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Published in
The New Palgrave Dictionary of Economics and the Law
.1998.
Informal Contract Enforcement:
Lessons from Medieval Trade
1
1998
Avner Greif*
Department of Economics.
Stanford University
Exchange fosters economic efficiency by enabling the reallocation of endowment and products,
increasing specialization and motivating innovations. For efficiency enhancing exchange to take
place, the parties to the exchange have to be able to
ex ante
commit not to breach a contract
ex post
.
They must commit to respect the property rights generated by their contractual arrangement.
Hence, contract enforcement institutions which enable such commitment determine the discrepancy
between the set of optimal exchange relations and that of feasible exchange relations. Formal
contract enforcement institutions, that is, the legal system and the private order institutions that
evolve in the shadow of the law, often enable such commitment (Williamson 1985). Yet, the ability
of formal institutions to support exchange is limited due to asymmetric information and the
boundaries of the state's jurisdictional power. Thus, the discrepancy between the sets of optimal
and feasible exchange relations in an economy is also determined by the nature of the available
informal contract enforcement institutions, namely, institutions that enable commitment in the
absence of a legal system with authority over (all) those parties to the exchange who can gain from
breaching the contract.
The importance of informal contract enforcement institutions (henceforth ICEIs) is well
reflected by the large extent to which exchange in pre-modern, modern, developed and undeveloped
economies takes place outside the domain of the legal system. (For a survey, see Greif 1997a.)
Macaulay (1963), for example, found that among businessmen in Wisconsin "many, if not most,
exchanges reflect no [contractual] planning or only a minimal amount of it" (p. 60). A survey of
224 randomly selected Kenyan manufacturing firms found that 58 percent of them borrowed from
informal sources without legal contracts or collateral (Fafchamps and others 1993). In Russia,
despite the lack of an appropriate legal system prior to (and after) its market reform, informal
exchange had been extensive (Greif and Kandel 1995).
2
What are the origin, nature, and implications of a society's ICEIs? This paper advances the
following perspective regarding ICEIs. They emerge spontaneously as a response to efficiency
enhancing opportunities. Yet, they are a product of the larger economic, cultural, social and
political processes of which they are an integral part. Cultural, social and political factors impact
ICEIs by coordinating actions and expectations, determining the availability of information,
influencing the ability to initiate collective action, determining the ability to use coercive power in
the pursuit of economic ends and influencing the existing set of formal contract enforcement
institutions. At the same time, existing ICEIs can reinforce the social structures and cultural
features which led to their emergence, and influence processes of formal and informal institutional
innovations and change. In short, although ICEIs reflect and impact economic needs and outcomes
their particularities and implications reflect their inter-relations with the broader organization of
society (Greif 1994). They shape the cultural and social aspects of the relevant society as well as its
formal institutions. Thus, they are not necessarily "optimal" in the sense that they can support the
exchange relations required to bring an economy to the (constrained) pareto frontier, given the
economy's enforcement technology, endowments, preferences, and production technology.
Furthermore, ICEIs exhibit path dependence (David, 1988) in being incapable of evolving
significantly away from the forms and functions shaped by their historical origins. Consequently,
they may have a lasting economic impact.
This paper substantiates these points by briefly presenting and elaborating on several private
order institutions which facilitated exchange during the Late Medieval Commercial Revolution
))
the developmental epoch stretching from the eleventh to the fourteenth centuries, which witnessed
the re-emergence of Mediterranean and European long-distance trade after an extended period of
decline. This place and period lends itself to an examination of the role of ICEIs in facilitating
exchange, since the emergence of long distance commerce depended on the mitigation of
contractual problems despite the absence of appropriate legal enforcement provided by the state.
Furthermore, the nature, origin and implications of ICEIs during this period have recently been the
subject of several studies which advanced a new methodology for their investigation. It combines
explicit game theoretical models and detailed, micro level historical analysis (Greif 1997c).
Common to all these studies is a reliance on the game theoretical formulation of the idea
that when contractual relations are expected to be repeated, a reputation mechanism can provide the
basis for informal contract enforcement among self-interested individuals. Conditioning future
3
exchange on past conduct creates a linkage between past conduct and the future utility stream. If
the long term cost of losing future gains from exchange is higher than the short run gains from a
breach, one acquires a reputation for honesty: he can credibly commit
ex ante
not to breach a
contract
ex post
.
To identify the ICEI which governs a particular exchange it is thus necessary to examine
theoretically and empirically how the linkage between past conduct and the future utility stream is
created. It requires identifying the exact nature of the sanctions which would be imposed following
a breach of contract, how the appropriate information is obtained and disseminated, who applies the
sanctions, how the sanctioners learn or decide what sanctions to apply, why they do not shirk from
their duty, and why the offenders do not flee to avoid sanctions. Once this identification takes
place, the examination of the ICEIS can be further advanced to study their origin and implications
and inter-relations with various economic, social and political features.
The paper proceeds as follows. The first section briefly presents several ICEIs. The second
section examines the inter-relations between them and the cultural, social and political aspects of
the relevant societies. The third section examines the efficiency and path dependence of these
institutions. Due to space limitation, these sections neither present the methodology utilized to link
the game theoretical and historical analyses nor delineate the relevant evidence. The
methodological approach is discussed in Greif (1997c) while the relevant historical evidence is
provided in the works cited below.
I.
Informal Contract Enforcement Institutions
1.
Institutions which Governed the Relations between Rulers and Alien Merchants
As discussed in Greif, Milgrom and Weingast (1994), since the political units during the
Late Medieval period were relatively small, spatial specialization in production required trade
across political boundaries. But a difficulty arose: having a local monopoly over coercive power,
any medieval ruler faced the temptation to abuse alien merchants who frequented his realm and
their property. Without an institution which enabled the ruler to commit
ex ante
to secure their
rights, alien merchants were not likely to frequent that ruler's territory, thereby depriving its
population, the ruler, and the merchants of the benefits of trade.
Since trade relationships were expected to repeat, one may conjecture that an ICEI based on
a bilateral reputation mechanism (in which a merchant whose rights were abused ceased trading), or
4
based on an uncoordinated multilateral reputation mechanism (in which a subgroup larger than the
one that was abused ceased trading), could surmount this commitment problem. The Folk theorem
of repeated game theory suggests that since these mechanisms created an
ex ante
linkage between
past conduct and the future income stream, a ruler who highly valued future income could credibly
commit himself
ex ante
not to abuse merchants' rights
ex post
.
Yet, although each of the mechanisms above can support some level of trade, neither can
support the
efficient level of trade
. The bilateral reputation mechanism fails because, at the efficient
level of trade, the value of future trade of the "
marginal
" traders to the ruler is zero, and hence the
ruler is tempted to abuse their rights. In a world fraught with information asymmetries, slow
communication and plausibly different interpretations of facts, the multilateral reputation
mechanism is prone to fail for similar reasons.
Theoretically, to overcome the ruler's commitment problem at the efficient level of trade an
organization that
coordinates
traders' responses is required. When coordination is achieved, the
threat by
all
the merchants to cease trading if
any
merchant were to be abused enables the ruler to
commit
)
given that the merchants' threat of retaliation is credible. Unfortunately, however, the
threat is not credible: it entails a complete boycott during which trade would shrink below the level
at which, for example, a bilateral reputation mechanism is effective. Hence some traders would
renegotiate with the ruler to resume trading. This impedes the coordinating organization's ability to
surmount the commitment problem by reducing the penalty threatened to be imposed on the ruler.
Thus to support the efficient level of trade, a multilateral reputation mechanism must be
supplemented by an organization with the ability to coordinate responses and to ensure traders'
compliance
with boycott decisions. The traders must have some mechanism which makes the threat
of collective action credible.
Historical evidence indicates that during the Commercial Revolution an institution with
these attributes
)
the
merchant guild
)
emerged and supported trade expansion and market
integration. Merchant guilds exhibited a range of administrative forms
)
from a subdivision of city
administration, such as that of the Italian city-states, to an inter-city organization, such as the
German Hansa. Yet their functions were the same: to ensure the coordination and internal
enforcement required to make the threat of collective action credible. (Note that the argument does
not relate to craft guilds.)
5
The German Hansa is perhaps one of the best examples of a guild's contribution to fostering
trade expansion. For historical reasons, membership in the basic organizational unit that
coordinated the activities of German merchants abroad
!
the
Kontor
!
was not conditional on
residency in one particular town. Any German merchant who arrived in a non-German city could
join the local
Kontor
. Hence, a
Kontor
could coordinate the responses of the German merchants in
disputes with the town, but it lacked the ability to enforce sanctions against its members.
In 1252, a
Kontor
of German merchants obtained extensive trading privileges from the city
of Bruges (Flanders), which was the main trading center of Northern Europe at that time. Despite
promises to the contrary, the property rights of alien merchants in Bruges were continually abused.
An embargo imposed by all alien merchants on Bruges from 1280 to 1282 secured the property
rights of the Italian and Spanish traders, but failed to secure the German traders' rights. The
relatively large and well-organized political units of the Italian and Spanish merchants furnished
them with a state-provided mechanism to supplement the self-enforcing relations between them and
Bruges by making their threat of future trade embargoes credible. In contrast, because the
Kontor
encompassed only the German merchants actually present in Bruges
)
rather than all the potential
German traders who might want to trade during a boycott
)
its threat of sanctions against Bruges
was not credible.
Another embargo by the German merchants, from 1307 to 1309, was required to force
Bruges to respect their property rights. Its successful conclusion enabled the commerce between
Flanders and Germany to flourish and expand for the next 50 years. What had changed between
1280 and 1307 was the ability of the German towns to coordinate their responses and enforce their
embargo decisions on each other. A milestone occurred in 1284 when merchants from the city of
Bremen refused to cooperate in an embargo against Norway, and the other German towns excluded
Bremen's merchants from all German
Kontore
. The German towns had achieved the coordination
needed to exclude one of their members from the economic rent generated by their common
activities. The ability to exclude, in turn, was used to make their decisions self-enforcing.
The importance of the German towns' ability to impose their decision on their own traders
to strengthen the operation of a multilateral reputation mechanism is seen clearly when their
relations with Bruges were strained. The war between England the France around the middle of the
fourteenth century increased the cost to Bruges of securing the German traders' property and lives.
Increasing the level of protection required the Hansa to enhance its ability to impose a trade
6
embargo on Bruges and to demonstrate this ability. In 1356 the German Hansa held its first
Diet
(assembly of representatives from all the Hansa's towns), and its authority over the
Kontor
of
Bruges was declared. The enhanced ability of political units to exercise their coercive power over
their merchants fostered the operation of the institution that governed the relations between these
merchants and Bruges. In the Hanseatic embargo against Bruges in 1358, it was announced that
any disobedience, whether by a town or an individual, was to be punished by perpetual exclusion
from the Hansa. Bruges attempted to defeat the embargo by offering trade privileges to individual
cities, including both non-Hanseatic ones like Kampen and a Hanseatic one, Cologne, but only the
non-Hanseatic cities accepted Bruges's terms. The embargo proved to be a success and, in 1360,
Bruges came to terms with the Hansa.
2.
Institutions which Governed the Relations between Merchants and Overseas Agents
During the Commercial Revolution market expansion and integration were facilitated by the
employment of
overseas agents
who enabled merchants to reduce the cost of long-distance trade by
saving the time and risk of travelling, diversifying sales, and so forth. The contribution of agency
relations to reducing the cost of trade, and hence to fostering market integration, has been
recognized in the context of many pre-modern trading systems. For agency relations to promote
efficiency, however, overseas agents had to have control over a merchant's capital abroad, enabling
them to act opportunistically and expropriate that capital. Hence in the absence of institutions
limiting opportunism, merchants would not hire agents.
But such institutions did come into existence: the institution which governed agency
relations among the Maghribi traders, who operated in the Muslim Mediterranean during the
eleventh century, is a striking case-in-point (Greif 1989, 1993). Agency relations among the
Maghribis were governed by an economic institution that can be referred to as a
coalition
)
a
nonanonymous institution based on a multilateral reputation mechanism. The Maghribis employed
each other as agents, and all of them retaliated against any agent who had cheated a coalition
member. Their social and commercial network provided the information required to detect and
announce cheating, and the multilateral punishment was self-enforcing since what kept an agent
honest in his dealings with a specific merchant was the fear of losing the rent stream available to
him from his future dealings with all the Maghribis. Hence if it was expected that a specific agent
would not be hired in the future, he did not stand to lose the value of future relations with the
7
Maghribis if he was caught cheating. Therefore, to keep such an agent honest, a Maghribi merchant
had to provide him with a rent much higher than the one which would have kept an alternative
agent honest. The merchant had to pay this unusually high rent in order to make the future value of
their relations high enough to induce the agent to be honest in the absence of collective punishment.
Since that implied a reduction in the merchant's own profit, each merchant was induced to hire only
agents who were expected to be hired by others, making collective punishment self-enforcing.
Collective punishment enhanced efficiency and profitability relative to bilateral punishment,
since it enabled the employment of agents even when the relations between a specific merchant and
agent pair were not expected to recur. The resulting additional gains from cooperation, the value of
the information flows and the expectations concerning future hiring ensured the "closedness" of the
coalition. That is, Maghribis were motivated to hire and to be hired only by other Maghribis, and
non-Maghribis were discouraged from hiring Maghribis.
Besides traders from the Muslim world, Italian traders were very active in Mediterranean
trade, particularly during and after the twelfth century. These traders also benefitted from
institutions which governed agency relations, but, in contrast to the coalition, agency relations
among Genoese traders were governed by a Patron system based on a bilateral reputation
mechanism facilitated by state enforcement (Greif, 1994). In other words, among the Genoese an
agent was induced to be honest fearing that his relations with a particular merchant (who could have
represented a family or even a clan) would be terminated if he were not. Furthermore, the legal
system contributed to inducing honesty by providing contract registration facilities in many trade
centers, specifying a minimum rate of return in case accounts were not furnished and holding an
agent's property and family hostage until the agent's return.
3.
Institutions which Governed Relations Among Merchants with Limited Information
Market formation and integration during the Commercial Revolution required the
appropriate governance for exchange relations characterized by separation in time or space between
the
quid
and the
quo
. Credit markets, insurance markets and markets for future delivery could not
be sustained otherwise. Yet, the separation between the
quid
and the
quo
made opportunistic
behavior possible. While local courts could enforce property rights generated in spot exchange or
among members of the same community, they were unable, by themselves, to provide the contract
8
enforcement required for exchange characterized by separation between the
quid
and the
quo
among
merchants from different localities.
Yet the historical records indicate that exchange relations characterized by separation
between the
quid
and the
quo
were frequently established among individuals from different
localities during the Commercial Revolution. Such inter-community exchange relations contributed
greatly to trade expansion during the Commercial Revolution. The "take-off [of the Commercial
Revolution] was fueled not by a massive input of cash, but by a closer collaboration of people using
[commercial] credit" (Lopez 1976: 72). What institutions governed these contractual
arrangements?
Milgrom, North and Weingast (1990) have maintained that contract enforceability over time
at the Champagne Fairs was achieved by a Law Merchant System, in which the court was used to
supplement a multilateral reputation mechanism. In particular, they present the following
theoretical analysis. Suppose that each pair of traders is matched only once and each trader knows
only his own experience. Since the fairs' court lacked the ability to enforce judgment once a trader
left the fairs, assume that the court is capable only of verifying past actions and keeping records of
traders who cheated in the past. Acquiring information and appealing to the court is costly for each
merchant. Despite these costs, symmetric sequential equilibrium exists in which cheating does not
occur and merchants are induced to provide the court with the information required to support
cooperation. It is the court's ability to activate a multilateral reputation mechanism by controlling
information that provides the appropriate incentives. Hence a local court can ensure contract
enforcement through time even if it can not use coercive power against cheaters.
The historical records indicate that another ICEI was operating which supported exchange
among traders from various localities, despite the absence of a legal system with jurisdiction over
these localities (Greif 1997b). This institution took advantage of intra-community (formal and
informal) contract enforcement institutions and the large extent to which community affiliation
during the medieval period was common knowledge. By placing the future trade of all the
members of his community as a bond, an alien was able to commit, for example, to repay a debt
despite the lender's inability to locate and sue him.
Specifically, the lender's local court (as well as other courts) held all members of a
community responsible for the default of any member. They were held responsible in the sense that
following a default by one community member, the lender's court implemented a strategy which
9
called for confiscating the goods of any member of the defaulter's community present in its
jurisdiction. The goods were confiscated until the loss was recovered or the defaulters' community
advanced compensation for the default. A community was thereby provided with the incentive to
employ its intra-community contract enforcement institution to
ex post
punish one who defaulted in
inter-community exchange. Since this was known
ex ante
, a lender could commit to
ex post
repay
his debt. Hence, the Community Responsibility System enabled inter-community impersonal
exchange relations characterized by separation over time and space.
Once this situation is modeled as a repeated, imperfect monitoring game the analysis reveals
the rationale for various patterns of behavior reflected in the historical records. Modeling the
situation as one of imperfect monitoring seems appropriate since the historical records indicate that
at times the courts of different communities disagreed about whether a breach of contract had
indeed occurred. Among other insights, the model indicates that in the equilibrium which sustains
exchange, a finite period of retaliation would follow disagreement among courts. During a period
of retaliation inter-community trade ceased, and each community's court confiscated the goods of
the members of the other community. While such retaliation periods are costly, the model indicates
that they were unavoidable: had the communities been expected not to retaliate, they would have
provided dis-incentives to the courts to reveal their private information about cheating even when
there was no genuine disagreement. This, however, would have motivated borrowers to breach
their contractual obligations. Hence, the model provides a rationale for behavior that was
considered "barbaric" by an earlier generation of historians.
This section briefly presented several ICEIs which governed various exchange relations
during the Commercial Revolution. By providing the contract enforcement required to enable
commitment, institutions such as the Merchant Guild, the Coalition and the Community
Responsibility System enabled exchange and the emergence, operation and integration of markets.
II.
INFORMAL CONTRACT ENFORCEMENT AND THE ORGANIZATION OF
SOCIETY
The above ICEIs were a response to efficiency enhancing opportunities but their origins and
natures reflect more than economic factors; each of them was embedded in a broader cultural, social
and political context. They were part of the organization of society: the inter-related web of
complementary economic, legal, political, social and moral features which is the essence of a
society's nature. It is within this broader context that one has to comprehend the origin, nature,
10
change and implications of ICEIs. To further substantiate this assertion, this section briefly
elaborates on some of the inter-relations between cultural traits, social features, political factors and
the above ICEIs.
1.
Cultural Factors
The origin, nature and implications of the distinct institutions which governed agency
relations among the Maghribi and Genoese traders illustrates the relations between cultural factors
and ICEIs (Greif 1994). A main distinction between the Coalition and the Patron System relates to
expectations off-the-path-of-play, namely, in situations which do not transpire. Only among the
Maghribis were there the expectations for a collective punishment to be inflicted on an agent who
cheated. While a game theoretical analysis of agency relations indicates that each set of
expectations is self-enforcing, cultural factors (as well as the social factors discussed below)
determine which expectations will prevail in each group.
Cultural factors among the Maghribis made expectations for a collective punishment a focal
point. The Maghribis were
mustarbin
, that is, non-Muslims, who adopted the values of the Muslim
society. Among these values was the view that they were members of the same
umma
. This term,
although translated as "nation," is derived from the word
umm
meaning "mother," reflecting the
basic value of mutual responsibility among the members of that society Further,
umma
's members
shared the fundamental duty not only to practice good, but also to ensure that others did not practice
sin. In addition, the Maghribis were part of the Jewish community, within which it was a
prominent idea that "all Israel is responsible for every member." In contrast, Genoa's cultural
environment did not make collective punishment a focal point. The Genoese traders were part of
the feudal world in which bilateral patronage relations prevailed. Furthermore, Christianity during
that period placed the individual rather than his social group at the center of its theology, advancing
the creation of a new society based on the individual.
While these cultural aspects of the two societies made a distinct expectation focal points,
their concrete embodiment in particular ICEIs transformed these expectations into cultural beliefs:
ideas and thoughts common to several individuals which govern interaction
)
between these people,
and between them, their gods and other groups
)
and which differ from knowledge in that they are
not empirically discovered or analytically proven. In other words, the expectations which
crystallized with respect to a particular game became part of the 'view of the world' of members of
11
these societies, and thus provided the basis for extrapolating behavior in situations that had not been
encountered before. As such, they impacted outcomes following exogenous change in the rules of
the game and provided incentives for particular trajectories of organizational change. Hence, they
directed the evolution of the organization of society by influencing institutional change,
organizational innovations, social structure and the formation of values and identities. (Greif 1994.)
With respect to organizational change, for example, the "collectivist" cultural beliefs
associated with the operation of the coalition and the "individualistic" cultural beliefs had profound
and lasting implications. Theoretically, the individualistic cultural beliefs of the Genoese, but not
the Maghribis' collectivist cultural beliefs, provided an incentive to establish a "firm" through which
the wealth of several merchants was aggregated. Such a firm did not prevail among either the
Genoese or the Maghribis when they began operating as traders. Yet, it was the Genoese, but not
the Maghribis, who adopted the family firm during the thirteenth century (Greif 1996a, 1996b).
Individualist cultural beliefs, but not collectivist cultural beliefs, also provided incentives to use a
bill of lading. Indeed, the first historical evidence for its use in Europe is from late medieval
Genoa. In sharp contrast, the Maghribis, although familiar with the bill of lading, did not utilize it.
Hence, distinct ICEIs led to and reinforced distinct cultural features, which, in turn, directed these
two groups along separate paths of organizational development. The importance of distinct cultural
beliefs to the evolution of a society's organization is further exemplified below through the
examination of their implications on other formal organizations and social structures.
2.
Social Features
By directing available information and specifying social identities, a society's social features
impact the set of feasible ICEIs. At the same time, ICEIs and their implications impact the
evolving nature of these social features. In some case they re-enforce them while in others
undermine them. Social structures and ICEIs thus shape and are being shaped by each other.
The emergence of the Maghribi traders coalition reflects a particular social structure. The
Maghribis were the descendants of Jewish traders who, during the tenth century, had left the
increasingly politically insecure surroundings of Baghdad and emigrated to North Africa. By
coordinating expectations and providing a social network to transmit information, immigration
made initiating a collective punishment possible while, as discussed above, cultural factors made it
a focal point. In contrast, the social environment within which agency relations were initially
12
established among the Genoese forestalled, rather than encouraged, the formation of a coalition.
Toward the end of the twelfth century, the number of Genoese active in trade rose dramatically,
while Genoa experienced a demographic expansion despite a high mortality rate. This demographic
and social setting did not support the stable social networks required for the development of a
coalition based on collective punishment.
While the initial social setting within which agency relations were organized among the
Maghribis and Genoese impacted their ICEIs, these distinct ICEIs influenced the nature and
evolution of the associated social structures. For example, the details of collective punishment
among the Maghribis were such that they implied that one's investment in trade enhanced his ability
to commit to being honest while serving as an agent. Merchants, therefore, were motivated to hire
other merchants who also invested in trade as agents, thereby determining the social
characterization of the Maghribis. One does not observe the existence of two separate "classes"
among them -- an agents' class and a merchants' class. Socially, the Maghribi traders group was an
homogenous group of middle class traders and each of them operated as a merchant and as an agent
at the same time. This was not the case among the Genoese traders, however. The lack of
collective punishment implied that one's investment in trade diminished his ability to commit to
being honest while serving as an agent. This determined the social characterization of Genoese
traders among whom one can recognize two distinct sub-groups, that of the merchants and that of
the agents. In the long run, these social characterizations impacted economic mobility and wealth
distribution (Greif 1994).
The inter-relations between the initial social characterizations of the Maghribis and the
Genoese and the distinct cultural beliefs associated with their ICEIs also influenced other social
features of these groups. Specifically, following various military and political changes in the
Mediterranean, both groups had the opportunity to expand their trade to areas previously
inaccessible to them. Commercially, both groups responded similarly and expanded their trade
from Spain to Constantinople. Socially, however, their responses differed: the Genoese responded
in an "integrated" manner while the Maghribis responded in a "segregated" manner. The Maghribis
expanded their trade by employing other Maghribis, who emigrated from North Africa as agents,
rather than employing Jewish or non-Jewish local merchants. For generations the descendants of
Maghribis continued to cooperate with the descendants of other Maghribis. The Genoese also
responded to the new opportunities by emigrating abroad, and agency relations among them
13
prevailed. Yet, although the historical sources are biased toward reflecting agency relations among
Genoese, they nevertheless clearly indicate the establishment of agency relations between Genoese
and non-Genoese.
The rationale behind the different responses of the Maghribis and the Genoese to the same
exogenous change in the rules of the game is clear once one considers the relations between cultural
beliefs and equilibrium selection. Agency relations among the Maghribis were governed by the
expectations for collective punishment within the coalition. Yet, since agency relations were not
established with a non-coalition prior to the point in time in which such relations became feasible,
there was uncertainty about whether collective punishment would be relevant in agency relations
with non-coalition members. After all, the existing cultural beliefs implied that merchants would
continue to hire only agents who were coalition members. Hence, it led to the "closedness" of the
coalition: since agency relations within the coalition were more profitable even when less efficient,
the Maghribis were motivated to hire and to be hired only by other Maghribis. For similar reasons
non-Maghribis were discouraged from hiring Maghribis. Such closedness did not prevail among
the Genoese, however. Without expectations for collective punishment, the same uncertainty about
it in agency relations with non-Genoese did not influence the profitability of hiring an agent.
Hence, Genoese merchants were motivated to hire non-Genoese agents whenever such agency
relations were efficient. (Greif 1994, 1996a).
This symbiosis between social structures and the nature of the associated economic
institution is well reflected in the later history of Maghribi traders. The Maghribi traders retained
their separate identity within the Jewish communities as long as they were active in long-distance
trade. During the second half of twelfth century, however, they were forced by the Muslim rulers
of Egypt to abandon that trade. At that point, as far as we know, they integrated completely within
the Jewish communities and vanished from the stage of history. In other words, as long as the
Maghribis traded, the nature of the economic institution that governed agency relations contributed
to maintaining their social entity.
The Community Responsibility System (henceforth CRS) reflects that the operation of an
ICEI may crucially depend on the extent to which social affiliations are common knowledge.
Under the late medieval CRS, unless a lender knew the community affiliation of a borrower,
lending could not have taken place since no punishment could have been imposed on the borrower
in a case of default. In other words, a particular feature of the late medieval society - merchants'
14
affiliations with particular communities and the large extent to which these affiliations were
common knowledge - enabled the operation of an ICEI. At the same time, the CRS reflects that
ICEIs may undermine the social feature of the society on which it is based. The same processes
that the CRS fostered - processes through which trade expanded and merchants' communities grew
in size, number, and economic and social heterogeneity - reduced the economic efficiency and the
intra-community political viability of the CRS over time. This had occurred since the economic
impact of the CRS segmented communities and made it relatively easy to falsify, and difficult to
verify, one's community affiliation.
3.
Political Factors and Formal Organization
ICEIs are also inter-related with political factors and formal organizations. Formal
organizations influence the feasible set of ICEIs, political factors influence the ability to alter them,
and the nature of available ICEIs impacts the demand for formal contract enforcement institutions.
Examination of the timing of the emergence of merchant gilds in various localities in
Europe indicates that it was determined by political and social factors. For example, the major
Italian city states grew large because of political and social events around the Mediterranean.
Italian trade expanded since each city functioned as a merchant gild, and its size implied that its
traders were not "marginal." Although the potential gains from trade in the Baltic Sea were
substantial as well, that region's settlement process resulted in small towns which could not assure
the safety of their traders abroad. Only after a long process of institutional evolution were these
towns incorporated into an intercity merchant gild, the German Hansa, which enabled Baltic trade
to prosper. If all these small cities had been part of a unified political regime, this long period of
institutional evolution would not have been required. (Greif 1992.) The history of the German
Hansa presented above also illustrates the complementary nature of the relations between formal
and informal means for contract enforcement. The relations between the German towns, members
of the Hansa and non-member political units were informal. The relations between any individual
German merchant and the Hansa, however, were based on a formal institution - the legal authority
of the town in which he dwelled.
The history of the CRS illustrates the extent to which political factors and formal
organization influence the ability to alter ICEIs. In the second half of the thirteenth century
attempts were made in England, France, and Italy to abolish the CRS. Yet, the extent to which
15
communities could have replaced this ICEI with an alternative formal institution based on a legal
system depended on their political environment. The kings of England and France were able to
provide traders with a legal procedure enabling relatively fast and cheap contract enforcement based
on individual legal responsibility. This, however, was not the case in politically fragmented Italy.
Due to a lack of central authority, the repeated attempts of the Italian city-states to abolish the CRS
failed. In the absence of a third party - a king - able to provide a legal system whose decisions did
not reflect the community's self-interest, the Italian city-states could not adopt the institutions
implemented in France and England. (Greif 1997b.)
While the above discussion indicates that political factors impacted the ability to abolish
ICEIs, it is also true that ICEIs impacted society's formal institutions. Consider, for example, the
Maghribis and the Genoese. Among the Maghribis, agency relations were governed by an
institution based on self-enforcing, collective, economic punishment, and supported by the
closedness of the coalition and an ingroup social communication network. In such a "collectivist
society" the enforcement required to support collective actions and facilitate exchange could be
achieved without "formal"
)
legal or political
)
organizations which specialized in communication
and enforcement. In contrast, among the Genoese agency relations were governed by an institution
based on bilateral punishment which reduced the benefit of informal communication. Such an
"individualistic" society had a relatively low level of informal economic enforcement over its
members. Hence to support collective actions and facilitate exchange, it needed to develop formal
)
legal and political
)
enforcement organizations. (Greif 1994.)
Indeed, the Genoese developed formal organizations to support collective actions and
exchange, whereas the Maghribis abandoned them. During the twelfth century the Genoese quit
entering contracts with a handshake and developed an extensive legal system for registering and
enforcing contracts. This system supplemented the operation of the patron system, as agents were
legally required to provide merchants with verifiable accounts regarding their expenses and
revenues. An agent who failed to submit such an account was legally obliged to provide a
minimum return on the merchants' investment. Furthermore, the customary contract law which
governed the relations between Genoese traders was codified as permanent courts were established.
In contrast, despite the existence of a well-developed Jewish communal court system, the Maghribis
entered contracts informally, used an informal code of conduct to govern exchange and attempted to
resolve disputes informally.
16
The emergence of the family firm and the adoption of the bill of lading, discussed above,
also reflect the impact of distinct ICEIs on organizational development. The development is further
reflected, for example, in the formation of merchant guilds in these two societies. Among the
Maghribis compliance with embargo decisions was assured through informal means. After the
Muslim ruler of Sicily abused the rights of some Maghribi traders, they responded by imposing,
circa 1050, an embargo on Sicily. This embargo was organized informally, although the Maghribis
could have utilized the Jewish court system or the formal Jewish communal organization. In
contrast, among the Genoese the city of Genoa itself functioned as a formal enforcement
organization to ensure compliance with collective actions. After the city authorities declared that a
certain area was a
devetum
, that is, prohibited for trade, any merchant who was found in that
location was subject to legal prosecution.
III.
INSTITUTIONAL EFFICIENCY, CHANGE AND PATH DEPENDENCE
ICEIs enhanced efficiency during the Commercial Revolution. This doesn't necessarily
imply, however, that they were optimal in the sense of enabling exhaustion of all the gains from
trade that were feasible given that period's production, information and contract enforcement
technology. As a matter of fact, the above discussion of the processes that molded these non-
market institutions suggests that they were not optimal.
For example, an analysis of the Law Merchant suggests that the centrality of the Fairs of
Champagne in European trade reflects economies of scale in the operation of a multilateral
reputation mechanism. If this is the case, the geographical distribution of much of the European
trade of the period reflects the historical process that led to the emergence of that institution at that
specific time and place. As theoretical studies of path dependence indicate, this process need not be
optimal.
The institutions that governed agency relations do not seem to have been optimal either.
The Maghribis' coalition and the patron system were different institutions linked to specific
historical, political, and social processes of which they were integral parts. These processes, rather
than merely economic efficiency, determined the nature of these institutions and the timing of their
emergence and disappearance. Indeed, the evolution of these institutions and the details of their
operations suggests that neither of them could have supported the set of optimal exchange relations.
Among the Maghribis, the extent of agency relations was limited by the coalition's size, which had
17
been determined by immigration and cultural beliefs. The historical evidence indeed indicates that
the Maghribis did not establish efficient relations with non-Maghribis, preferring more profitable
but less efficient agency relations among themselves. This deficiency could have been remedied by
an appropriate coordinating organization but none emerged. (Greif 1993.)
Was the institutional infrastructure provided by the above ICEIs converging to an optimal
one? Was it inducing organizational or technological innovations which were growth enhancing?
The historical and theoretical analyses indicate that it was not. Rather, this institutional
infrastructure was path dependent in the sense that its capacity to change was constrained by its
own history. Examination of the sources, manifestations, and implications of this path dependence
reinforces further the conclusion regarding the non-optimality of the period's institutional structures.
The emergence of merchant guilds in the Latin world entailed the consolidation of political
and legal entities which shaped and constrained later institutional and commercial development. In
particular, the emerging German Hansa was a new political entity aimed at preserving the property
rights of German merchants. Although its establishment enabled Northern European trade to
flourish, once organized, its concern was not efficiency but profitability. In its constant effort to
preserve trade rights and supremacy, the Hansa crushed the advances of other traders' groups
without considering their comparative efficiencies. In 1368, for example, the King of Sweden
provided the German Hansa with control over the autumn fairs of Skania (the southern province of
Sweden). Before then English merchants were selling west-European cloth at these fairs and using
the proceeds to purchase herring and salt. The English merchants were able to compete
successfully with Hanseatic merchants, who were also importing west-European cloth to that area.
In February, 1370, a Hanseatic diet ruled that English, Welsh and Scottish merchants would no
longer be allowed to engage in such trade. The complaints of the English King, Edward III, were to
no avail. Distributional considerations took precedence over efficiency. (Greif 1992)
The sources of path dependence in institutions which governed agency relations are much
more complex. Cultural beliefs, as have been discussed above, directed institutional path
dependence by providing distinct incentives for organizational innovations. The relative efficiency
of these separate organizations, in turn, depended on the economic environment. Yet, since cultural
beliefs are uncoordinated expectations, a society lacking the appropriate cultural beliefs would be
unable to take advantage of the superior organizations. Similarly, the dependence of the Maghribi
traders' coalition on uncoordinated collective punishment by merchants located at different trade
18
centers implied another source for path dependence. For the threat of collective punishment to be
credible, "cheating" must have been defined in a manner that ensured collective response. If some
merchants considered specific actions to constitute "cheating" but others held a different opinion,
the effectiveness of the collective threat would have been undermined. To mitigate this problem,
the Maghribis employed a set of cultural rules of behavior which specified how an agent should act
to be considered honest in circumstances not mentioned in the merchant's instructions. These rules
were shared by all the Maghribi traders and served as a default contract between agents and
merchants. This set of rules promoted efficiency by providing a coordination device necessary for
the functioning of the coalition, economizing on negotiating cost and enabling flexibility in
establishing agency relations. Yet, in the absence of any mechanism able to coordinate changes,
this set of rules among the Maghribis was a source of rigidity and path dependence. It imposed
rigidity on the system because its process of adjustment was impeded by agents' concerns regarding
what others would be thinking about their actions rather than what the outcome of their actions
would be. (Greif 1993).
The above short discussion illustrates that ICEIs during the Commercial Revolution
suggests that they exhibited path-dependence and were not necessarily converging to optimal
institutions. They gave rise to political units which employed their coercive power to affect
distribution at efficiency cost, and even the self-enforcing institutions were based on expectations
that, in the absence of coordinating mechanisms, impeded efficient adaptations. Furthermore,
various institutions and their associated cultural beliefs provided a separate impetus to the
introduction of different organizations, leading to institutional path dependence. (Greif 1994,
1996b.) Hence, different societies, even when encountering similar organizational problems, can be
"locked in" to different trajectories of institutional development, each of which will have distinct
economic implications in various possible situations.
IV.
CONCLUSIONS
Adam Smith's intellectual heritage includes the view that much of the institutional
framework provided by the state and aimed at directing the economy can be replaced by the
"invisible hand" generated by the uncoordinated interactions among self-interested individuals.
Menger (1963) has further advanced this view to claim that such interactions provided the basis for
all social institutions, including contract enforcement institutions. Some have taken this view to
19
mean that informal contract institutions emerge spontaneously to advance exchange. They provide
an efficient, welfare maximizing enforcement that pareto dominates the enforcement provided by
the state. (E.g., Benson 1989, Ellickson 1991, Cotter 1997.)
The study of informal contract enforcement institutions during the late medieval period
challenges this view. It provides support to other studies of ICEIs which concluded that efficient
institutions would not necessarily be forthcoming. (De Soto 1989, Putnam 1993.) Its contribution
to this line of argument is not limited to additional case studies. By combining explicit game
theoretical analysis and detailed historical examination, it is able to present a comparative study of
institutions over time and space which reveals their underlying rationale and their complementary
nature with other aspects of society.
Understanding the functioning of economies and processes of economic growth and
stagnation in various societies requires an examination of their nexus of contract enforcement
institutions. In particular, it requires comprehending the inter-relations between cultural factors,
endogenous social features, formal organizations, political factors and ICEIs. It demands an
understanding of how a society's ICEIs inter-related with the other features of that society's
organization, thereby influencing its economic performance and institutional changes.
20
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