Even Without Law, Contracts Can Be Enforced?

The New York Times, "Economic Scene" , October 10, 2002

Would you lend a complete stranger $10,000? How would you get your money back?

Trusting people you don't know with large sums may sound like the height of foolishness. But a modern economy depends on exactly such impersonal exchange.

Every day, people lend not thousands, but millions of dollars, to strangers with every expectation that they'll be repaid. Vendors supply goods and services, trusting that they'll be compensated within a reasonable time.

How does it all work?

Traditional economics tends to assume away that basic question. On the blackboard, supply and demand meet without a doubt that supplier will really deliver or that demander will pay.

A lively field of economics with an unfortunately clunky name looks behind the blackboard assumptions.

The new institutional economics studies how people arrange their affairs; how they create institutions, including legal sanctions, social norms and organizational structures, to govern their relationships; how those institutions spur or hinder economic growth; and how those institutions improve through trial and error.

The International Society for the New Institutional Economics (www.isnie.org) recently held its sixth annual meeting at the Massachusetts Institute of Technology, attracting about 200 economists and other social scientists from 40 countries. Once a heterodox challenge to convention, this field is increasingly part of the mainstream.

It asks deep theoretical questions and ties those questions to pressing empirical realities, most notably how formerly Communist countries can successfully make the transition to markets.

Researchers look at economic activity through what Oliver E. Williamson, a former president of the society, calls the "lens of contract."

"The lens of contract focuses predominantly on gains from trade whereas orthodoxy is focused on resource allocation (prices and output)," writes Professor Williamson, an economist at the Haas School of Business at the University of California at Berkeley.

To the "science of choice" developed by traditional economics, the new institutional economics adds a "science of contract."

To understand how contracts work, it helps to examine problem cases where contract law is underdeveloped or contracts are hard to enforce.

In a paper for the conference, the economic historian Avner Greif of Stanford looks at how merchants in the late Middle Ages developed institutions that allowed a commercial revolution.

"How," he asks, "could a creditor from one corner of Europe, for example, trust a debtor from another corner, about whom he knew little and who could avoid interacting with him in the future, to pay his debt?"

The answer was the community responsibility system, in which every member of a community was liable for every other member's debts. If someone in Community A didn't pay what he owed, Community A had the choice to either cease trading with Community B or compensate it for the damage and seek retribution from the individual.

Because communities wanted to maintain trading relations, they policed their own.

As trade flourished and communities grew, however, the system began to break down. The costs to an individual who cheated shrank, while larger merchants had to bear a high cost for other people's cheating.

Communities abandoned the old system. In 1279, for instance, Florence, Venice, Genoa and other cities agreed not to hold any person or his goods because of someone else's debts. They also agreed to imprison debtors who fled to their towns.

Over time, new forms of enforcement developed, forcing creditors to evaluate borrowers by using indicators of their individual merits. But the community responsibility system provided the institutional scaffolding that made the expansion of trade possible. Even without centralized law, it was possible to make enforceable contracts.

Turning to the present, Guido Friebel of the Stockholm School of Economics and Sergei Guriev of the New Economic School in Moscow offer a provocative argument about an extralegal contract: the payments illegal migrants promise traffickers who arrange long-term, long-distance moves from, say, China to the United States or Europe.

It costs an illegal migrant as much as $35,000 to go from China to the United States and $25,000 to go to Europe. (This research does not apply to short-haul migration like that involving the United States and Mexico.)

But these are mostly poor people who can't possibly pay that much in advance. Instead, they make a down payment and agree to work a certain term -- for Fujian Chinese, the average is 26 months -- to repay the rest.

On arrival, they become temporary slaves or, as they were known when America was settled, indentured servants. But in contrast to colonial times, these days these contracts aren't legally enforceable.

In theory, the immigrants could run away once they were in the country. They don't escape, however, because they fear deportation. Their illegal status acts to enforce their contracts.

(Traffickers generally keep their deals because they face competition in the home country. A bad reputation would cost them future business.)

Tightening immigration enforcement paradoxically supports indentured servitude and, hence, illegal migration. By contrast, Professors Friebel and Guriev argue, making legal immigration easier could actually reduce low-wage migration. Traffickers would have less leverage to collect debts and wouldn't be as likely to finance poor migrants. But more affluent, higher-skilled people would be able to immigrate legally.

These are two small examples of a much larger phenomenon: When the rule of law is absent or imperfect, people find other ways to make contracts workable. But those alternatives may be unstable or inefficient.

"Whatever the rules of the game," Professor Williamson writes, "the lens of contract is also usefully brought to bear on the play of the game."