Why Rule of Law matters

Everyone knows the joke about the economist who, when marooned on a desert island with only a bottle of beer and no opener, said: "let's assume it".

What is not so funny, says Avinash Dixit, is when they assume the existence of the Rule of Law. Amazingly, however, and in spite of mounting evidence to the contrary, that is what they had been doing until recently.

But, happily, they have realised the folly of this assumption. Whence, more-or-less, this book by one of the world's leading economic theoreticians. In Lawlessness and Economics: Alternate Modes of Governance, Dixit tries to see what happens when property rights and contracts are poorly enforced.

The issue is of central importance because weakness here means weak incentives to perform at high levels of economic activity, a point which Indian Marxists seem unable to grasp.

One of the consequences""because people don't wait for the government to get its act together while they operate at lower levels of economic activity and value creation""is that they create their own institutions for enforcing these rights.

We have seen this happening right here in India. As the authority of the state has weakened over time, local chiefs who are often gangsters have sprung up to enforce this or that. Other things have also happened.

For example, the enormous spread of corruption, which is just one aspect of lawlessness, has resulted in the Reserve Bank of India's writ on monetary policy covering only the formal part of the economy. That is about 40 per cent. In the rest, non-formal institutions do the job.

The book has five chapters and a conclusion. The chapters are: "Economics with and without the law"; "Private ordering in the shadow of the law"; "Relations-based contract enforcement"; "Profit-motivated contract enforcement"; and "Private protection of property rights".

The method is of game theory: that is, the working out of equilibrium strategies for different players when the Rule of Law is weak. As such, it is not a book for laymen.

That said, the main message is not hard to grasp. It is that if the state is weak and is unable to foster strong institutions which can enforce property rights and contracts, the economy as a whole will perform below potential.

How far below potential it performs will depend on how weak the Rule of Law is. The distance from the ideal situation, to which some Western countries are close, and the degree of underperformance are directly proportional.

Underperformance creates a problem for the government, which, if it is not predatory and is democratically elected after fixed intervals, finds that it cannot deliver on its social welfare-maximising promises. This leaves the government with two options: it can either improve the Rule of Law and governance; or it can turn predatory.

Dixit has discussed the latter in detail but on the assumption that predatory tax policies are meant only as a consequence of mala fide. Thus, a predatory government, of which there are plenty, acts only to enrich its members.

In fact, as various finance ministers, including the present one, have shown, the government can turn predatory without intending only to enrich its members.

The fringe benefit tax (FBT) is the most recent proof of that. To the extent that such predatory habits lead to people hiding their incomes and assets, the effect is the same.

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LAWLESSNESS AND ECONOMICS
ALTERNATE MODES OF GOVERNANCE

Avinash Dixit
Oxford University Press
Price: Rs 495; Pages: 167