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The Economic Role of Political Institutions: Market-Preserving Federalism and Economic

Development
Author(s): Barry R. Weingast
Source: Journal of Law, Economics, & Organization, Vol. 11, No. 1 (Apr., 1995), pp. 1-31
Published by: Oxford University Press
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JLEO.VtlNi 1

The EconomicRole of PoliticalInstitutions:


Federalismand
Market-Preserving
EconomicDevelopment
BarryR. Weingast
StanfordUniversity

Thrvingmarketsrequirenotonlyan appropriately designed economicsystem, but


a secure politicalfoundationthatlimitsthe abilityof the state to confiscatewealth.
Thisrequiresa formof limitedgovernment, thatcredibly
thatis, politicalinstitutions
committhe state to honoreconomic and politicalrights.Thisarticlestudies how
limitedgovemmentarose in the developed West, focusing on the criticalrole of
federalismforprotectingmarketsin both Englandand the UnitedStates. Feder-
to theimpressive
alismprovedfundamental inthe18th
economicriseof England
centuryand the UnitedStates inthe 19thand early20thcenturies.Thearticlealso
shows thatfederalismunderpinsthe spectaculareconomic growthin Chinaover
the past 15 years.

Introduction
The fundamentalpolitical dilemma of an economic system is this: A govern-
mentstrongenoughto protectpropertyrightsand enforcecontractsis also
strongenoughto confiscatethe wealthof its citizens. Thrivingmarketsre-
quirenotonlytheappropriate systemof propertyrightsanda lawof contracts,
but a securepoliticalfoundationthatlimitsthe abilityof the stateto confis-
catewealth.Farfromobvious,however,arethecircumstances thatproducea
political system thatplays one role instead of the other.
This dilemmais readilyapparentfor the case of economic reformin Eastern
Europe and the former Soviet Union. Economists focus on providingfor the
broadoutlines of a marketsystem, that is, on "gettingprices right" Unfortu-

The authoris a seniorfellowof theHooverInstitutionandprofessor,Department


of Political
Science,at StanfordUniversity.He gratefullyacknowledgesAnneliseAnderson,RobertBates,
PeterBemholz,PeterBoettke,ThomasGilligan,VictorGoldberg,AvnerGreif,NinaHalpern,
Gabriella
Montinola, DouglassNorth,RichardPosner,YingyiQian,DouglasRivers,HiltonRoot,
KennySchultz,Urs Schweizer,KennethShepsle,SusanShirk,DorothySolinger,PabloSpiller,
ScottThomas,GeorgeTsebelis,OliverWilliamson, andChristineWongforhelpfulconversations
Thisarticlewasprepared
andPaulinaFavelaforeditorialassistance. agreement
underacooperative
betweentheInstitutionfor PolicyReform(IPR)andtheAgencyforInternational Development
(AID),Cooperative Agreement No. PDC-0095-A-00-1 126-00.Viewsexpressedherearethoseof
theauthorandnotnecessarilythoseof IPRorAID.

? 1995by OxfordUniversityPress.All rightsreserved.8756-6222/95/$5.00

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2 TheJoumal
ofLaw, &Organiation,
Economics, V11N1

nately, the economists' focus ignores politics and the possibility thatpolitical
forces might inteivene in the futureto halt the developmentof a marketsystem
or to redistributea largeportionof the wealth thus created. Not only do politi-
cal forces hold the potentialto destroya fragile, nascenteconomic system, but
theirprospectdetersthe economic activitynecessaryfor economic growth. As
economistshavelong realized,the absenceof secureprotectionfor the rewardto
effort detersinvestmentand, hence, economic development(Eggertson,1990;
North, 1981, 1990; Olson, 1982; Williamson, 1994).
The fundamentalpolitical dilemma forces us to ask what form of political
system is requiredso that a viable, privatemarketeconomy is a stable policy
choice of that political system? The answer concerns the design of political
institutions that credibly commit the state to preserving markets, that is, to
limits on the future political discretion with respect to the economy that are
in the interestsof political officials to observe (Levy and Spiller,.1994; North,
1993; Weingast, 1994a, 1994b; Williamson, 1994). The centralcomponentof
a crediblecommitmentto limited governmentis thatthese limits must be self-
enforcing. For limits on governmentto be sustained, political officials must
have an incentive to abide by them. This implies that designers of economic
reformmustpay attentionnot only to the reform'scontentbut to how the future
exercise of political discretionmight alterthatpolicy.
In the language of the new institutionaleconomics, providinga secure and
predictablepolitical foundationfor the marketsrequiresa form of governance
structure(Williamson, 1985, 1994; Weingast,1993b).' To understandthe po-
litical foundafionsof markets,we must begin with the constitution,conceived
here as the set of institutionsgoverningpolitical decision-making-that is, the
institutionsor rules governinghow policy choices are made, especially among
alternativespecificationsof the economic system. All societies possess a con-
stitutionin this sense, whetheror not they possess an explicit documentcalled
"theconstitution."2For example, Roeder(1993) describesthe operationof the
working constitutionof the former Soviet Union, as opposed to its nominal,
written constitution. Understandingthe relationshipsbetween constitutional
provisions and economic performancerequiresdevelopmentof a new positive
theoryof constitutionalismthatseeks to explainhow constitutionallimits work
and why some constraintsprove binding in practice.3

1.Notice thatthislogic directlyparallelsthatin the theoryof the firm. williamson (1985: 48-49),
forexample, arguesthatwhen transactionsare subjectto ex post problems,wise bargainingparties
will attemptto mitigatethese problemsex ante by creatinga governancestructure. See Milgrom
and Roberts(1992) for a recent and comprehensivestatementof the theory.
2. Nor does this requirethat the constitutioncontain provisions supportingdemocracy,repre-
sentation,or secure political and privaterights for individuals,thoughmiostWesternconstitutions
do so. Constitutionsin the developedWest are thus an importantspecial case of constitutions. In
contrastto the more generalrange of constitutions,those in the West possess a rangeof additional
(and generally thoughtto be desirable)attributes.
3. Recent work includes Hardin (1989), North and Weingast (1989), Ordeshook(1993), Or-
deshook and Schwartz (1994), Przeworski(1990), Riker (1982), and Weingast(1994a); see also

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TheEconomic
RoleofPoicalInstituions
3

Oneof the centrallimitsof the literatureis thatfew scholarsactuallypro-


videa completeanalysisof anymechanism purported to providesuchcredible
commitments (animportant is
exception Levy and Spiller,1994). Weremain
remarkably ignorantabouthow constitutionsaffectcrediblecommitments to
secureeconomicrightsand,moregenerally,limitedgovernment
Tolearnsomethingabouthowconstitutions crediblycommita stateto mar-
kets,thisarticleconsiders how such commitments wereprovidedin thedevel-
oping West overthe pastfew centuries.Because manyof thecrucialquestions
facingtoday'sdeveloping states were once faced by developednations,con-
siderableinsightcanbe providedabouttoday'sproblemsby studyingsimilar
problemsas they arosein the past Althoughtoday'scircumstances differ
substantiallyfrom thoseof earliereras,important lessons about the political
foundations of marketscanstillbe learned.
Forthispurpose,I focuson federalism,an important mechanismunderpin-
ningdevelopment in manynations.Formostof thelast300 years,therichest
nationin theworldhashada federalstructure:theNetherlands fromthe late
16ththroughmid-17thcentury,Englandfromthelate17thorearly18ththrough
themid-19thcentury,andtheUnitedStatesfromthelate19thcenturyuntilthe
late20thcentury.A specificformof federalism,herecalledmarket-preserving
federalism,limitedthedegreeto whicheachof thesecountry'spoliticalsystems
couldencroachuponits markets.
The economicconsequencesof market-preserving federalismare well-
known:Federalism restrictseconomicpolicymaking vialimitsonthediscretion
of the government (Tiebout,1956;Oates,1972). Less well understood is the
centralproblemof thisarticle:howa systemof federalismprovidesforits own
survival.If federalismhasstrong,bindingeffects,whatmakesits restrictions
self-enforcing?Specifically,whatpreventsinterestgroupsanddistributional
coalitions,limitedin theirinfluenceoverlower-levelgovernments, frompress-
ingthecentralgovermentto breaktherestrictions of federalismandintervene
in the economy(Riker,1964)? The answercannotbe simplya writtenrule,
for rules can be changed,avoided, or ignored. To survive,federalismrequires
self-enforcingrestrictions,ones thatmakeit in theinterestsof nationalpolit-
ical actorsto honorthem. The purposeof this articleis to showhow these
mechanismsworkin threecontextswherefederalismhas underpinned rapid
economicdevelopment:Englandduringthe 18thcentury,the UnitedStates
duringthe 19thcentury,andmodemChina.In so doing,the articleprovides
somegeneralprinciplesof a society'sconstitutionalorderthatarenecessaryto
providesecurepoliticalfoundations for markets.
Thearticleis dividedintothreeparts.Part1 containstwosectionsthatfocus
ontheeffectsof federalismandputsthesein apoliticalperspective.Section1.1
describesthepoliticaltheoryof market-preserving federalism,andSection1.2
discussesits role in the economicdevelopmentof Englandand the United

Elster(1991),Hammond andMiller(1989),North(1981,1990).MuchofBrennan andBuchanan's


(1984)workis alsoincluded,thoughmuchof it is alsonormative
in character.

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4 TheJournal
ofLa, Economics, Vii N
&Oganization.

States. Part 2 focuses on the deeper question of what made federalism and
its restrictionscredible. Section 2.1 analyzes how federalism was sustained
in England, and Section 2.2 does so for the United States. Part 3 turns to
contemporarysettings of economic reform in the former communist states,
focusing on economic reformin China. My conclusions follow.

1. The Effects of Federalism


1.1 A PoliticalTheoryof Federalism
The essence of federalismis that it provides a sustainablesystem of political
decentralization.Althoughthepolitical theoryof federalismhas a long history,
it is useful to start with Riker.4 In his seminal work on the political theory
of federalism,Riker (1964: 11) defines a political system as federal if it has
two characteristics: (F1) a hierarchy of governments, that is, at least "two
levels of governmentsrule the same land and people," each with a delineated
scope of authorityso that each level of governmentis autonomousin its own,
well-definedsphereof political authority;and (F2) the autonomyof each gov-
ernmentis institutionalizedin a manner that makes federalism's restrictions
self-enforcing.
In what follows, I focus on a subset of federal systems called market-
preservingfederalism (see also McKinnon, 1994; and Montinola, Qian, and
Weingast, 1995). A federal system is market-preservingif it has three addi-
tional characteristics:(F3) subnationalgovernmentshave primaryregulatory
responsibilityover the economy; (4) a common marketis ensured,prevent-
ing the lower governmentsfrom using theirregulatoryauthorityto erect trade
barriersagainst the goods and services from otherpolitical units; and (F5) the
lower governmentsface a hard budgetconstraint,thatis, they have neitherthe
ability to printmoney nor access to unlimitedcredit. This conditionis not met
if the centralgovernmentbails out the lower one wheneverthe latterfaces fiscal
problems(McKinnon,1994).
Each of these characteristicsplays an importantpartin federalism'smarket-
preservingrole. The first is clearly a definingcharacteristicestablishingmini-
mal or necessary conditionsfor a federal system. But it alone is not sufficient
The reason is thatfederalsystems are not generallysustainableif they depend
solely on the discretionof the highest political authority,because that delega-
tion of power can always be reversed. As Riker observes, a centralproblem
for federal systems is thatthe highest or centralgovernmentmay overawe the
lower units. A sustainable system of federalism thereforemust prevent the
centralgovernment'sability to overawe the lower governments,as condition
two requires.
The firsttwo characteristicsdefinea viable system of federalism,butthey say
nothing aboutthe authorityover economic issues. To have market-preserving

4. Thissectiondrawson theworkof Aranson(1991),McKinnon(1994),Oates(1972),Riker


(1964), and Tiebout (1956). See also Elazar(1987), Friedrich(1968), Hayek (1939), and Wheare
(1953). Althoughmostofthelatterdiscuss manyoftheconditions thatfollow sometimesimplicitly,
all omit the criticalthirdcondition aboutself-enforcement.

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Th Econonmc
Ro!eofPoItical S
InslituUons

economiceffects,federalismmustalsohavethe third,fourth,andfifthcharac-
teristics.Thecentralgovernment's to makeeconomicpolicymustbe
authority
limited;thisauthoritymustbe in thehandsof thelowerpoliticalunits.More-
over,thelocal governments mustface hardbudgetconstraint.Thisconstraint
inducesproperfiscalmanagement(McKinnon,1994). Werelowergovern-
mentsbailedout of fiscalproblems,eitherby the centralgovernmentor via
accessto printingmoney,theywouldhavefarless reasonto worryaboutthe
fiscalconsequencesof theirdecisions.
Noticethatsomestateswill callthemselvesfederalalthoughtheyfailtomeet
theabovefivecriteria,whileothersmaynotcall themselvesfederalbutdomeet
thecriteria.Thus,asWilliamson(1994)observes,thereis adistinction
between
de factoandde jurefederalism.This suggeststhattraditional approaches to
federalismarebasedon formalor legaldistinctionsthatareirrelevant for the
questionsstudiedhere. In whatfollows,we studystatesthatmeetthe above
fivecriteriawithoutregardto whethertheycall themselvesfederal.

1.1.1 EconomicConsequencesof Market-Preserving Federalism.The econo-


micconsequencesof market-preserving federalism,exploredby Hayek(1939,
1960)andmadefamousby Tiebout(1956), aresufficientlywell-knownthat
theyneedbe describedonlybrieflyhere5 Thefirstandperhapsbeststudiedef-
fectis theinducedcompetitionamonglowerunitsof thefederalstructure. The
restrictionson thecentralgovernment'sregulatory powercombine with com-
petitionamonglowerjurisdictions to implythatno government hasmonopoly
controlovereconomicregulation.As long as capitalandlaborare mobile,
market-preserving federalismconstrainsthe lowerunitsin theirattemptsto
place politicallimits on economicactivity,becauseresourceswill move to
otherjurisdictions.
The literatureon the economiceffects of federalismyields two principal
conclusionsaboutpublicpolicy choice. First,politicalcompetitionimplies
thatjurisdictionsmustcompetefor capital,labor,andeconomicactivityby
offeringmenusof publicpolicies(e.g., levels of taxation,securityof private
rights, social amenities, and public goods). Economic actors make location
decisionsbasedin parton thosemenus.In combination, the choicesof local
jurisdictionsandeconomicactorsyielda diversityof publicgoods,withsome
providinglowertaxesanda lowerlevelof publicgoodsandothers
jurisdictions
providinghighertaxesanda higherlevel of publicgoods.6
Second, competition implies that only those restrictionsthat citizens are
willing to pay for will survive. Were a jurisdiction to respond to political
pressureby attemptingto cartelize an industry,the mobility of labor implies
thatit will relocatein morecompatible
jurisdictions.If ajurisdictionattempts
to confiscatethe wealth of an industry,the mobility of capitalimplies thatfirms

5. Forrecentresultsandsurveysof thisliterature,
see Aranson(1991),CasellaandFrey(1992),
Inman(1987),McKinnon(1994),Oates(1972),Rubinfeld(1987),andScotchmer (1994).
6. Heretoo, qualifications
to the generalresultshaveappeared;see Aranson(1991),Inman
(1987),andScotchmer (1994).

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6 TheJoumal &Organizalion,
o La, Economics, V11N1

will relocate. The mobility of resourcesthusraises the economic costs to those


jurisdictionsthat might establish certainpolicies, and they will do so only if
the political benefits are worththese and othercosts.
Federalismthus greatly diminishesthe level and pervasivenessof economic
rent-seekingandthe formationof distributionalcoalitions. Competitionamong
the lower units limits the success from rent-seeking. Because such regulation
qua rent-seekingcan only be local, it provides firms outside that locale with
a competitionadvantageover those being regulated. Nonetheless, when, in a
given locale, individuals' willingness to pay is sufficient, local governments
will providea specific arrayof goods and services.

1.1.2 SustainingMarket-preserving Federalism. Aprincipal featureof the eco-


nomic analysis of federalism is that it takes federalism's division of political
authorityas given. In political terms, the economic analysis of federalism
ignores how Riker's second characteristicF(2) is achieved. Although I post-
pone until Part2 the discussion of how it is achievedin practice, the previous
discussion demonstrateswhy it is necessary.
The beneficial economic consequences of federalism result from the polit-
ical decentralizationof economic authoritythat induces competition among
the lower political units. Were the structureof political authoritysolely at
the discretionof the centralauthorities,the beneficialeffect could not be real-
ized, because they would respond to the interests' appeals for interventionin
precisely the same manneras if there were no federalism. Withouta mecha-
nism to preventthis action by the centrallevel, market-preservingfederalism
would be neithersustainablenor market-preserving.Somethingmust provide
durabilityto the limits on the central government'sauthorityto regulate di-
rectly, to usurp that authorityyor simply to remove its earlier grant of that
authorityto the lower levels. In short, federalism'srestrictionsmust be self-
enforcing.

1.2 Market-preservingFederalismin Practice


This section surveys two systems characterizedby market-preservingfederal-
ism: 18th-centuryEnglandand the 19th-centuryUnited States.7

1.2.1 Federalismin England. Though the British do not use the labelfederal-
ism, by the criteriagiven above, 18th-centuryEnglandwas a de facto federal
system.8 First, the nationaland local governmentswere importantand distinct
sourcesof political authority.Second, by the beginningof the 18thcentury,the

7. Thoughwhat follows focuses only on Anglo-Americancases, similarargumentscan be made


for the role of federalismin the economic riseof Switzerlandand Germany.
8. The reason England was not a de jure system of federalism is that 18th-centuryEngland
did not possess political jurisdictionssuch as states, cantons, or lander that are associated with
governmentstypicallylabeledas federal. Nonetheless,despitethe absenceofstates or ltnder, 18th-
centuryEnglandfits the five criteriagiven above. As we show below, various local governments
had considerablepolitical and economic freedomover the economy.

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TheEconomc
Roleo PoltcalInstituUons
7

nationalgovernmentwas limited in its abilityto regulatethe domesticeconomy


(thoughinternationaltradewas heavily controlled).The constitutionalchanges
duringthe 17th centuryabolished,greatly restricted,or grantedjointly to Par-
liament and the Crownmany of the powers used by the deposed Stuartkings.
Throughoutthe Stuarts' reign, rent-seeking activity was prevalent(Ekelund
and Tollison, 1981), and many of these constitutionalchanges were aimed at
preventingit
From the standpoint of this article, England's market-preservingfederal
structureproved critical to the industrialrevolution. The importanceof the
induced competition among localities is revealedby its effects on the pattern
of local economic controls. In nearlyall the establishedcommercialcentersof
England,productionwas controlledvia local regulatorylaws. Variousindus-
tries and professions,for example, were governedby guilds, whose regulatory
controls attemptedto limit competition, pricing, entry, and training. These
constraintshandicappedpotentialentrants,includingthose attemptingto devise
new formsof economic activityor to promotesignificantinnovationfor existing
activities.
Two interrelatedaspects of the industrialrevolutionconcernus. First, eco-
nomic historiansemphasize that one of the centralfactors underlyingthe in-
dustrialrevolutionwas the absence of enforcementof these restrictions(see,
e.g., Mokyr, 1988). Second, that absence was neitheruniformnor accidental
(see Hartwell, 1971; and esp. North, 1981: chap. 12). And it is importantfrom
our perspectivethat the absence of restrictionsreflected local political policy
choices. As is well-known,industrializationdid not proceedin the established
commercialcenters, but instead in the north. One of the foremost scholars of
the industrialrevolution,T. S. Ashton, concludedthatthe absenceof regulatory
restrictionswas decisive for location decisions:

It is beyond doubt that employers often transferredtheir activities from


corporatetownsin ordertoescapefromrestrictionsimposedby privileged
groups of workers,or from municipalregulationsas to labour... MT]he
movementof industrywas rarelyinducedby the prospectof lowerwages
in the new area. (Ashton, 1955: 94)

Trying to evade local economic restrictions, many of the new entrepreneurs


who were so critical to the industrialrevolutionlocated in areas traditionally
outside the commercialorbit.
Root's (1994) comparisonof England and France reveals an importantdif-
ference in the legal response to the locational decisions of new enterprises.
In England, Parliamentand many local Justices of the Peace (JPs) refused to
extend guild restrictionsandjurisdictionto the countryside.Typicallyselected
from the local gentry,JPs were unpaidand owed only nominalallegianceto the
crown,particularlyaftertheGloriousRevolution(1688-89). LocalJPscaredfar
more aboutlocal prosperity-often their own-than aboutimplementingpoli-
cies for the benefit of those outside theirjurisdiction."By contrast,the French
royal courtssupportedthe claims of Frenchguilds to regulateruralproduction,"

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ofLaw,Economics,
8 TheJoumal V11NI
&Organization,

thus hinderingratherthanfosteringindustrialdevelopmentin France(Root, in


press: chap. 5).9
Two aspects of England's market-preservingfederalismfostered economic
growth duringthe industrialrevolution. First, limits on the national govern-
ment's authorityto regulateeconomic activitypreventedit from respondingto
efforts by the establishedeconomic intereststo provide nationalcontrols that
would have effectively preventedmany of the new industrialactivities.10Sec-
ond, the induced political competition among local jurisdictionsimplied that
some localities were willing to take on the extra burdensin exchange for the
prospectof generatingnew forms of economic activity,local employment,and
taxes. The absenceof local political freedomwouldhave significantlyhindered
the industrialrevolution. Federalismthus provided a necessary and decisive
political foundationfor England'sindustrialrevolution.

1.2.2 Federalisminthe UnitedStates. At its inception,the United States Con-


stitutiongrantedthe statesthepowerto providetheircitizens with variousforms
of public goods. The historicalrecordshows thatthey took advantageof these
powers in differentways (Handlinand Handlin, 1947; Hartz, 1948; Hughes,
1977). The Constitutionalso allowed states to respondto interestgroups and
distributionalcoalitions, but limited the reach of each state's policies to its
own territory.Federalismprovidedstrong limits on the degree to which these
coalitions could impose uniformnationalregulations.
The commerceclause providedone of the Constitution'scentralpillarsin its
protectionof markets(for a discussion of this issue, see Aranson,1991).11This
clause preventedstates from regulating interstatemarketsand from erecting
variousforms of tradebarriers. It also limited federal regulationto problems
truly national in scope, an authoritynot exercised via direct interventionin
domestic marketsfor the first 100 years of the Constitution.As Hayek (1960:
chap. 12) observed, federalism thus proved the solution to the dilemma of
how to limit the states' protectionistactivities without providingthe national
governmentwith too much power.
The consequencewas one of the largest common marketsin the world, one
with strongprotectionof propertyrightsandan absenceof economic regulation.
The constitutionallimits on state and federalgovernmentsprovidedthe critical
politicalfoundationfor the enormousexpansionof the economy duringthe 19th
century.By mid-century,the patternof interregionaltradehad transformedthe

9. These conclusions are shared by a range of scholars. Landes (1969: 18-19), for example,
emphasizesthat"acrucialelementin therise of industrialcapitalism[was] thespreadofcommercial
manufacturefrom the towns to the countryside... (Yet] the very unevennessof this development
... is testimonyto the fierce and successful oppositionit encounteredfrom privilegedinterestsin
the towns."
10. Indeed,the Stuarts'inclinationtowardthis formofregulation,parallelingsimilarinclinations
in absolutistFrance,underpinnedone group of the domestic opposition to them duringthe Civil
Warin the 1640s and the Glorious Revolutionin the late 1680s.
11. The commerceclause was by no means the sole clause designed for this purpose;another
example is the privilegesand immunitiesclause.

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TheEconomicRoeof
PoticaInstitutons9

nationfrom one of largely self-sufficientfarmersat the time of the Constitution


to oneofstrikingregional-andinternational-economic specialization(North,
1961; Fogel, 1989). The growth in national wealth reflected this patternof
specialization.
In broadoutline, the South specialized in the productionof cotton and other
exports. During the early partof the century,strongand growinginternational
demandfor cotton helped fuel Americaneconomic growth(North, 1961; Lee
and Passell, 1979). The Northeast specialized in providing commercial ser-
vices, for example, transportingcotton to Europeanmarkets. It also provided
insurance, marketing,and other financial services attendingthe growth and
delivery of these exports. The Northwest, largely self-sufficient at first, in-
creasinglycame to specialize in growingfood. These cropswere shippedsouth
along the water routes and, increasingly,east via canals and railroads. On the
eve of the Civil War,a large portionof Midwesternfarmerswere specialists in
internationalmarkets,producinggrainbound for Europe(Bogue, 1963; Fogel,
1989). Except for the interruptionof the Civil War(includingits lastingdelete-
rious effects on the South), this process of growthand specializationcontinued
throughoutthe century. By century's end, the United States was the richest
nation in the world.
The relativelyunregulatedaspect of the thrivingmarketsof the 19th century
is so takenfor grantedby moder economic historiansthatit is not analyzedin
any detail (see, e.g., Lee andPassell, 1979; or Fogel, 1989: Part1; an important
exception is Temin, 1991). Neoclassical economics, takingpropertyrights as
given, acceptssecureeconomicrightsin the 19thcenturywithoutanalysis. And
yet the absence of federal interventionto altermarketsandpropertyrightswas
neitherinevitablenordue to lack of demand. Justas todaywe observea host of
displacedeconomic interestsprovidingpolitical supportfor interventionto halt
or reversethe changesaccompanyingeconomic growth,so too didgroupsin the
19thcentury.Thus commercialagentsalong thetraditionalwatertransportation
routesfought the growthof the railroads.Cattleproducersin upstateNew York
sought relief from cheaperproducersfartherwest. Nascent manufacturersin
the Northeastfought cheap landpolicy at the federallevel becauselower prices
increased immigrationrates. Although the reasons varied from case to case,
theseinterestswere by andlargeunsuccessfulin theirattemptsto gainbeneficial
legislation.12
The absence of debilitatingregulatoryinterventioncritically depended on
the common market'ssecure political foundationlimiting the ability of state
and federal governmentsto respondto distributionalcoalitions. For well over
a century,domestic, interregionalmarketswere not only unregulatedbut pro-
tectedfromregulationby the Constitution'sconstraints.As emphasizedabove,
federalismwas centralto these constraints.

12.SeeMiller(1971) on the railroadsandPassell andSchmundt(1971)onNortheasterninterests


and immigrationpolicy. More generally, see Chandler's(1977) systematic study of industrial
change in the second half of the 19th century.

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10 7heJournal
ofLaw.Economics,
&Organization,
V11NI

2. CredibleCommitmentto Federalism
Part2 discussestheprincipalconstitutional
mechanisms fed-
thatunderpinned
eralismin Englandandthe UnitedStates,focusingon whatmadefederalism
self-enforcing.

2.1 Self-EnforcingMarket-preserving Federalism andtheRuleof Lawin17th-and18th-


Century England
The task of this sectionis twofold: to developa modelof a constitutional
consensusaboutthelimitsongovernmental actionandtoapplyit tohelpexplain
theabsenceof economicintervention in 18th-centuryEngland.
Thequestionwe studyconcernsthelimitson sovereignorstatepower.Why
areinstitutional constraints on government observed?In particular,giventhe
omnipresent to
temptations avoid,break,ignore, or end-run theserestrictions,
whatpreserveslimitedgovernment?One approachconcernsthe notionof
legitimacy:A regimefindsit difficulttoviolateprovisionsof a constitutionthat
its citizensfeel arelegitimate.Althoughpromising,this approachis fraught
withproblems:Whatdetermineswhena constitutionis legitimate?Canthis
notionbeoperationalized so thatitisnottautological?Andhowdoeslegitimacy
translateintothepreservation of a specificconstraint
on government?
Thepurposeof thissectionis to developanapproach to theproblemof legit-
imacyin a waythatanswersthesequestions.13 Tomakesenseof thisconcept,
we begin with individualcitizens. To avoid tautology,we root legitimacy in
individualcitizens,not in the society. We assumethateach citizenholds a
specificview abouttheappropriate boundson governmentalaction.
Definedin thisway,theproblemof legitimacycreatestwoenormoussocial
problems.The firstarisesbecausein andof itself,nothingbringscitizensto
a uniform view. Indeed, economic, political, and social differences work to
theirnotionsof whatactionsare legitimate.In the languageof
differentiate
gametheory,the problematicnatureof citizenagreementon the appropriate
boundsof government createsa coordination
problem.
Thesecondproblem betweena citizen'sviewsabout
concernstherelationship
the appropriateboundson government andwhathappenswhenthosebounds
areviolated.Putsimply,evenif allthecitizensagreeontheappropriate bounds
of government, whatkeepsthegovernment fromignoringthosebounds?
The importanceof these two problemsarisesbecausethey hold the key
to the successof limitedgovernment.Constraints canbe policedonly when
citizensreactin concertagainstthegovernment's violations.Successrequires
the conjunctionof two aspects of citizen behavior:First, citizens must react to
violationsbypunishingthegovernment; andsecond,theymustholdsufficiently
similarviews aboutthe appropriateboundson government thattheyreactin
concertwhenthegovernment oversteps thosebounds. In thelanguageof game
theory,we aresearchingforan equilibriumto a gamein which thegovernment
has the opportunityto violate constraintsbut chooses not to do so.

13. What follows summarizesthe model and results presentedin Weingast(1994b).

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TheEconom'cRo!eof PojticalInsti'tions 11

Acq
II %
Transgressagainstboth I
I
Acq/ I
/
I
sChall
Transgress.ag.A A I
I
s- I !

Chall
\Chall 'I I ' I/ Chall
Acq
Transgressag. B I
? I
I
I
I Chall
Transgressag. neither

Fgure 1. The sovereign-constituency game. (Acq= to acquiesceto a


transgression
Chall= to challengeit).
transgression,

The model is based on two assumptionsabout the relationshipbetween a


sovereign and his or her citizens. First, a necessaryconditionfor an individual
citizen to supportthe sovereignis thatthe sovereignnot transgressthatcitizen's
rights. Second, remainingin powerrequiresthatthe sovereignretaina sufficient
degree of support among the citizenry. Without the necessary support, the
sovereign loses power.

2.1.1 The Model. We suppose there is a single sovereign, S, and two groups
of citizens, A and B. The groups of citizens have different views about the
legitimateboundariesof the state and hence what actions by the sovereign are
considereda fundamentalviolation of theirrights. In this game, the sovereign
needs the supportof at least one of the two groupsin orderto retainpower.
The sequence of actions in this game is shown in Figure 1. S moves first
and may choose to attempt to transgressagainst both A and B, against A
alone, against B alone, or against neither. After S moves, A and B move
simultaneously.14Each may choose to acquiesce or to challengethe sovereign.
Challengingis costly; moreover,each may challenge even if the sovereignhas
not transgressed. If both A and B challenge, the sovereign is deposed and
any transgressionattemptedby the sovereign is rebuffed. If only one group of
citizens challenges S, the challenge fails and any transgressionattemptby S
succeeds. Of course, if both A and B acquiesce, any attemptedtransgression
succeeds.

14. The simultaneousmove between A and B is representedin Figure 1 as follows: A moves


first, followed by B, and the dashed ellipse or "informationset" aroundB's two nodes indicates
thatB does not know A's decision when choosing his own move.

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12 TheJoumalof &Organization,
Law,Economics, V11Nt

Table1. PayoffsfortheSovereign-Constituency Game


Transgression
Sovereign'sMove InducedSubgameBetween AandB
S, A, B)
(Payoffs:
B
both Acq Chall
Transgressagainst Acq (5,1,1) (5,1,0)
A Chall (5,0,1) (0,3, 3)

B
Acq Chall
TransgressagainstA (3,1,4)
Acq , (3,1,3)
A Chall (3,0,1) (0. 3,3) !

B
Acq Chall
Transgress
againstB
Acq i (3,4,1) i (3,4,0)i

B
Acq
Ac q(1,4,4) Chall
againstneither
Transgress (1,4,3)
A Chall (1,3,4) (0,3,3)

Power is valuableto the sovereign, who receives 1 if he retainspower. Suc-


cessful transgressionsare also valuableto the sovereign and are worth2 each.
A transgressionagainst eithergroup costs thatgroup 3, reflectingthe fact that
thereareeconomic costs associatedwith transgressions-for example,a loss of
wealth. Challengingcosts each challenger 1, regardlesswhetherthe challenge
is successful.
The payoffs from this game are given in Table 1. Outcomes and payoffs
are determinedby the strategycombinationschosen by the threeplayers. IfS
attemptsto transgressagainstbothA andB andbothacquiesce,the transgression
succeeds andthepayoffs are: 5 to S, I to A, and 1 to B. IfS attemptsto transgress
against both A and B and both challenge, the transgressionfails and S loses
power,resultingin payoffs of 0, 3, 3. The Paretooptimaloutcome for society
occurs when no transgressionsor challenges are attempted(the partiesobtain
1, 4, and 4, respectively).
Althoughmorecomplicatedthanthe standardPrisoners'Dilemma, the struc-
tureof this game resemblesit. This holds becauserespondingto transgressions
is costly to each citizen group. Considerthe set of incentivesfacing the citizens
if S attemptsto transgressagainst B. B prefers that both challenge. Notice,
however, that A has a dominantstrategy: no matterwhat strategyB plays, A
prefersto acquiesce. Knowing this, B will acquiesce.
This structureof interactionallows the sovereignto transgresssome citizens'
rights and survive.15In the one-shot game, thereare threepure strategyequi-

15. Throughoutthis analysiswe use the conceptofsubgame perfectionas an equilibriumconcept,


of theactiona playerwill takeat everybranch
definedas follows. A strategyis a specification

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Roleol Poticalnstituions13
TheEconornc

libria,andthe Paretooptimalstrategycombination with no transgressions is


not amongthem. Whichequilibrium occursdependsin parton the reaction
functionsof thecitizens'groupsto a transgression. Theworstoutcomefor the
citizens-where the sovereigntransgressesagainstboth-is an equilibrium.
This occursif citizensacquiescewhenevertheyare the targetof a transgres-
sion. Actingaloneandtakingthebehaviorof theothersas given,eachcitizen
groupcanonlyincreaseits costsby challenging; it cannotchangetheoutcome.
Ontheotherhand,A andB mightbothplaya differentstrategy,namelythat
theychallengeS if andonlyif botharethetargetsof a transgression. Inthiscase,
therearetwoequilibria, depending on which citizen group S chooses asa target
Suppose that S chooses to B
target in everyperiod and thatA and B respond
as just suggested.ThenS has no incentiveto deviate:transgressing against
bothleadsto beingdeposed;transgressing againstA insteadof B is no better;
andtransgressing againstneitherleavesthesovereignworseoff. Furthermore,
neithercitizengrouphas an incentiveto deviate. For A, this conclusionis
obvious.ForB, it followsbecauseB can do no better.GiventhatB aloneis
the target,andthusthatA will not challenge,challengingwill notchangethe
outcomebutwill increaseB'scosts.HenceB is betteroff acquiescing if it alone
is thetarget.
Thesituationis morecomplicated wfienthisgameis repeated,thatis, when
theinteraction betweenthesovereignandcitizensis ongoing.Giventhestruc-
tureof payoffs,the"folktheorem" applies,implyingthatvirtuallyanyoutcome
canbe sustainedasanequilibrium of therepeated game(Fudenberg andMaskin,
anyof the equilibriaof the one-shotgameis an equilib-
1986). In particular,
riumof therepeatedgame. The existenceof multipleequilibriais a problem
forprediction,anissuewe returnto below.
Thefolk theoremimpliesthattheParetooptimaloutcomecanbe sustained.
Thekeyto thisresult,as withtheone-shotgame,concernsthebehaviorof each
citizengroupwhenthesovereignattemptsto transgress againsttheother.The
differenceis thatrepetitionprovidesthe opportunity for citizensnot only to
punishthe sovereign,butto punishone another.TheParetooptimaloutcome
is supportedby bothgroupschallengingthe sovereignwhen the sovereign
attemptsto transgressagainsteither. The reasonwhy thatbehaviorcan be
supported underrepeatplayis that,as in therepeatedPrisoners'Dilemma,the
playerscanuse"trigger" topunfshoneanotherforfailure
strategies tocooperate.
If, forexample,A failsto challengethesovereignwhenthesovereignattempts
to transgressagainstB,thenB canretaliateby failingin thefutureto challenge
the sovereignwheneverthe sovereignattemptsto transgressagainstA. This
behaviorby B allowsthesovereignto transgress successfullyagainstA.
B's triggerstrategyprovidesA with the followingstrategychoice. It can
acquiescetoday,avoidingthe cost of 1, andthenface losing 3 in all future
periods;or it can challengetoday,costing 1 but maintaining3 in all future

of the gametree. An equilibrium is a set of strategycombinationsin whichno playerhas an


incentiveto deviategiventhestrategies of others.Theequilibrium
is subgameperfectif it remains
an equilibriumwhenrestricted to everysubgame.

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14 TheJournalo LawEconomics,&Organization,
V11N1

periods. Clearly,when A does not discountthe futuretoo heavily, it will prefer


the latter,so thatB's threatstrategyinduces A to challenge the sovereignwhen
the latterattemptsto transgressagainstB alone.
Unfortunately,the Paretooptimal outcome is not the only equilibrium.Al-
though that equilibriumis normativelyattractive,it will not inevitably occur.
The game might insteadyield any of the threeequilibriaof the one-shotgame,
allowing successful transgressionsagainst some or all citizens. In particular,
the sovereign may transgressthe rights of some citizens while retaining the
supportof others.
So far, we have takenthe definitionof a transgressionas given, ignoringthe
content of the underlyingviews of individualsabout these transgressions.The
most naturalway to interpreta transgressionin the model is as an act directed
againsta groupof citizens-for example,an attemptto confiscatetheirwealth.
Anothersubtlerway to thinkabouta transgressionis to disassociateit from the
target For many citizens, the importanceof a transgressionlies in its nature,
regardlessof who is the target.This view of transgressionsimplies thatcitizens
have a duty to challenge the sovereignwhen the latterattemptsa transgression,
regardlessof the target. This view still allows for a diversityof opinion over
what acts constitute transgressions. The question then becomes, given this
interpretationof transgressionsand citizen duty,what combinationsof beliefs
aboutthe natureof transgressionscan be supportedin equilibrium?
Given the second interpretationof a transgression,one way to think about
the problem of multiple equilibria is that the question of which equilibrium
will occur depends on the diversity of beliefs about transgressionsand about
citizen duties when the sovereign attemptsto transgressagainstothercitizens.
Indeed, as Ferejohn (1990) argues, in the context of multiple equilibria, we
can suggest which equilibriumwill result if we know the patternof beliefs in
a society.
In the present context, Ferejohn's argumentimplies the following. Sup-
pose there is a diversity of preferencesover outcomes, especially if citizens'
economic circumstancesdiffer considerably-some might be wealthy elites,
others successful commercialagents or economic entrepreneurs,others farm-
ers who own their land, still others peasantswho work land they do not own.
Under these circumstances,the natureof citizen views about the appropriate
role of the state and what actions constitutea transgressionare likely to differ
widely. Because there is no automaticmechanismto producea consensus on
these issues, the most naturalequilibriumof the game is the asymmetricone.
Put anotherway, the diversityof preferencesimpedes the developmentof the
Paretooptimal equilibrium,making it more likely that the game will result in
one of the asymmetricequilibriain which the sovereign transgressesthe rights
of some and retainsthe supportof others.
Ferejohn'sargumentalso implies that, for those issues over which citizens
agree about the natureof a transgression,the Paretooptimal outcome can be
supported.Whenthe stateof agreementin society is large,producingsomething
approachingaconsensus, a sovereignwho attemptsto transgressagainstcitizens
cannotsurvive.

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ofPobtcalInsttutions15
TheEconomicRole

Summaryand Implications. The model shows thatit is costly for the citizens
to police the sovereignor government Policing limits on the staterequiresthat
citizens be willing to bear this cost when the state violates them. Yet if citizen
beliefs aboutthe appropriatelimits on the statedifferconsiderably,it is difficult
for them to react in concert to state actions. Indeed, this diversity allows
the sovereign to form a coalition with one group of citizens against another,
allowing the sovereign to transgressboundariesconsidered fundamentalby
othercitizens.
This approachmodels the problem of policing a state or sovereign as a
coordinationproblem. In this context, a constitutionserves as a coordinating
device, helping citizens to coordinatetheir strategy choices so that they can
react in concert and police state behavior.t6Anappropriatelychosen set of
public rules embodied in a constitution can serve as a coordinationdevice
because it provides each citizen with a similar way of judging and reacting
to state action. Of course, the availabilityof such a mechanismin principle
does not tell us under what circumstancesit may be used in practice. This
approachdemonstratesthata centralstep in the creationof limitedgovernment
is that citizens or their representativesconstructa mechanismthat solves the
coordinationproblem.

2.1.2 Applicationof the Modelto theGloriousRevolution. This model has con-


siderable implications for the contitutional changes following the Glorious
Revolution in England and the rise of a national consensus about the appro-
priate boundariesof the state. Two aspects of market-preservingfederalism
allowed the industrialrevolutionto take place outside the traditionalcommer-
cial areas: decentralizedregulatoryauthority,which allowed local variationin
economic controls; and the absence of nationalregulatoryauthorityto extend
economic controls to cover those areas that did not have them. A range of
elements contributedto this result The most importantfrom our standpoint
was the strengtheningof the rule of law at the end of the 17thcentury,whereby
a consensus emergedopposing nationaleconomic intervention.17
The 17th century saw considerablepolitical turmoil. Within a decade of
the accession of the Stuartsin 1603, problemsemergedbetween the sovereign
and many of his citizens. The centuryincluded a civil war and the beheading
of the king (1640s), a restorationof the monarchy (1660), and the Glorious
Revolution (1688-89), which deposed the last of the Stuartkings, JamesI, in
favor of William and Mary.
Throughoutthe century, the citizenry was deeply divided over the role of
the sovereign, the appropriatelimits on state behavior,and the benefits of var-

16. This point is made generallyby Hardin(1989).


17. Other aspects include: first, among all states in early modem Europe, England had the
strongest traditionof private propertyrights; second, after the Glorious Revolution, Parliament
counterbalancedthe Crown,by and large opposing nationaleconomic intervention.

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16 TheJoumralofLaw,
Economics VIIN1
&Organization,

ious publicpolicies. By century'send,two politicalcoalitionshademerged,


calledToriesandWhigs.Whigsweremorefocusedon commercialactivities,
favoredsecurepropertyrights,advocatedlow andstabletaxeson economic
activity,andtookan activistprofilein international
relationsto promoteand
defendtheireconomicclaimsaroundtheworld.Theyalsosoughtexplicitlim-
its on the sovereign'sbehavior.Tories,on the otherhand,caredmuchless
aboutcommercialactivity,wanteda limitedinternational presence,andpre-
ferredlow andstabletaxeson land,theirprimarysourceof wealth.Theyalso
stronglysupportedthe Churchof Englandandopposedexplicitlimitson the
Crown.s1
Duringthe reignof the late Stuarts(fromthe Restorationto the Glorious
Revolution)andespeciallyby themid-1670s,theToriessupported the Crown
whiletheWhigsopposedit. Moreover,thelateStuartstransgressed significant
rightsoftheWhigswhileretaining thesupportof theTories.Themostimportant
sovereigntransgression concernedthecampaignto "packthe constituencies'.
In the early 1680s,the Crownbeganto disenfranchise the majorsourcesof
Whigopposition.Thestrategyproveda hugesuccess.19
Althoughthe eventsthatoccurrednext are straightforward in outline,the
explanationfor themhas been debatedfor morethan300 years. First,the
initiatorof the campaignto disenfranchise the Whigs, CharlesII, died and
wassucceededby his brother,JamesII. Second,for a varietyof reasons,there
was considerable suspicionbetweenJamesandhis supporters. Not longafter
takingpower,Jamesbecameembroiledin a disputewiththeToriesandreacted
by attempting them.Althoughthisattemptnearlysucceeded,
to disenfranchise
it endedin dismalfailure.Theresultwas apoliticalnationunitedagainstJames
I, forcing him to flee.
The GloriousRevolutionwas more than a simple coup, however,for it also
resultedin significantconstitutionalchanges. James's behaviorconvinced the
Tories that explicit limits on the sovereign and the state were required. Al-
thoughthe two coalitions disagreedabout the content and role of these limits,
they agreed not only that limits were necessary, but so too was a consensus
about those limits (Schwoerer, 1981). The result was the Revolution Settle-
ment passed by Parliamentin early 1689. From our standpoint,the key is
the Bill of Rights, a set of two lists. The first identified those actions of the
previous sovereign that constitutedfundamentalviolations of citizens' rights.
The second listed activities that the sovereign could no longer undertake.Al-
thoughsovereignpower would wax and wane over the next century,the limits
establishedin theRevolutionSettlementwere,by andlarge,adheredto.

18. "It is an oversimplificationto see the Whigs as the party of business and the Tories of
seigneurialpower.... But one can safely contrastemphasis on commerce as a point in the Whig
profile, and emphasis on agricultureas a point in the Tory one. So, too, the Whigs tended to
internationalism.. while the Tory was inward-lookingand protectionist"(Carswell, 1973: 40-
41).
19. Jones (1972: 47) reportsthat of the 104 formerlyWhig strongholdsrecharteredbetween
1681 and 1685, only one returneda Whig to the next parliamentin 1685.

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TheEconomic
Ro ofPoibcalInstitutons17

2.1.3 SustainingMarket-preserving Federalism in England. Theseeventsare


readilyinterpretedin termsof themodel above. BeforetheRevolution,citizens
fundamentally disagreed aboutwhat actionstheyconsideredviolationsof their
rights. Marked divisionsin 17th-centuryEnglandpreventedtheformationof
a sharedsystemof beliefsaboutcriticalmatterssuchas the role of the state,
the limit of sovereignpower,citizenduty,and the appropriate definitionof
economicandpoliticalrights. The diversityof beliefsallowedthe Crownto
transgress rightsheldas fundamental by theWhigsas longas theTorieswere
to
willing acquiesce. This describedthe situationfromat leastthemid-1670s
throughthe mid-1680s. This patternof transgressionwas seemingly stable,
reflectingthenatureof theasymmetric equilibrium of thegame.
James'smoveagainsthis ownconstituents brokethispattern,losinghimthe
supportrequiredto retainpower.Notonlywashe removedfrompower,buthis
actionscauseda wholesaleandspeedyrevisionin opinionsandbeliefsabout
fundamental issues. This changeled to the constructionof a new consensus
thatprovideda clearerdefinitionof the legitimateactionsof the stateandof
citizenduty.
Thesechangesreflectan attemptto constructa coordinating device. Con-
stitutionalinnovations,suchas the RevolutionSettlementandits Declaration
of Rights,weredesigned,in part,to definewhatactionsconstituteda funda-
mentaltransgression.The new consensuswas criticalto preventingfurther
transgressions.Accordingto Jones(1972:318):
Thethirteenpointsin theDeclaration werenotjuststatementsof thetrue
natureof thelawof theconstitution,theywerealsointendedto providea
guidelineforthefutureconductof government,so thatanydeparturefrom
legalitywouldbe instantlysignalled,andremedialactioncouldbe taken.

Thisis preciselythemechanismmodeledabove.Becausethenewboundaries
werebothexplicitandconsensual,theyfundamentally changedtheinteraction
betweenthecitizenryandthenewsovereign.Formanyof thecentralpolitical
issuesof theera,a singlesetof limitsonsovereignbehaviorhadbeennegotiated
byleadersof theopposingparties.Thisprocessresultedina setof sharedbeliefs
aboutwhatconstituted a fundamental by thestateandaboutwhat
transgression
citizensshoulddo in thefaceof thesetransgressions. Thesesharedbeliefsim-
pliedthatcitizenswouldreactin concertagainstanyfuturesovereigntransgres-
sion,thusensuringthattheirpoliticalandeconomicrightsweremoresecure.20
Buthow did thisnew coordinating mechanismtranslateintoprotectionfor
federalismin England?Giventhe distincthierarchyin Englishgovernment,
themainquestionas towhetherpost-Glorious RevolutionEnglandhadmarket-
preserving federalismconcerns thelimitson national
regulatoryauthority.

20. Reflectingthe achievement of coordination,


the AmericanJusticeBradley,writingin the
late 19thcentury,observedthata constitutional
violation"wouldproducea revolution
in anhour"
(J.Bradley'sdissentin theSlaughterHouseCases,1873).

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18 TheJoumalof
LavEconomics, V1 N1
&Organization.

Afterthe GloriousRevolution,citizensmoreclosely guardedlocalpower,


andautonomy.Becauseviolatinglocalpoliticallibertyhadbeenthe
authority,
factor
principal in the campaignto packtheconstituencies-andhencein the
Revolution-citizensthroughout Englandwerewaryof nationalinterference
withtheirauthority.As Miller(1992:53) suggests:

The right,in most towns,to practicea particulartradeor takepartin


municipalgovernment wasconfinedto a comparatively restrictedgroup
of craftsmenandtraderspossessingthe"freedom" of theirtownor craft
guildwhichgave themrightsdeniedto othercitizens. Municipaland
othercorporations(includingcollegesanduniversities)
hadbeengranted
(usuallyby the Crown)the rightto a measureof controlovertheirown
affairs:here"freedom" meantimmunityfromoutsideintervention.

Localpoliticalfreedomthusemergedas partof theconstitutional consensusat


theendof the 17thcentury.21
By wayof summary, nationalinterference withlocalpowerduringthecam-
to
paign pack the constituencies
produced a consensus thatprotectionof local
poweragainst nationalinterferencewas essentialto themaintenance of individ-
uallibertyandsecurity.Theconsensuswasembodiedin theRevolutionSettle-
ment,animportant additiontotheEnglishconstitution. Thisexplicitagreement
servedas a coordinating devicenecessaryto establishtheequilibrium in which
citizensreactin concertto violationsof thelimitson governmental action.
ThoughtheGloriousRevolutionwaslargelybackward looking,in thesense
thatits limitswereintendedto preventtransgressions by the sovereign,it had
important-ifunintended-forward effectson theeconomy.By strengthening
local powerandlimitingthe abilityof the nationalgovernmentto intervene
in the economy,the new Englishconstitutional systemprovidedfor market-
preservingfederalism.This in turnproveda criticalpoliticalcomponentof
industrialrevolution,for it allowed local governmentsto ignore, avoid, or re-
peal the reguIatoryrestrictionson the local economy that economic historians
have emphasized were crucial to the success of the new entrepreneursand
enterprises.

2.2 The Durability


of Federalismin the UnitedStates
The United States had market-preservingfederalismfrom the inceptionof the
Constitution
throughthemid-1930s.22 Duringthisperiod,whatmademarket-
federalism
preserving is, whatprevented
durable-that thefederalgovernment

21. An additional to regulate:theelevationof thecommon


elementlimitednationalauthority
lawcourtsastheprotectorandpromoterof privatepropertyrights.Thiseffectivelyremovedmany
decisionsaboutpropertyrightsfromnationalpolitics. Oneof the centralconsequences of the
wasalsoto establishan"independent"
GloriousRevolution judiciarymuchlesssubjecttopolitical
manipulation.
22. Whatfollowsdrawson Weingast(1993a,1994a).

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TheEconomicRo!eof
Poltical
InsUtutions
19

fromoverawingthestates?Theimmediateanswer-thattheConstitution pre-
ventedit-begs thequestion,forit ignorestheissuesof constitutional interpre-
tationandconstitutional adherence.
At the mostfundamental level, the answerto the questionis thatnot only
didtheConstitution proscribeintervention, butthevastmajorityof Americans
favoredthisoutcome.A nationalconsensussupportedthe limitedroleof the
federalgovernmentBecausethisviewwasso widelyheld,allthemajorparties
beforethe1930schampioned it (first,theFederalists
andJeffersonians,
thenthe
DemocratsandWhigs,andfinallytheDemocratsandRepublicans).23 National
partiesnot only promotedthe view of a limitedfederalrole, butcreatedand
maintained a seriesof institutional mechanismsdesignedto providea credible
commitment to limitedfederalgovernment
To see how theconsensustranslated intothe mechanisms of Constitutional
durability,considertheproblemduringthesecondpartysystem,roughly1828
throughtheearly1850s.Duringthistime,thenationwasdividedintofreeand
slavestates.Thisdivisionhada criticalinfluenceonAmericanhistory,notably,
on the interpretation of the Constitution, the threemajorantebellumpolitical
crises,andtheCivilWarandReconstruction.24
Mostcitizenswere deeplysuspiciousof the nationalgovernmentbecause
of its potentialto imposepoliciesfavoredby otherregionsor interests.Early
in the 19thcentury,beforethe rise of an integrated,interregional economy,
thesolutionwas simplyfor bothNorthandSouthto agreeto limitthefederal
government'sauthority,thus limitingthe abilityof eitherregionto impose
its will on the other. Althoughthe partisandebateinvolvedthe role of the
federalgovernmentin the economy,the rangeof involvementwas relatively
circumscribed, limitedto suchissuesas tariffsandinternalimprovements.
The "balancerule,"or the equalrepresentation of theNorthandthe South
in the Senate,servedas the principalinstitutionprovidingdurabilityto the
agreementbetweentheregions.Thebalanceruleaffordedeachregiona veto
overnationalpolicymaking.As I argueatlengthelsewhere,thisinstitution had
aprofoundeffectonnationalpolitics(Weingast,1994a;see alsoRoback,1994).
Themainimplicationforpresentpurposesis thattheset of concurrent vetoes
preventednationalpoliciesthatwereconsideredespeciallyinimicalby either
region.Thebalancerule'sdoublevetothusprovidedthepoliticalfoundations
for thepreservation of a slaveeconomyin theSouth,a freeone in theNorth,
anda limitednationalgovernment
As theeconomybecameinterregional, however,manypolicyquestionswere
no longerso easilydisaggregated. Forexample,shouldgrowthof interregional

23.Theonepossibleexceptiontothisunanimity wastheRepublicanpartyontheissueofslavery
andtherightsof thefreedmen.Thesepoliciesemergedonlywithinthecontextof theCivilWar.A
versionof theviewthatfollowsappliesto thebulkof thepoliciestheydevisedandimplemented
duringtheirperiodof politicalhegemony(1860-1932).
24. Otherpoliticaldivisionswerealso important, butin whatfollowswe concentrate on the
former.Fora discussionof the interaction of slaveryandotherissuesduringtheperiodof the
secondpartysystem,see WVeingast (1994a).

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20 TheJoumalof V N1
Lav,Econorcs,&Organization,

tradebe subsidizedby federalsupportfor roads,canals,and,later,railroads?


Shouldnationalandagrarianexpansionbe encouragedvia low pricesforfed-
erallandon thefrontier?At aboutthesametime,theMissouricrisis(1818-20)
convincedSouthernersthatthe nationalgoverment's authoritymight be used
againsttheir"property" andtheir"institutions"--that is, againstslavery(Car-
penter,1930).
In thelate 1820sandearly1830s,theJacksonian Democratstriedto forma
politicalcoalitionto retainnational In
politicalpower. responding to thepoliti-
calquestionsnotedabove,theyarticulated a set of policygoalsconsistentwith
limitedfederalgovernment anda constitutional jurisprudence of states'rights
to underpin theselimits.TheJacksonian appeal was built on a set of principles
thatprovidedconsiderable security for slaveholders, helping partysecure
this
majoritysupportin the South andin thenation. This approachheldconsiderable
appealtoSoutherners seekingtoforestallanyprecedentfor expandingthescope
of nationalauthority.But it also appealedto manyNortherners, particularly
throughoutthe old Northwestand among laborersand farmersin the East
The Democrats' approachallowed them to dominatenationalelections and
hence to control national policy.25 Their successes depended on more than
merecampaignpromisesandreputation.Indeed,theJacksoniansaddeda series
of politicalinstitutionsto providetheirofficialswithincentivesto implement
andadhereto theirpolicies. Threeinstancesof institutionsandpracticesare
worthnoting. First,the Democratsarticulated a constitutional
jurisprudence
of states'rights,avoidinganyprecedentsfor increasednationalauthority.As
theirSupremeCourtappointments reflectedtheseviews,theyledto compatible
constitutionaldecisions. Second,as partof theirappealto Southerners, they
adoptedthetwo-thirds rulefornominating candidates to thepresidency(Potter,
1976;Weingast,1994a). This grantedSoutherners a veto overtheirparty's
presidentialcandidate,assuringthemconsiderable influencenotonlyovertheir
party'scandidatebut-as the Democratsheld the presidencyin three-fourths
of theCongressesbetween1828and1860-over thepresidentsas well. Third,
they were willing to maintainthe balance rule at the national level, assuring
the South a veto over nationalpolicy via its equalrepresentationin the Senate.
Expansionand imperialismwere rationalizedby "manifestdestiny.:'Given the
centrality of slavery to the South, significant slippage between promise and
implementationwould clearly ruin the party'sability to compete in thatregion
and thus, as all knew, its ability to maintainits majorityposition.
ThisargumentshowshowtheConstitution andalliedinstitutions
providedthe
principalmechanisms inherentinfederalism
ofpoliticaldecentralization during
thesecondpartysystem.Becausethemajoritypartyin thenationfavoredthat
position, it was able to maintain strong limits on national governmentboth

25. Duringthe 16 Congressesbetween the elections of JacksonandLincoln, the Democratsheld


all three nationalinstitutionsin 9 of 16 Congresses, whereas the Whigs held all three only once.
The Jacksoniansalso dominatedSupreme Court appointments. From 1828 to 1860, 11 justices
were appointedunderunited Democratic control, 2 underdivided control, and none underWhig
orRepublicancontrol (see Weingast, 1994a).

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ThaEconomic
RoeofPoticalInsttutions21

as officialpolicy andas constitutional law. The majoritypartyin the nation


provedinstrumentalin translatingabroad, nationalconsensusforlimitedfederal
government intoa seriesof institutions
makingthoselimitscredible.
Theargument in thissectionexhibitsstrongparallelswiththeapproachde-
velopedin Section2.1. Underlyingthelimitedroleof thefederalgovernment
wasa nationalconsensusthatthiswasappropriate. Althoughno sovereignwas
relevantfor theUnitedStates,aparallelproblemexistedbetweenthetwogroups
of citizens:eachworriedthatthe othermightcome to dominatethe national
government,allowingit to use nationalpowerfor its ownregionalpurposes.
Becausethe problemwas symmetri, bothsides agreedto limitson national
authority as a meansof limitingtheabilityof theotherto dominate.Thisagree-
ment,in turn,requireda combination of institutionsandattitudesto succeed.
The institutionsrangedfromfederalismand the commerceclausediscussed
above,to thevariousattemptstoprovideregionalbalancein theSenate.These
institutions,in turn,fundamentally restedon the attitudesandpreferencesof
citizens,requiringthatthevastmajorityin thenationbelievetheseagreements
wereappropriate. Problemsemergedonlyattheendof thesecondpartysystem
whena newparty,theRepublicans, provedno longerwillingto maintainthese
institutions,notably,thebalancerule(Weingast,1994a).

3. Implicationsfor EconomicReform
3.1 Federalism EconomicGrowth
Chinese-style: inModer China
Thecontrastbetweenthesuccessof economicreformin southernChinaandthe
troubledpathof reformin theformerSovietUnionandits satellitesnotonlyis
strikingbutappearsto reflectthelessonsof thisarticle.26
Beginningin thelate
1970s,Chinaembarked on economicreform.As oneof Asia'sfastest-growing
economiesin thepast15years,it hashadremarkable success,especiallyin the
south.
A rangeof factorshas contributed to China'seconomicsuccessrelativeto
the formerSovietUnion. Thesefactorsinclude,for example,the proximity
of SouthChinato foreigncapital,notablyfamilywealthof thosewho had
previouslyfledthecommunists to HongKongorTaiwan;therelativelylimited
initialscope of economicreform,perhapsincludingits focus on agriculture
whileignoringthelarge-scale publicenterprises; incontrasttotheformerSoviet
Union,China'srelativelyshorterexperience withcommunism, itsleaders'more
pragmaticandless ideologicalpursuitof socialisteconomicprinciples,anda
farless interdependent economy.Moreover,in contrastto the republicsand
satellitesof theformerSovietUnion,whichinheriteda rangeof economicand
fiscalproblemsfromtheirformerregimes,Chinainitiatedthereformsfroma
positionof relativelystrongfiscalhealth.
All of thesefactorscontributedto China'ssuccess.Andyettheseandrelated
factorsprovideaninadequate understanding of thatsuccess.A centralthough

26. TheseideasarepursuedatgreaterlengthinMontinola,
Qian,andWeingast(1995)andQian
andWeingast(1995).

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22 TheJoumaol
lf w. Economics,
&Organiation,
V11N

underemphasizedfactorof China'seconomic reformis thatit was initiatedwith


political reform.As appliedto China,the termpolitical reformusuallyrefersto
democratization.Democratizationis clearly a centraltask of political reform,
one of sufficientvalue thatit receives special attention.Yet it reflects only one
aspect of politics and political reform.'In what follows, I use the term in its
broadersense (see Montinola,Qian, and Weingast, 1995).
As part of the effort to pursue economic reform, the Chinese central au-
thorities instituteda form of political decentralizationthat limited their own
power. This decentralizationproduced a form of market-preservingfederal-
ism. This federalism, Chinese-style, differs considerablyfrom Western-style
federalism-for example, in having no connection to individualrightsandpo-
litical freedoms. Nonetheless, China's political system approximatesthe five
necessarycharacteristicsof market-preservingfederalismidentifiedabove.27
Critical to China's economic success, the new decentralizationaffords lo-
cal governmentsconsiderablediscretionover economic policy. In many areas,
officials have used this authorityto create marketsand entrepreneurialenter-
prises, and it is these areas that are experiencingthe most significantgrowth.
The economic effects of the decentralizationhave been felt in the growing en-
trepreneurialismfound at the local level and the growingparticipationof these
enterprisesin internationalmarkets(ByrdandLin, 1990; Montinola,Qian,and
Weingast, 1995; Nee, 1992; Oi, 1992; Qian and Xu, 1993; Walder,1992).
Underpinningthis success was the centralgovernment'sseeming toleration
of the loss of political control over local economic policy-making. This has
had two effects. First, it has lowered the influence and importanceof the
relevant ministries of the central governmentand hence of central planning.
Second, the incentives of local political officials changed dramatically.With
the growingsuccess of economic reform,local revenuescame to dependon the
economic healthof the local economy, not on political allegianceto the central
goverment orconformityto a centralplan. Parallellihgtheincentivesfacingthe
Englishjustices of the peace duringthe industrialrevolution,decentralization
in Chinaprovidedmany local political officials with the incentivesto createan
economic andpoliticalenvironmentthatfosterseconomic growth. In both 18th-
centuryEnglandand modem China, prosperingeconomic enterprisesprovide
an expandinglocal resource base, aligning the interestsof local officials with
local economic success.
The loss of central governmentinfluence and control over local officials
providesthe answerto why the criticalsecond condition of market-preserving
federalism holds. The process by which the decentralizationwas initiated
sheds considerablelight on how durablelimits on governmentare established.
Decentralizationwas established by decree, and, initially, it had no special
durability. Nonetheless, the degree of supportamong the central authorities,

Theeconomiccostsof these
27. Onenotableexceptionis thepresenceof internaltradebarriers.
provisionsareunknown.Mostof China'sgrowthhasoccurred in theareaswiththefewestbarriers
to theriseof anexporteconomy.

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TheEconomic
RoleofPolitcal 23
InstituUons

notablyDengXiaoping,ledtoarangeof experiments, emphasizingaspectsthat


couldbe changedin theshortrunandthatdidnotleavelong-terminvestments
vulnerable.As theseprovedsuccessfuland the centralgovernmentdid not
revokethem,theywereexpandedandimitated.As theprocesscontinued,local
incentivesgraduallychangedfromthosepromotingallegianceandcontrolby
to thosereflectinglocal economicprosperity.Thusthe
the centralauthorities
durabilityof the reforms did not ariseall at once butgrewas the degreeof
economicsuccessincreased.
The centralgovernment'sloss of controlover local officials directlylimits its
abilityto interveneadverselyin thesenewmarkets.Shortof usingthearmy-
stillundernationalcontrolandthereforepotentiallya factorin thefuture-the
centralgovernment no longerappearsableto reverseits political,andhence
economic,reformefforts.
The Chinesegoverments failedeffortto haltor reverseeconomicreform
afterTiananmenSquaresuggeststhe durabilityof the politicalreforms. At
thattime,theconservatives gainedthemostpolitical,ideological,andmilitary
power.If evertheyhadsufficientpowerfor a reversalof reform,thatwas it.
Moreover, economicwoesof inflationandcorruption in 1988andthefollowing
politicalbacklashafterthe Tiananmen Squareincidentin 1989 also puteco-
nomicreformon hold. An austerityprogramwasimplemented between1989
and1991tocooldowntheso-called"overheated" economy.In 1990,therewere
evendiscussionsamongconservatives aboutthepossibilityofrecollectivization
of agriculture.
Severaleventscombinedtoundothecentralgoverment'sattempted reversal.
First,manyareasof theeconomybeganto decline,raisingfearsof unemploy-
mentandvastnew fiscalcommitments for the centralgovernmentwithouta
concomitant expansionof fiscalresources.Second,aspartof thegoverment's
campaign,it attemptedto promotethe large,state-ownedenterprises.This
effortnotonlyfailedtoproduceresultsbuthadsignificant, negativefiscalcon-
sequences.Third,the economicretrenchment was resistedby local officials
fromtheareasexperiencing thehighesteconomicgrowth,officialswhohadno
interestin seeingtheretrenchment succeed.Li Peng,theconservative premier,
failedin his attemptto recentralizeinvestmentandfinancialpowersfromthe
provinces.The governorof Guangdongrefused,andmanyothergovernors
followedsuit(Shirk,1993).
Thisincidentemphasizes thestrikingnewpoweroflocalgovernments, power
notheldduringmostofthecommunistera.28 Theabandonment of retrenchment
revealedthatthe government was unwillingto pay the priceof reversingthe
reforms.This,in turn,reducedthepoliticaluncertainty aboutthedurability of
the reforms.29The new decentralization limitedthe discretionof the central

28. In contrast,on severalpreviousoccasions when the economy faced difficulties(forexample,


in 1962,andasrecentlyas 1981), ChenYun,an advocateofcentral planning,successfullycompelled
the provincialgovernmentsto "help the centralgovernmentovercome the difficulties"-that is, to
turnover more revenueto the centralbudget.
29. Growthratessince the abandonmenthave, if anything,been higherthanbefore the retrench-

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24 TheJouralofLa/,Economics, V11NI
&Organization,

government,adding an importantdegree of durabilityto the reforms. Barring


extremeevents, the reformshavebecome a centralcomponentof modem China.
A numberof importantqualificationsto China'seconomic success must be
raised. First,China'sstrategyfor economic reformhas put off dealing with the
extensive and growing problem of the state enterprises,including their large
subsidies.(see Wong, 1991). Second, the decentralizationof power has not
been uniform,explainingin partwhy refdrmhas variedacross regions. Third,
critical nationalpublic goods remain underprovided.The common marketis
inadequatelysecured, and considerableinternal trade barriersremain across
regions, including barriersto labor migration. In some areas, local officials
have taken advantageof political decentralizationto protect local enterprises,
raisingcomplaintsaboutrising "dukedomeconomies." Considerableproblems
also arisefrom the lack of centralizedcontrolover the monetarysystem, result-
ing in softness of budget constraintsand in inflation. Fourth,a large number
of tasks of economic reformemphasizedby economists have yet to be tackled
(e.g., a law of commerce or credit). The mechanismsfor enforcing long-term
agreementswith sources of foreign capital remain underdeveloped. Finally,
given the aging octogenariansunderpinningthe central goverment's reform
effort, uncertaintyover political succession implies a degree of political risk.
Considerableuncertaintyremainsaboutthe possibility of an antireformback-
lash, and hence aboutthe course of Chinese reform.

4. Conclusions
The main lesson of this analysis for contemporarydevelopmentand economic
reformis a varianton the now commonplaceobservationthat the benevolent
attitude of the government cannot be taken for granted:30Markets require
protection and thus a governmentstrong enough to resist responding to the
inevitable political forces advocating encroachmentson marketsfor private
gain. The fundamentalpolitical dilemma of an economic system is that a
state strong enough to protect privatemarketsis strong enough to confiscate
the wealth of its citizens. The dilemma implies that understandingeconomic
growth requires attention to the question of what guides the state down the
formerpath. As North (1993: 11-12) argues:

Throughoutmost of historyandin muchof the presentworld,institutions


have not provided the credible commitmentnecessary for the develop-

ment The Economist, for example, reportsthat they have been over 20 percentper year in some
areas. This is consistent with the view thatremovinga degree of political risk increasedexpected
economicreturns,thusenhancingthewillingnessofentrepreneursandinvestorstoundertakeactions
promotinggrowth. Similarly,since early 1992, Hong Konghas felt a new optimism. The increasing
ties of Hong Kong's economy to that of South China are one factorcontributingto the durability
of Hong Kong's economy. Unfortunately,as recent events remindus, it is not the only factor.
30. On the limits of assuming a benevolentgovernmentin the developing context, see, among
others, Camposand Root (1994), Ekelundand Tollison (1981), Krueger(1992), Levy and Spiller
(1994), North (1981, 1990), North and Weingast (1989), Przeworski (1990), Root (in press),
Weingast(1994a, 1994b), and Williamson (1994).

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TheEconomic
RoleofPoitical
Instiutons25

ment of low'cost transactingin capitaland othermarkets. Thereis,


therefore,littleevidenceto supportthe view (apparently implicitlyheld
by many economists the
doctoring ailing economies of central
andeast-
ernEurope)thatthenecessaryinstitutions will be theautomaticoutcome
of gettingthe pricesrightthrougheliminatiofiof price and exchange
controls.

Putsimply,thepoliticalfoundations of marketsareas essentialto theirsuc-


cessas thedetailsandspecificationof themarketitself. Thisconclusionimplies
thatmarketsandlimitedgovernment arecomplementary aspectsof economic
and
development reform; each enhances the value of the other.Politicalde-
velopment must thereforetake with
place'simultaneously economicdevelop-
ment
Limitedgovernment,in turn,requiresthatrestrictionson the government
be self-enforcing.Althoughthisclaimis maderegularlyin theliterature, few
analyses have shown how constitutions actuallyaccomplish this difficult
task
in practice. The possibilityof beneficiallimits on governmentis not real-
izedautomatically. Thisobservation forcesus to askwhatmakesthoselimits
credible-thatis, whatmakesthembindingonpoliticalactors?Toaddressthis
question,I haveexaminedherehow Englandandthe UnitedStatesgrappled
withtheseproblemsin thepastandhow Chinais grapplingwiththemin the
present.Althougha rangeof considerations is important, I havefocusedon
theinstitution
of market-preservingfederalism,a centralfactorin theeconomic
developmentof all three.
Severalfacetsof federalismaccountforits successinEnglandandtheUnited
States. First,federalismprovidedthepoliticalbasisfor the commonmarket.
Second,theprohibitionsagainstthenationalgovemment'sexerciseofeconomic
regulationgreatlyreducedthegoverment'spoliticalresponsiveness to interest
groups.In a growingeconomy,thislimitedthe abilityof economicinterests,
potentiallydisplacedby economicchange,to use politicalmeansto constrain
orpreventtheircompetitors'success.Third,theprohibitions on internaltrade
barriersallowedentrepreneurs, new enterprises,
andnew economicactivities
to emergein new areasthatcould outcompeteinterestsin olderareas. In
England,thesefactorsprovidedthepoliticalfoundation for the successof the
industrialrevolution. In the UnitedStates,they fosteredfirstregionaland
theninternational specialization,
underpinning Americaneconomicgrowth.31
By creatingcrediblerestrictionson governmental policy choice, federalism
providedthebasisfor theruleof law andhencethepoliticalunderpinnings of
economicfreedom.
Yetwhatmadetheserestrictions credible?Whatmadethembindingin prac-
tice?Thoughthedetailsdifferconsiderably, bothcasesrevealthatfederalism's
successinpracticereliedonamixofformalandinformalconstraints. As North

31. As CasellaandFrey(1992:640) argue:"Ifprivateeconomicdecisionsareinfluencedby


public goods, ... as we expect them to be,then marketsand institutionsshould develop together."

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26 TheJoumal
ofLaw,Economrcs, VI N1
&Otganizaton,

(1993)emphasizes,it is not only the institutionsof societythathelpprovide


for securerights,buta mix of institutionsandcomplementary informalnorms
thatconstrainthe behaviorof theplayersat numerousmargins.It is thismix
of formalinstitutions
andinformalnormsthatI now wishto stress,forthefirst
twopointsreceivedconsiderable emphasisabove.
Thecriticalfeaturefor EnglandandtheUnitedStatesis thatthe successof
constitutionalconstraints
promoting theruleof lawdependedontheemergence
of a socialconsensusabouttheappropriate limitsof thestate.Holdingthestate
to prescribedlimits does not depend on a constraintbeing explicit, nor does
it requirethatit mighthavebeenagreedon at sometimein thepast Limited
government insteaddependson how citizensreactto a potentialviolationof
thatconstraint.The ultimatesanctionon a governmentis the withdrawal of
supportby a sufficientportionof its citizensso thatthe governmentcannot
survive.
The failureof this formof'citizenreactionallowsa host of constitutional
violationsin LatinAmericaandotherpartsof the thirdworld(see, e.g., Mon-
tinola's1994discussionof Marcos'srejectionof thePhilippineConstitution).
Notice,in contrast,thereactionto PresidentFranklinRoosevelt'sfamouscourt-
packing scheme. Although it wasproposedata timeof unprecedented political
supportforRooseveltandtheNew Deal,andalthoughit wasdesignedto ben-
efit his constituents,it was deemedillegitimateby a sufficientnumberof his
supporters thatits futurewashighlyquestionable.32
ForbothEnglandandtheUnitedStates,thedecentralization of politicalau-
thorityimplied by market-preservingfederalismwas the productof a historical
process resulting in a strong consensus supportingthese limits. The English
state's failure to respect citizen rights in'the late 17th centuryled not only to
the Glorious Revolution but to a new consensus about the appropriatelimits
on the nationalgovernment'sauthority. Constructedthroughnegotiationsin
Parliamentamong the leadersof the variousfactions in society, the consensus
over limits was embodied in a new set of constitutionalarrangements,includ-
ing increasedreliance on the common-lawcourts ratherthan royal discretion,
increasedsecurityof propertyrights, and concernfor the maintenanceof local
political authority,especially in mattersof economic control and regulation.
These arrangementsat once createdthe political decentralizationnecessary to
supportmarket-preservingfederalismand the nationalconsensus to provide it
with durability.
During the first 150 years of the United States, the foundationsof market-
preservingfederalismrestedon the fact thatthe vast majorityof the population
consistently favoredpolicies and parties limiting the federal governmentand
protectingeconomic rights. The two breakdownsof this consensus underscore
its role and importance. The first concerned the role of the federal govern-
ment with respect to slavery and resulted in a civil war. The second-and

32. Rooseveltdid notpursuethisschemefor severalreasons,mostnotablythatthe Supreme


Courtitselfreverseddirectionin early1937.Fora recentreview,see GelyandSpiller(1992).

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TheEconomic
RoleofPoliUcal
lnsttuions 27

permagent-breakdown occurredduringtheGreatDepression.At thattime,a


newpoliticalmajorityemerged.Thenewmajoritynotonlyresultedin expan-
sionofthenationalgovernmentbeyond thetraditional
limitsof theConstitution,
butengineereda reinterpretation of theprincipalconstitutionalconstraints
un-
derpinningmarket-preserving federalism.Withinfive years,the latterwere
removed.
Thediscussionof economicreformin Chinaalsoemphasizestheimportance
of the economicrole of politicalinstitutions.Becausethe problemsfaced
by ChinaandRussiaarevery different,strongconclusionscannotbe drawn
froma briefcomparison betweenthem.Nonetheless,it is strikingto notenot
only the enormous differencein the approachesto reform,but theirrelative
degrees of success. The former SovietUnion,andlaterRussia,concentrated
onreformof its economicsystem,retainingstrongdiscretionary powersforthe
No
government attempt was made to establishlimitedgovernment or to tie
thegovernment's handswithrespecttofutureeconomicpolicy(Boettke,1993;
Litwack,1991;Williamson,1994). Althoughtherehasbeensomeattemptto
institutepoliticalrightsanddemocracy, theselimitson thegovernment do not
yet extendto economicrightsor the basicstructureof the economicsystem.
As Ordeshook andSchwartz(1994)emphasize,all rightsin Russia-personal,
property,anddemocratic-remain highly insecurebecauseof theliberalclauses
in theRussianConstitution thatallowthegovernment to suspendtheserights
whentheyproveinconvenient
Incontrast,Chinabeganwitha politicalreformin whichthecentralauthori-
ties,althoughnotcompletelybindingtheirownhands,madeit muchharderto
use thosehands.The centralgovernment limiteditselfby transferring
power
to local authorities
in a way thatwouldbe difficult-andthatrecentlyproved
difficult-to retake. This transfer,in turn,set the stagefor a seriesof eco-
nomictransformations acrossmuchof China.Forlocalgovernments, political
freedomand politicalprotectionfrom the centralstatecombinedwith eco-
nomicopportunities to providestrongincentivesto fosterandprotectmarkets.
The resultsareremarkable.Moreover,the economiceffectsof localpolitical
freedomin Chinaexhibitssome strikingparallelswith thosein 18th-century
England.In bothcases,localpoliticalofficialshadstrongincentivesto foster
localprosperity,underpinning theriseof newandverysuccessfulfirms.
For the emergingdemocraciesof EasternEuropeand the formerSoviet
Union,this analysissuggeststhateconomicandpoliticalinstitutionsshould
be redesignedsimultaneously. Inparticular, theseinstitutionsneedto be con-
sistentwithone another.Whateconomicincentivesareimpliedby thedegree
of discretionaffordedthegovernment underthepoliticalinstitutions? Arethey
compatible withsecurepropertyrightsandthedevelopment of theruleof law?
The threecases of federalismstudiedhere do not constitutea test of the
theory,fortheywerenotrandomlyselected.Puttingthetheoryatriskrequires
a moresystematicinvestigationof market-preserving federalism,attempting
to testwhetherstatescharacterized by its provisionsrevealappreciably more
economicdevelopment thanthosenot so characterized. Although sucha test
is beyondthescopeof thisstudy,we do mentionthatotherinstancesof dejure

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28 TheJournalof
LawEconomics, N1
&Organizaton.V11

federalism,but not market-preservingfederalism, appearto have fared much


morepoorly thanthe cases studiedhere. Argentina,Brazil, and Indiaare all de
jure federal systems but not market-preservingfederal systems. In all of these
countries,the political authorityof the nationalgovernmentcompromisesthe
independenceof local politicalauthority.On the criticaldimensionof economic
performance,none of these states has experiencedeconomic developmentthat
parallelsthe cases studiedhere.
In sum, I have arguedthatsecuringthe political foundationsof marketsmust
be accomplishedat the same time andis equalin importanceto the development
of marketsand "gettingprices right?"The historicalevidence presentedabove
supportsthis position (see also North, 1981, 1993). The discussion of reform
in China furthersuggests that limited government appears to be an impor-
tantcomponentof economic reform. It emphasizes the critical economic role
forpolitical institutions-to providethe appropriatefoundationsfor economic
policy-makingand a secure system of economic and political rights.

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