The State as “Extorter of Last Resort”

To develop economically a territory needs an “extorter of last resort.”

The phrase is adapted from the idea of a lender of last resort. A lender of last resort lends when no one else will. The idea is, during a crisis, to extend money to those who are solvent but who may become bankrupt due to circumstance. The idea has been central to banking policy since 1873.

Traditionally the state has been viewed as an agent of development for a couple of reasons.

First of all is its role in enforcing property rights. The state ensures that you alone control the use of your goods. This gives you an incentive to invest in new productive technologies to make yourself richer, knowing nobody will steal that wealth from you. In making yourself richer you generate positive outcomes for everyone and so the state’s protection of your rights helps everyone.

Secondly the state plays a role in resolving market failures. It is difficult to profit from roads and infrastructure and the state can have a role in providing these. A market failure occurs when social gains from an activity are smaller than its private gains so it is under-provided. A state can force many people to pay towards the upkeep of roads etc. when they wouldn’t on their own.

Integral to the above ideas on the roles of the state is the idea that a state can be forced to fulfil those roles. Key to forcing a state to do this are veto points where a parliament, a senate, a court can stop arbitrary extortion, or unfair imprisonment, of a citizen. In addition a state must be strong enough to overpower its domestic rivals and force all under its control to pay the taxes set (c.f. Patrick O’Brien).

My theory is that the state plays a slightly different role, the state coordinates threats of extortion. Rather than act in a way which minimises extortion or threats to private property, the state focuses these threats in a single agent. This makes bargaining over how to share an economic surplus more straightforward. It makes investment decisions less risky as it is not only easier to secure a share of the profits for yourself, but is easier to argue that it is in your extorter’s interest to let you keep a large share to incentivise you into investing more.

In a crisis a central bank can credibly commit to lend to a troubled institution when nobody else will. A developmental state needs to credibly commit to be the only institution to steal from a individual or corporation if it wants to forment economic development. By coordinating this threat a state can simplify negotiations to avoid or mitigate extortion. This minimises uncertainty and makes investing more likely.

Knowing what to expect, and who to expect it from, is more conducive to economic growth than a credible commitment to not extort. A credible commitment to not extort isn’t worth much through a period in which the state is building a mountain of debt (see below graph). However a commitment to be the sole power with which those with an actor must negotiate how to split an economic pie can be credible, especially when the state has crushed all opposition (as Tilly argued European states had).

North and Weingast famously argued that the English state, from the C17th onwards, was able to credible commit to not steal from its citizens and helped enable the Industrial Revolution. The English monarch was neutered, after the Glorious Revolution Kings had to report to Parliament and had to respect the property of the wealthy. In the following two centuries England became the most powerful nation in the world.

However, although Britain could borrow somewhat more cheaply than absolutist countries like France, England’s economic development was only a little in advance of France, the Low Countries or Switzerland. A credible commitment to not extort does not seem to unite countries which successfully developed.

In support of this argument a comparison between European states and Asian states is required. From the C16th onwards Europe had a system of small competing states which needed to raise large amonts of money to defend themselves. This led to Europeans states becoming efficient at taxing their subjects.

Contrary to popular misconceptions, Empires like the Ottoman, Mughal or Qing taxed their subjects much more lightly than the Europeans, and especially the English. Qing China, contemporary with Glorious Revolution England, averaged a 6% of GDP tax take, England averaged a tax take of around 12% of GDP. Qing’s lower taxes financed a weak, but geographically vast, bureaucratic state but it did not provide the funds to maintain a state which could credibly commit to be the final extorter.

The taxes paid in C17th (and onward) England were the last likely threat of extortion. In Qing China or Mughal India your taxes were just one element of the expropriation risk you faced, corrupt officials could treat the territory you lived in as a little fiefdom or your landlord could charge an extortionate rent. The English state was able to commit to being the biggest, or only, thieving bastard you would face.

This helps to explain the success of France vis a vis England in the C18th and C19th despite its absolutist, unchecked power structures. Although the French state contracted out some of its extortions to tax farmers (hated local bastards who bought tax revenue at a discount from the state), the French state was the sole predictable source of extortion. Having your income extorted from you is not pleasant. This is why North and Weingast argued the English state benefited from promising to do as little of it as possible. I would argue that having your income extorted is somewhat inevitable and that knowing who is responsible is far more important than thinking it is less likely to happen than before.

I have chosen the phrase “extorter of last resort” because in Mughal India or the Ottoman Empire those that extort from the populace are  also able to extort from the state. The purchase, or forced awarding, of privileged positions to minor stationary bandits means that the state is merely primus inter pares of extorters. Successful European industrialisers (and other more recent industrialisers) have succeeded in becoming the sole extorter, and this makes life much more predictable.

Considering the above I would argue that the states role in coercing its citizens is not just useful because it allows for the enforcement of property rights, it is useful because it lends a predictability to who is going to be stealing from you. This predictability reduces uncertainty and makes investing more valuable than waiting to invest, at the margin.

I stress that this is a new theory which is only partially theoretically developed and which is as yet only partially supported by the evidence. However, I think it offers an important new way of looking at the state’s role in economic development. Coordinating threats of extortion simplifies decision making. The threat of extortion remains across early European and Asian States, but European states are better able to centralise this tendency and reduce the transaction costs of negotiating with the extorter.

This post has set out the theory and I hope to publish more posts on this theme trying to confirm, or falsify, it over the next few weeks. Although I’m off to Glastonbury on Wednesday so there may be a little delay. All feedback is welcome, of course. Luis, Chris, Paul, Paul, Carl, Tim, Duncan; thoughts? 

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Well Chris, it could make me $100,000 better off, which would be nice

Chris asks “what can macroeconomic policy do?” The answer is above.

A one percentage increase in the unemployment rate is associated with a 6-7% decrease in initial wages for someone like me, who graduated at the trough of the Little Depression. The effects are persistent, with long term indirect effects including “poor job match, lower prestige placements, and fewer opportunities for training and promotion.” These numbers were compiled comparing those that graduated in the US during the 1982 employment trough with those that graduated during the 1988 employment peak and cumulatively this difference amounts to a net present value of $100,000.

The early 80s disinflation and subsequent expansion may well have been worth it. Inflation attacks the old and the poor, who tend to live on fixed incomes or are unable to inflation proof their savings. Plus, as Harberger argues, inflation makes it more difficult to workout what innovations are worthwhile or business ventures viable, lowering our economy’s growth potential.

However, the benefits of macroeconomic policy are unevenly spread. The recessions and unemployment which helped tame inflation cost some their jobs and some of those entering the labour markets a lifetime of underachievement. Today we seem to be suffering without purpose. That purposeless suffering is unevenly distributed, and along with the disabled, the poor, those looking to work like me are suffering too, and that suffering will continue for years to come.

Some of Chris’s comments on macro matter. He is correct that successful policy might help cause crises, Hyman Minsky pointed out stable growth and low inflation can cause financial exuberance which causes a panic rather than prosperity. Likewise, Kalecki is correct too, that there are those that gain from unemployment because unemployment lowers workers militancy and raises bosses power to pay them less.

That there are things that macro cannot do, like replace decaying capital equipment, or reskill the unemployed doesn’t mean we shouldn’t use it for what it is good for. But, if there is excess demand for safe financial assets, somewhere safe to place your savings, then an expansionary macro policy, deficit spending by solvent governments like the – US, UK, Germany, France, Japan – is a much more effective way of increasing their supply than any micro policy.

However, this doesn’t mean we shouldn’t push for the best macro policy possible. If there are those that gain from suboptimal macro policy then we should make sure it is as difficult as possible for them to succeed, that means pushing for full employment. If finance poses a threat to the real economy then perhaps it needs to be repressed so that it has a smaller effect on it. Firms’ reluctance to invest is worrying, but returning demand for currently produced goods and services would be a good way to convince them investing is a good idea.