. The more he threatened to take in taxes, and the more unpredictable his behaviour in doing so, the less his people would want to invest in, or put effort into, income-generating economic activity. Instead, they would focus on hiding their income and wealth. The monarch needed a mechanism to signal that he would tax reasonably, even in times of war when he might be tempted to levy huge taxes or expropriate property in order to preserve his reign. So the king had to create institutions that would limit his own ability to be arbitrary, thus convincing people that their taxes would not be used to extort yet more from them. The Church was one such institution, but as discussed in the last chapter, its power was fading. In most European countries, monarchs therefore committed to levy new taxes or raise old ones only if approved by the representatives of the rich and propertied who, in England for instance, were seated in Parliament (and the Estates General in France and the Riksdag in Sweden). Given the difficulty of getting anyone to approve higher taxes on themselves, monarchs tried to find ways to not put the question to the representative bodies if they could find other ways of gathering revenues.

The obvious alternative was to do cozy deals with the businessmen in the towns, which the emerging absolute monarchs of sixteenth- and seventeenth-century Europe proceeded to do. Europe’s first stab at a regime more tolerant of business resulted in a pro-business but not pro-enterprise economy. Government and business formed a closed community – or what would be called crony capitalism today. The towns were certainly not free markets.

Taxing Towns

As agriculture became more commercialised and prosperous, it could provide more taxable income. There were limits, though, on how much the powerful landed could be taxed – in France they were not, and in England, landowners colluded to pass laws in Parliament to avoid taxes.[16] Moreover, the king needed every last bit of revenue for the new forms of mass warfare because, as Louis XIV declared, ‘after all it is the last Louis d’or which must win.’[17] So the king looked to the towns and ports, where excise duties could be levied on goods like beer and bricks and customs duties could be charged on imports. In England, for instance, over two-thirds of government revenue from taxation came from Customs and Excise in the early eighteenth century.[18]

In order to tax urban production, the monarch had to deal with town bodies like the guilds that had formed for different trades and crafts, as well as the emerging monopoly merchant companies. In the same way as the manor-ial community protected the peasant against the uncertainties of life lived at the economic margin, the guild in a town protected its members from competition, both from others within the guild and from outsiders. It fixed membership fees; hours of work; the prices the master craftsmen could charge, and the wages they could offer; the terms, number, and fees for apprenticeships; and it negotiated on behalf of its members with the monarch or with town leaders for restrictions to be placed on outside competitors. If the response from the authorities was inadequate, the guild was not above taking the law into its own hands. Some organised armed expeditions of their members to search out and destroy any competitor that tried to do business in the territory they had earmarked for themselves.

The guild was effectively a cartel trying to ensure all its members got a decent living in an environment of weak economic growth, but also seeing to it that none was so energetic or entrepreneurial so as to put the others at a disadvantage. Like the manor, it aggregated the power of its members, a necessity in times when the law was weak, and might often right. It was also a social organisation like the medieval manor, providing economic support to those in need and encouraging interactions between its members. A somewhat disapproving description of members of the merchant guild of the Dutch city of Tiel dating from 1024 comments that members ‘begin their drinking bouts at the crack of dawn, and the one who tells dirty jokes with the loudest voice, and raises laughter and induces the vulgar folk to drink, gains high praise among them’.[19] Like the manor, it ensured stability and comradery, at the cost of innovation and efficiency.

The Alliance of Town and Crown

The interests of the towns were initially opposed to those of the landed nobility. For the peasant working in the lord’s fields, the town represented new opportunities. The efforts of towns to attract additional labour set them in opposition to the lords, who resented the attractive pull of the town on their field workers. Furthermore, while towns wanted cheap food for themselves and their workers, and thus preferred low tariffs on food imports (and high tariffs on manufactured goods), the landed nobility who produced food and consumed manufactured goods preferred the opposite. Also, the increasingly wealthy merchants and financiers were a challenge to the social status of the landed nobility.

The alliance of the town and Crown was more than just a matter of befriending the enemy of the enemy. Each offered something important to the other. For the merchant or the craftsman, the king offered protection, not just from physical attack or intrusion from manorial or canon law, but also from competition – he endorsed the anticompetitive guild and its practices through a royal charter. The resulting monopoly profits were the rents that are so necessary to sustain relationships. It kept the guild members united, creating a tight-knit association that was a powerful defense against other predatory powers of the time. The guild shared some of those profits with the king through periodic fees or loans, thus fulfilling its side of the Faustian bargain.[20]

Why Monopolies?

Why could the king not tax his people directly, instead of leaving them to the tender mercies of the monopolist guilds? As we have seen, taxation required authorisation by Parliament. Instead, the king could offer royal charters directly, thus bypassing Parliament. Royally licensed monopolies were less clearly offensive to the people, since high monopoly prices were an implicit concealed tax. So long as they were on a relatively few items, they would be borne with only a little grumbling.

Equally important, the nation-states in their early incarnations had weak bureaucracies and therefore limited abilities to collect taxes, tolls, or custom duties. The king benefited far more by investing scarce revenue in an army of soldiers than in an army of tax collectors. Therefore, the guilds and the merchant companies essentially served as the king’s tax collectors, estimating and collecting what was owed from their members. They often paid directly to the treasury upfront for the monopoly privilege, which reduced the king’s need to borrow or rely on a costly corrupt bureaucracy to collect taxes.[21] Moreover, monopoly profits came into the guild’s coffers as repayment for the advances it had made the king, so it did not have to stand in line outside the treasury for an uncertain repayment, unlike ordinary creditors. Finally, because the privileges came directly from the king for the most part (only some were authorised by Parliament), the guilds and monopolist companies became his loyal supporters, if nothing else because their continued fortunes depended on his survival. Every side benefited except the consumer who paid the higher cartelised prices!

The monopoly charter was not a secure form of property right. It was an easily transferred charter, not fortified by the competence of the holder – indeed, the longer the monopoly was held, the more inefficient the holder would get, and the easier it would be to expropriate, as was the case with the monastery land. What kept the monarch from large-scale taking-back-and-reselling of monopolies was probably concerns about the risk of angering a large group of merchants or craftsmen in the guilds or companies, as well as the loss of reputation and the damage it would do to the sale price of future monopolies. These were fragile supports on which to build large-scale investments, and typically such businesses invested little.

… 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.

Market forces also do not always work to weaken the politically powerful, especially if they have alternative outs. The precise circumstances matter. As Barrington Moore argues, the boom in prices as well as the expanding market for grain exports in the sixteenth century in northeast Germany had the effect of strengthening, not weakening, the power of the landed nobility.[44] With labour scarce, the landed nobility could have moved to paying peasants market wages, and commuting feudal obligations. Instead, by common arrangement, they increased the labour obligations of the peasants, eliminated their ability to sell or bequeath property, and reduced their ability to marry, or even move, off the manorial estate.

What was different in northeast Germany (and Eastern Europe more generally) from England was that the peasant did not have much market choice himself. Central authority was weak and there were no royal courts that might have protected his rights against the nobility. Moreover, even though it was a common feudal practice that a serf who escaped the manor and lived in a town for a year and one day became free, towns had declined in size and prosperity in northeast Germany, and there were not enough of them to hide him or give him a livelihood, unlike in more urbanised England. In Poland, the land market was suppressed because of laws that prevented ownership from passing outside nobility.[45] As a result, rich businessmen, lawyers, and merchants could not buy land, put it to more efficient use, and put pressure on feudal arrangements. With few checks on the power of the landed nobility, market pressures increased peasant oppression and feudal obligations rather than diminishing them. Even today, perhaps because it stayed feudal much longer, much of northeast Germany is less prosperous than southern Germany.

CONCLUSION

The absolute monarchy symbolised by the Tudors and attempted by the Stuarts gave way to a state that obtained more capabilities after giving up its power to be arbitrary. Such a state enjoyed broader legitimacy among the propertied because of the widespread belief that it would continue to adhere to a social contract with its wealthier citizens and investors. This also assured it of access to finance from the wealthy. With the confidence that it had few domestic challenges to its legitimacy, and that it could borrow the money to meet external challenges when that necessity arose, the state did not need to favour a select few. It could operate at greater arm’s length from the market. Cronyism steadily gave way to a more open business environment, which in turn created many more competitive independent entities that could check state power.

As England became militarily powerful on the basis of its strong state finances, and economically powerful based on its competitive markets (which positioned it well for the Industrial Revolution), other European countries took note. They did not want to lose out in the great European quest for supremacy. It would be too much to claim there was only one way to a constitutionally limited state. The United States, despite inheriting a very English governance ethos and becoming an independent republic, went through a civil war to suppress its own Southern landed interests.[46] France went through a bloody revolution, followed by war and empire before it eventually became a constitutional republic (barring a few short relapses). Germany went through unification, empire, war, democracy, fascism, and war again before it too became a constitutional republic. As we will see, the United States played an enormous role in post–Second World War Western Europe in ensuring that countries continued to see value in both a democratic limited state and in markets. Nevertheless, many Western European countries needed only a nudge postwar, because the underlying distribution of political power and the existence of structures promoting competitive markets made them fertile ground for creating a constitutionally limited state.

The recognition of private property in land, and the emergence of a market for produce and land, also hurt many as the feudal community was destroyed. While independent private property owners could coordinate through Parliament or Congress to influence the state, the peasant and increasingly the worker in manufacturing establishments, dislodged from their traditional communities, had no explicit rights and no say in their own governance. In the next chapter, we will track the final steps toward liberal democracy as industrialisation picked up. The demand for a voice came especially from workers in the growing cities, whose squalid filthy communities needed public services. Having obtained democracy, as we will see in the next chapter, communities organised to get the political establishment to pay attention to their demands, especially that unbridled crony capitalism be controlled. The third pillar grew in strength once again.

## [3]. FREEING THE MARKET … THEN DEFENDING IT

As the state eliminated military challenges within its territory, and as parliamentary bodies came to be dominated by propertied individuals, the wealthy no longer felt their lives or property were under constant threat. Parliament would limit the government to legitimate activities. With the state constitutionally limited, trade- or community-based organisations that would provide members physical security and protect their business were no longer required. Nor were restraints on competition that made these organisations possible. Economic philosophers could now preach the virtue of free and unfettered markets, while political philosophers could extoll the benefits of individual liberty and minimal government, even while both sets of thinkers took the safety of life and wealth for granted. In the eighteenth and nineteenth centuries, markets were on the ascendance.

Laissez-faire, first propounded by French philosophers known as the Physiocrats, sought to take the emerging relationship between the state and markets to its logical conclusion: the state should leave business alone to do what it must, letting the full forces of market competition play out. The philosophers did not explain what they would advocate if market participants tried to subvert market competition with the aid of the state – a development that Adam Smith worried about – or shut it down themselves by cartelising the market. Nevertheless, as a blunt theoretical argument with which to bludgeon the remaining anticompetitive vestiges of both feudalism and mercantilism, laissez-faire was successful.

Yet, even as the votaries of the market celebrated, opposition was building. Not everyone benefited from the commercialisation of agriculture, even in England. There were losers other than the high aristocracy, most importantly those who benefited from the old manor community. The worst affected were older peasants, whose tenancy was terminated as their fields were given over to more productive uses or users, but who could not migrate to the towns unlike the young. Peasants also saw their customary right to graze animals, hunt for game, or pick firewood in the commons disappear without compensation, as the common grounds were legally enclosed and appropriated by the politically powerful landed. As a popular ditty went:

The law locks up the man or woman

Who steals the goose from off the common

But leaves the greater villain loose

Who steals the common from the goose.[1]

The commercialisation of agriculture broke up many a traditional English village community, resulting in masses of unemployed peasants who migrated to the towns in search of work. This was Marx’s ‘reserve army’ of the unemployed, which fed the Industrial Revolution.

The jobs in the hellish factories that mushroomed in the growing towns were hard and dangerous. They did put food on the table but too many children worked long hours, simply because they were more nimble than adults, and parents did not know where to leave them while they worked. Families had few alternatives since work back in the village had disappeared. Worse than the factory jobs were the appalling, polluted, overcrowded, and unsanitary urban ghettos where the workers lived. Few employers were enlightened enough to do anything about these living conditions. With everyone subsisting at the margin, there was little sense of community, let alone community support in these anonymous, unfamiliar industrial towns. Every worker feared the job losses from the emerging business cycles and financial booms and busts, which could quickly convert a barely tolerable existence into utter destitution.

Parliaments, as we have seen, arose to protect the wealth of the propertied against the state. To ensure the right members were elected, legislatures also instituted a property qualification for voting. Constituencies were small and easily influenced while the middle class, labour class, and the poor were disenfranchised. With no political representation, and limited competitive pressure on employers to treat workers better (given that so many were looking for work), workers had little hope from the system for either an improvement in the workplace or in living conditions.

The workers, and urban dwellers more generally, needed representation if matters were to change. Their push for democratic voice had varying degrees of success over the course of the nineteenth century, but male workers obtained the vote in most countries in North America and Western Europe by the beginning of the twentieth century, for reasons we will detail. The expansion of the vote typically resulted in the authorities putting greater emphasis on public goods like sanitation, schooling, and safety nets. It did not lead to the newly enfranchised expropriating the wealth of the rich, as was much feared. The broader realisation was that the democratically empowered community was not against markets or private property, it was perfectly happy to respect them when there was a sense that respecting these rights broadly benefited the community. Indeed, to the extent that the earlier balance between the constitutionally limited state and markets was based on the efficient holding of property, it was a distribution that the democratically empowered community could also respect.

With the expansion of the vote, the broader electorate’s views on the state, the markets, and the relationship between them had the potential to matter. As we will see, democratic community-based movements like Populism and Progressivism in the United States toward the turn of the nineteenth century helped avert the cartelisation of markets and the closing of opportunities for the small businessperson. With the democratic community’s prodding, the state’s role expanded, with new functions like antitrust and product safety regulation keeping the markets competitive and orderly, and friendlier to small entrepreneurs as well as consumers. Democracy became the mechanism through which the organised and vigilant community could influence the state and shape markets – parliaments started their transformation from solely protecting the property of the few to creating and preserving opportunity for the many. Let us now elaborate.

FREEING THE MARKETS

In his book An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, Adam Smith argued that by producing for the market and maximising his own profits, the manufacturer maximised the size of the public pie, and thus the wealth of the nation. Smith thus made the case for allowing the invisible hand of the competitive market, working through self-interest, to drive economic prosperity. The real damage was not caused by avarice or even the self-indulgence of the rich, it emanated from restraints on competition and the resulting distorted prices and quantities.

Seen in this light, Adam Smith was pro-market, not pro-business. Indeed, he was no fan of the businessmen of his time because of their cartelising tendencies. In arguing against guilds and monopoly corporations, he wrote, ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.’[2] About businessmen’s suggestions for regulation, he emphasised that these should be ‘carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.’[3] Smith was no starry-eyed forerunner of Ayn Rand, convinced of the heroism of the business class. Instead, he pushed for eliminating anticompetitive privileges, such as those enjoyed by the monopolist corporations of his time.[4]

He was equally scathing about mercantilism. He dismissed the notion that an accumulation of gold would make a country more powerful and able to wage war – for a country like Great Britain, any feasible accumulation of gold would be too small given the huge costs of war. What was needed to sustain a long war was greater domestic productive capacity. To give domestic producers a monopoly by levying high import tariffs or prohibiting imports was therefore either ‘useless or … hurtful’. If the local product could be made and sold as cheaply as the foreign product, the prohibition was useless for domestic production would be competitive on its own. If local production was not competitive, the tariff was harmful for it raised domestic prices of the product, and diverted precious domestic productive capacity toward its making. Smith wrote:

‘It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor … What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.’ [5]

Therefore, Smith pushed hard for freeing the domestic market from the hold of guilds and monopolists, while bringing down the barriers to foreign trade erected by the mercantilists. In the spirit of laissez-faire, Smith thought little of a government that tried to direct production or investment by the businessman from afar, for ‘every individual, it is evident, can in his local situation judge much better than any statesman or lawgiver can do for him.’ Indeed, Smith believed the government had only three essential duties: ‘First, the duty of protecting the society from … invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, … and, thirdly, the duty of erecting and maintaining certain public works, and certain public institutions, which it can never be for the interest of any individual, or small number of individuals to erect and maintain.’[6]

A PHILOSOPHY FOR THE MARKET

It was a short step from Adam Smith’s work to the manifesto for individualism and the free market, On Liberty, written by British economist John Stuart Mill. It was published in 1859, soon after the death of his wife Harriet, whom he acknowledged had influenced the work greatly.[7] Mill defended individual thinking and speech against the tyranny of the majority. He argued that the views of the community tended to be the views of the powerful or the majority, and there were good reasons to subject that view to challenge, including the obvious possibility that the majority view could turn out to be wrong.

Mill saw all individual actions as permissible that did not hurt the interests of others. Apart from this, he saw an individual’s duty to society as sharing in ‘the labours and sacrifices incurred for defending the society and its members from injury and molestation’. Society had no call on the individual beyond this. He argued he was not advocating selfish indifference to the community, but voluntary engagement. Not only would an individual’s engagement on his own terms improve social enterprise, he believed ‘the free development of individuality is one of the leading essentials of well-being.’ Individuality should be valued in its own right and not just as a means to a societal end.

Mill thus sought to restore free will’s role in the vibrancy and variety of human existence that Calvin had rejected. Calvinism emphasised obedience – ‘You have no choice; thus you must do, and not otherwise: “whatever is not a duty, is a sin.” Human nature being radically corrupt, there is no redemption for anyone until human nature is killed within him.’ Instead, Mill argued that ‘Pagan self-assertion’ is as much an element of human worth as ‘Christian self-denial’, that it is ‘not by wearing down into uniformity all that is individual in themselves, but by cultivating it, and calling it forth, within the limits imposed by the rights and interests of others, that human beings become a noble and beautiful object of contemplation’, and ‘in proportion to the development of individuality, each person becomes more valuable to himself, and therefore capable of being more valuable to others.’ He declared that ‘genius can only breathe freely in an atmosphere of freedom,’ for ‘the general tendency of things throughout the world is to render mediocrity the ascendant power among mankind.’

Mill’s was thus an attack on the stultifying effects of the community, the ‘despotism of custom’. He viewed the freedom of trade, contracts, and markets as consistent with his beliefs on liberty. This also meant limits on the state, for ‘where everything is done through the bureaucracy, nothing to which the bureaucracy is really adverse can be done at all.’ Instead, the state should be an ‘active circulator and diffusor, of the experience resulting from many trials … [enabling] each experimentalist to benefit by the experiments of others; instead of tolerating no experiments but its own.’

The state and the market had grown together from the crumbling edifice of feudalism. The constitutional limitations on the state that we traced in the last chapter did not shrink the state. Instead it helped the state build out its military and fiscal capabilities as it gained access to finance. Once the state had created a framework to ensure security and protect property rights, the proponents of laissez-faire started questioning how much more it should do. Smith and Mill were not rabidly antigovernment. Smith, for example, accepted a role for the state in education, as well as other services that would not be privately provided. For these reasons, he argued that the state in a civilised country would be larger than in a barbaric one.[8] Yet these nuances were ignored, as were his asides on the perfidy of businessmen if they were entrusted with their own regulation. Instead, public debate became focused on steadily eliminating any restraints on business practice, as well as any protections to labour.

Perhaps more than anyone else, the Reverend Thomas Robert Malthus epitomised the heartless side of liberalism, when taken to its extreme. In the various editions of his Essay on the Principles of Population published in 1798, he emphasised the tendency of man to reproduce faster than food supply. Man could restrain himself through self-imposed checks like delayed marriage or sexual abstinence, but Malthus did not believe these would work. Instead, disease, war, and famine would be the natural checks on mankind’s lack of self-control. No wonder historian Thomas Carlyle termed economics ‘the dismal science’! Malthus was wrong. Humans do not have an uncontrollable urge to reproduce. Indeed, prosperity has been a powerful contraceptive, with people becoming less willing to have children, even as they can afford more of them. Fertility rates for women are now below population replacement rates, not just in rich countries but in a number of emerging markets. Nevertheless, his views offered those who opposed even humanitarian government aid a theoretical rationale. Any relief schemes for the unemployed or the poor only encouraged them to reproduce more, and thwarted natural checks and balances. The indigent should be left free to starve, for only through a market-induced cull would succeeding generations have a better life.

Even if such callous theorising was never actually translated into action, it did help harden policies toward the poor and the destitute. As the eminent historian and sociologist Karl Polanyi pointed out, the Poor Law in England, which mandated parish support for the indigent, was made harsher in 1834, especially for able-bodied males. This was just as difficult economic times and the new machines of the Industrial Revolution were putting thousands out of work.[9] Some tried to put a better light on these policies, arguing they placed the community back in charge of any voluntary support, others claimed rich farmers were misusing Poor Law subsidies. There was some truth to these explanations. It was also true that Parliament was dominated by the propertied well-to-do, who had been complaining about the high taxes they had to pay before the Poor Law was reformed. Clearly, they were also voting for their pecuniary interests.

With the demise of feudal institutions, the powerful no longer had an obligation to the weak in the community, while market fluctuations and automation left workers, especially those who had left their traditional communities, utterly exposed. Something between the extreme individualism of unregulated markets and the enforced collectivism of an authoritarian, overweening state had to be rebuilt on the ashes of feudalism. Before getting to that, though, what did a market freed from all restraint look like?

THE UNBRIDLED MARKET

Initially, it resembled the perfect competition of textbooks, with producers competing with one another to give the consumer the best deal, but this did not last. For as Adam Smith recognised, competition drove down profits, making any producer’s life greatly uncertain. The inexorable political tendency of a free, unfettered, unregulated market was for the producers, after experiencing the rigors of competition, to attempt cartelisation.

John D. Rockefeller, the richest man in the world in his time, made his money in rock oil or petroleum, in the early days of the industry when oil’s primary uses were for fueling lamps and lubricating steam engines. Rockefeller was not attracted to the risky business of prospecting for oil. Not only was unscientific drilling more likely to unearth dry wells than oil, excess production whenever oil was found in a locality could bankrupt producers as prices plunged.[10] Rockefeller wanted a more stable business, and he found it in oil refining in Cleveland, the urban portal to Oil Creek, Pennsylvania, where oil had been discovered first. As Rockefeller worked to make his refinery the lowest-cost producer – at one point reducing the number of drops of solder on the tin cans used to carry kerosene from forty to thirty-nine after checking that any further reduction would cause the can to leak – he managed to drive out the truly incompetent and gained market share.[11] Yet many, having sunk money in their investments, and having debts to pay, refused to quit, and kept the price of refined products low – so long as the price was a little more than their incremental cost of refining, the zombie producers staggered on. At one point in the 1870s, refining capacity was three times greater than demand.[12]

Rockefeller wanted to bring order to refining, and his first target was the twenty-six remaining independent Cleveland refiners. In 1872, as Ron Chernow details in his biography of Rockefeller, Rockefeller struck a deal with the railroads serving Cleveland, whereby Rockefeller and his cartel would get discounts (from the posted transport price) for the crude and refined oil they shipped. More egregious, the railways agreed to pay the cartel for every barrel shipped by the competing independent non-cartel refiners. Effectively, this meant the railways would face a higher cost to transport non-cartel products, and thus would have to charge the cartel’s competitors more.[13] In addition, the cartel was to get full information about the oil shipped by competitors. In exchange, the three participating railroads each got a fixed share of the oil that the cartel shipped, and fixed transport fees, thereby eliminating the cutthroat competition they otherwise engaged in. The arrangement would bring stability to their revenues. Rockefeller’s keen business sense helped him recognise that both refiners and railroads might want to cartelise, and the combination would be deadly to those not in the cartel.

With no alternative methods of transport, the angry oil drillers along Oil Creek decided to boycott the cartel and sell only to local independent refiners. Protesters attacked the railroads, emptied oil cars and spilled their contents on the ground, and ripped up tracks. Even as the industry was in turmoil, though, Rockefeller bought up twenty-two of his twenty-six Cleveland competitors. As an owner recounted, ‘There was a pressure brought … that if we did not sell out we should be crushed out … It was said they had a contract with the railroads by which they could run us into the ground if they pleased.’[14]

In the face of prolonged public protests, legislators eventually withdrew the charter for the shell company at the center of Rockefeller’s cartel, while Congress started investigations. The railroads, who were much more dependent on government favour and public opinion for their activities, backed down, and instituted uniform rates for all shippers once again. In the meantime, Rockefeller had created a refining monopoly in Cleveland, as well as a strategy that would serve him well going forward – cost efficiency was good, but monopoly on top of it was even better. Five years after what became known as the Cleveland Massacre, Rockefeller’s company, Standard Oil, controlled 90 per cent of oil refined in the United States. There were about a hundred struggling small independent refiners still in existence at that time in the United States, which allowed Rockefeller to maintain the pretense of competition in the refining industry.

In Rockefeller’s mind, he had only helped his inefficient competitors end their misery by taking them over – in many cases, he closed their plants.[15] The surviving refiners would enjoy greater economies of scale and more stable prices, their workers would be more secure in their jobs, and customers would benefit in the long run. This argument for cooperation among producers – coordinated by Rockefeller – instead of competition, while not entirely implausible, was entirely self-serving. Competition was the only guarantee in a free market that a producer would be solicitous to customers, whether through innovation, better customer service, or low prices. Faced with a refiner monopoly, customers were dependent on Rockefeller’s benevolence. How much could it be trusted?

Rockefeller was a superbly efficient businessman in the Calvinist mode; he saw his work as his calling. His confidence in his own capabilities blinded him to alternative paths. He saw unfettered competition as greed, causing unnecessary booms and busts, and impoverishing the entire industry. What he tried to restore were cooperative structures such as trusts, pools, and monopolies that brought order to markets – and he had no hesitation in bribing entire legislatures or misleading public hearings with fake testimonials to get his way.[16] Manipulating government was just another means to business success. Many successful businessmen of the time thought similarly – Rockefeller was just more successful at executing plans. Many at the receiving end saw the kind of order he brought, which was spreading to a number of industries in the United States such as railroads and steel, as monopoly capitalism, perhaps the worst form of calculated greed. For essentially, the capitalists at the center of these cartels insisted that they, not the free market, knew what was best for the public.

The free market was not perfect. Bouts of euphoria, fuelled by easy money, undoubtedly led to overexpansion and industry hangovers. However, eliminating these wasteful and volatile episodes would also eliminate the innovation, dynamism, and creative destruction of the free market. What the cartels called waste was in fact the constant experimentation fostered by the market, energized by competition. In a sense, the magnates of the late-nineteenth-century Gilded Age in the United States wanted to restore the aristocracy, where they decided what was best for the public, but without the explicit responsibilities of the feudal manor.

In many ways, Rockefeller’s personal life was exemplary. He lived in the Gilded Age but was not of it. In the latter part of his life, he did take public responsibility seriously, figuring out how to spend his enormous fortune on the well-being of society. Among the extraordinarily successful institutions he founded are the University of Chicago, where I teach. His dismal view of competition had less resonance with Adam Smith, though, than with another insightful economist, Karl Marx.

THE MARXIST RESPONSE

The Industrial Revolution that started in Britain in the late eighteenth century created tremendous new possibilities as well as widespread despair. I have already referred to workers displaced by new machines like the power loom. In addition, though, the promise of new technologies, as well as new lands, especially in the Americas, made accessible by railways and the steamship, prompted waves of euphoria fuelled by finance. The business cycle, with its production booms and busts, emerged in many industrialising countries, as did the financial cycle, with sustained booms in lending and euphoric rises in land and stock prices, followed by crashes. In the United States, there were serious financial panics about once every twenty years between 1819 and the start of the Great Depression in 1929. Among these were the Long Depression, a series of global downturns between 1873 and 1896, bookended by financial crises. The seventy years or so of relative financial calm between the bank failures of the Great Depression and the Global Financial Crisis in 2007–2008 were an aberration, not the norm.

Barring a few at the top of the societal pyramid, people in preindustrial times had experienced collective poverty. While industrialisation, transmitted through the competitive market, lifted average living standards steadily over generations, what was also new was great dispersion in incomes across society at any particular point in time, and great volatility over time. The market offered bountiful rewards and merciless punishment, which was both its greatest economic strength and its greatest political weakness. Economic security, not physical security, was now the primary public concern in industrialising countries.

Karl Marx was wrong in some ways, especially in his economic theories, but he was one of the greatest social thinkers of modern times. He recognised that society adapts to, and is therefore shaped, by the underlying production technologies of the time. ‘The hand mill gives you society with the feudal lord; the steam mill society with the industrial capitalist,’ he wrote.[17] Subsistence agriculture bred feudal arrangements, while industrialisation and machines facilitated capitalistic corporations run by the emerging bourgeoisie. The technology of production did not fully determine the nature of society, of course, but Marx was right in that it was influential.

Unlike Rockefeller, who wanted capital to be left alone to create its mon-opolies, or utopian socialists like Robert Owen who, touched by the plight of the worker, called for a responsible, sharing, capitalism, Marx and his long time coauthor, Frederick Engels, were convinced that capitalism itself was fundamentally flawed and would collapse because of its own contradictions. Moreover, instead of appealing to the social conscience of the elite, Marx wanted to eliminate them. He believed that it was both morally right and economically beneficial for property to be commonly owned. Marxists did not look for crumbs off the capitalist’s table, they wanted the whole table itself to belong to those they thought were its rightful owners, the community of workers.

In their view, the industrialist exploited the worker through his ownership of the fixed plant and equipment of the factory, its capital, which was also why capitalism contained the seeds of its eventual downfall. Marx believed labour was the source of all value, and the only reason the industrialist made a profit was because the industrialist’s ownership of the means of production gave him bargaining power over workers. Any worker could go off on her own and become self-employed, but without the machines she would be unproductive. The industrialist would pay her a better wage than the self-employment alternative, but less than the value she produced for him. The difference between the value she produced working for the industrialist and her wage was the surplus value accruing to the industrialist, the source of his profits.

The more unemployed workers there were – the so-called reserve army, set adrift as enclosures rendered agricultural labour redundant and better machines rendered industrial workers redundant – the lower would be the employed worker’s alternative options, her bargaining power, and hence her wage. The industrialist’s profits would rise. By emphasising labour as the only source of value, Marx was wrong, but not out of line with economic thinkers of his time. This theorising also meant that all profits ought morally to belong to labour, and the profits accruing to the industrialist were mere exploitation, made possible by his property rights over capital.

But Marx went further to say that the capitalist structure of ownership was economically unsound, and the world should change for this reason only, even if it was not convinced by the moral argument. Essentially, competition would force the profit accumulated by the industrialist to be reinvested in yet more productive machines, forcing more workers out of the labour force, pushing wages further down. Crises, where product prices collapsed and industrial losses exploded, could arise for a variety of reasons. Along the lines of Rockefeller’s thinking, it could stem from the myopic greed or irrational exuberance of industrialists, pushing to get a greater share of the market, and ending up overinvesting and overproducing. It could arise when overindebted industrialists, pressed by bankers to repay, dumped their excess inventory and machines on the market. Most important, it could arise because the true source of industrial profits was appropriating the surplus value of labour. As the quantity of labour fell relative to accumulated capital machinery, Marx believed it was inevitable that the rate of profit would also fall, and hence the susceptibility of the system to accidents and crises would rise. A more modern version would be that as labour’s wages were squeezed, the ability of workers as consumers to buy what was produced would fall, leading to overproduction and crises.[18]

When crisis hit, the Rockefellers of the industrial world would buy up failing competitors, close them down and fire their workers, and eventually restore equilibrium between supply and demand, but with much distress for all. The collapse of capitalism was not inevitable – it might be stuck in perpetual torment. As the Russian revolutionary Leon Trotsky wrote, ‘capitalism does live by crises and booms, just as a human being lives by inhaling and exhaling. First there is a boom in industry, then a stoppage, next a crisis, followed by a stoppage in the crisis, then an improvement, another boom, another stoppage, and so on…. The fact that capitalism continues to oscillate cyclically … merely signifies that capitalism is not yet dead, that we are not dealing with a corpse. So long as capitalism is not overthrown by proletarian revolution, it will continue to live in cycles, swinging up and down. Crises and booms were inherent in capitalism at its very birth; they will accompany it to its grave.’[19]

The Marxist solution to the problem – ending competition – resembled Rockefeller’s, except Marxists wanted to replace the monopolist capitalist with the dictatorship of the proletariat. Since they argued capital was essentially accumulated profit extracted by squeezing labour (or amassed from other dishonorable activities buried in a typical family enterprise’s past like smuggling, bootlegging, usury, war profiteering and outright theft), the capitalist should be expropriated. All property would be held by the state in the name of the working proletariat, and a centralised bureaucracy would make production decisions. As Frederick Engels wrote, ‘If the producers as such knew how much the consumers required, if they were to organise production, if they were to share it out amongst themselves, then the fluctuations of competition and its tendency to crisis would be impossible.’[20]

Therefore, instead of the benevolent Rockefeller directing production and prices, it would be the benevolent revolutionary turned bureaucrat. Once again, what would prevent the benevolent from becoming self-interested? No amount of idealistic Marxist literature prevented the chosen elite, the nomenklatura, a superclass that had access to the best shops and the choicest luxuries, from emerging in every Marxist country, even as the fundamental inefficiencies of centralised monopolistic production slowed growth. Without competition to show up inefficiencies and penalize the merely greedy, and without the decentralized decision making that Adam Smith and later Friedrich Hayek thought was essential to make best use of local information, centralised monopolies eventually ended up as a sclerotic mess, as exemplified by the former Soviet Union.

In a sense, though, revolutionary Marxism had the potential to be much worse than monopoly capitalism, for it eliminated political competition explicitly, concentrating political power and economic decision making in the same hands. Anarchists like Mikhail Bakunin fought against the centralized state implied by Marxism, and argued for decentralised self-governing structures, only to see their influence in radical Left circles diminish. The communists, like Rockefeller, wanted to retain all the power to decide for themselves.

Fortunately, neither Rockefeller’s nor Marx’s vision was realised in the industrialising West. Democracy preserved market competition, and market competition preserved democracy. That is what we will examine in the remainder of this chapter, and in the next one, focusing on the special role played by the community.

EXTENDING THE FRANCHISE

Early in their industrialisation, most market economies concentrated economic and political power in the same hands – even in the middle of the nineteenth century, British cabinets were dominated by the landed peerage. However, as the dissatisfaction of the working classes mounted, the elite recognised that while their explicit responsibility for the rest had evaporated with the end of feudalism, some accountability had to be restored for the nation as a whole to function with more cohesion. The centralised government of the nation-state had stripped the community of some of the powers to determine local policies, even while the Industrial Revolution and the changing market brought many new pressures that the community needed addressing. Those lower down on the economic pyramid demanded a political say – else their plight would simply be dismissed, as it always has been, as the unpleasant but unavoidable consequences of progress. Undoubtedly, if the state was weak and ineffective, a coup or revolution from below was always a possibility. If it was stronger, though, the underprivileged had to stay broadly within the system to change it. In nascent democracies, this meant pushing for broader enfranchisement.

In feudal England, the right to vote was reserved for male ‘freeholders’, that is, those who had independent ownership of land.[21] Ostensibly, these would have a long-term interest in the well-being of the community.[22] More plausibly, property holders believed that by keeping the vote restricted to people like themselves, they would protect their property from the poor. They would also prevent the state from expropriating their wealth to finance imprudent spending. Indeed, despite a war of independence against the British in which Americans from all economic strata participated, the newly independent colonies of the United States typically restricted the right to vote to those men with property, with only Pennsylvania and South Carolina going further to allow all men who paid taxes to vote. In all these would-be states, women and slaves were excluded.

Over time, the vote was extended. None of the states that joined the Union after the original thirteen had property requirements restricting voting eligibility. Even the majority of the original thirteen colonies that entered the Union eliminated the property requirement by the middle of the nineteenth century, with the battle over economic-based restrictions on franchise waged seriously only in the older states like Massachusetts, New York, and Virginia, where land or wealth inequality was more pronounced, and populations more diverse.[23] Even in venerable old England, suffrage steadily expanded during the nineteenth century as property requirements for eligibility were whittled down, in 1832 to include the middle class, in 1867 the urban worker, and in 1884 rural workers.[24]

The expansion of the suffrage was typically followed, both in the United States and the United Kingdom, by an increase in local public spending: on local schools open to all, on health care and public heath necessities like sewerage systems and public toilets in urban areas, and on local support systems for the indigent and elderly.[25] Thus community powers and activity centering on local spending strengthened as the voting franchise broadened.

The expansion of the suffrage was rarely linear. For instance, in the United States, at the same time as economic-based restrictions on voting eligibility were abandoned under the populist president Andrew Jackson, groups that were deemed unsuitable for participation in community decisions, such as blacks, women, Native Americans, the mentally incompetent, criminals, and the newly resident, were explicitly excluded.[26] Indeed, on the eve of the Civil War, only the five New England states where blacks were few, and New York, which had a $250 property requirement applied only to blacks, still allowed blacks to vote. When Southern blacks obtained the right to vote after the Civil War, they started being excluded again through a variety of targeted measures such as literacy and residency tests.

Latin America also followed a similar pattern, starting with strict property requirements, followed by an extension of the franchise as pressure on landowners came from other citizens of European descent, and eventually a replacement of economic restrictions with literacy tests so as to specifically exclude workers and the poor, especially Native Americans. By the end of the nineteenth century, suffrage was still far from universal in much of Western Europe and North America, with women and minorities generally excluded (New Zealand was the first modern country to let women vote in 1893). However, there had been a substantial expansion in the electoral franchise to nearly all white men, a significant broadening of the franchise since the minuscule electorates at the beginning of the century. Why did this happen?

WHY WAS THE FRANCHISE EXTENDED?

As markets became more integrated, both nationally and internationally, economic adversity from far away could affect a community, and disproportionately the less well-to-do. In the same way that a free market decentralised economic decision making, a more democratic structure would allow many more voices to be heard, allow the local community to influence their representatives and the federal government, and allow people to feel more in control of their destinies. Political empowerment could compensate, in a small way, for the lack of economic empowerment.

Why did legislators, whose allegiance was to those who already had the vote, extend the franchise? After all, few who have power want to share it. We can dismiss the possibility that the legislators suddenly absorbed the spirit of the Enlightenment, believing that in the interests of fairness, suffrage should become universal, and in the interests of legitimacy, every one among the ruled should have a voice in government. While the rallying cry of the American Revolution was ‘no taxation without representation’, it said nothing about the representation of those who did not pay taxes. In fact, the franchise was typically extended in steps, not in one go (as might have been the case if legislators became suddenly enlightened). Therefore, we have to look elsewhere for explanations.

Fear

Economist Daron Acemoglu and political scientist James Robinson argue that an important reason for the elite to extend the franchise was perhaps the fear that if it were not extended, the unwashed masses might revolt.[27] The French Revolution was a warning to those in power that if they were not careful, many of their heads could end up mounted on pikes. And yet the Revolution could also be read as a cautionary tale of what could happen if revolutionaries were given a role in government. The archconservative Edmund Burke warned ‘the occupation of a hair-dresser … cannot be a matter of honour to any person … Such descriptions of men ought not to suffer oppression from the state, but the state suffers oppression if such as they … are permitted to rule. In this you think you are combating prejudice, but you are at war with nature.’[28] This then was the dilemma that tormented the guardians of political power: Should the masses be kept outside the gate, with the hope that the gate would withstand their anger, or should they be let inside with the hope that they would be tamed?

Widespread economic adversity did certainly precipitate violent political agitation for greater inclusion. For instance, after the failure of the harvests of 1829 and 1830 in England, agricultural labourers burned the fields of the gentry under the orders of a mysterious Captain Swing and destroyed threshing machines.[29] Some argue that this led to the first voting Reform Act of 1832. Yet the state repressed the agitation fiercely, with over two thousand people arrested, five hundred transported to Australia, six hundred imprisoned, and nineteen executed. Moreover, the Reform Act gave the vote to those with property having a rental equivalent of 10 pounds a year, a sum far outside the reach of the labourer. It was widely alleged that the elite were buying off the middle class. At any rate, the newly enfranchised certainly were not in the crowd with pitchforks.