Markets, Institutions, and Underpants

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The title of this post is my proposed re-naming of Sven Beckert’s Empire of Cotton: A Global History. Grabs the attention, right?

The short recommendation is that you should read this book if you are interested in economic history and growth.

The long recommendation is that Beckert’s is an entry in the “global history” genre, this time using cotton production, processing, and trade as the framing device. But it is not just another version of Salt: A World History, with a new commodity plugged in. Beckert actually has a larger point to make about how a “market” in a commodity is something that is created by people, sometimes explicitly and sometimes not. In that sense, this book is better at explaining how institutions shape economies than most books that are specifically about institutions.

A key component of the story is the recognition that the global market for cotton was created prior to the Industrial Revolution, as part of what Beckert somewhat awkwardly calls “war capitalism”. De Gama and Columbus created direct links between Europe, South Asia, Africa, and North America. Europeans then used a superior ability to coordinate firepower and capital to ship goods between these nodes. Cotton from India was sent to Africa for slaves or South-east Asia for spices. The slaves were sent from Africa to North America, the spices to Europe. One could refer to there being “markets” for these things, but only in the sense that Europeans were trading claims on these various people or goods amongst themselves.

Beckert separates the institutions of modern capitalism, which governed the intra-European trade, from the institutions of war capitalism, which governed European trade with non-Europeans. The former developed along the idealized lines of protected property rights, secure contracts, and so forth. The latter was about coercion and expropriation. The Europeans played “cooperate” with each other, so to speak, while playing “deviate” with the rest of the world. In Liverpool the English cotton brokers developed standards of quality, separated physical location in a warehouse from nominal ownership, and created futures contracts. In the American South planters enslaved millions in order to fulfill those contracts.

The consequences of the global market in cotton were far-reaching. The cotton factory, all spindles and chimneys, becomes the epitome of the Industrial Revolution. Beckert’s implied story about innovation in this industry is Allen-like. The major costs of cotton trade were in spinning and weaving, not in growing. So innovation occurs in Britain where those costs are particularly high. But cotton also has far more scope for innovation in processing than the other major crops. It may be natural that cotton production was innovated on. There just isn’t much innovation to do on sugar once it is refined. What are you going to do, make clothes out of it? This isn’t the book to use in an argument about factor prices versus the enlightenment in generating the IR.

The more interesting question that looms over Beckert’s book is whether slavery, or the coercion of labor in any form, was necessary for the growth of the cotton trade and Industrial Revolution. Here you have to be careful about wording. Necessary? No. It was certainly possible that the global cotton trade could have evolved in a different way, perhaps with India and Egypt remaining major exporters and the American South a patchwork of small-holding cotton farmers. But did slavery and the coercion of labor accelerate the development of the global cotton trade and likely the Industrial Revolution? The answer seems to be yes. Ceteris paribus, slavery and coercion made the IR happen sooner rather than later. I think that’s what Beckert would argue. I am leaning towards agreement with him, but I need some more information before I would come down hard one way or the other.

Probably the most compelling thing I learned reading the book is about the layers of institutions that exist within economies. Beckert makes clear that there is no such thing as “English institutions” (or any other) that are constant across all transactions. Institutions are a characteristic of two entities (states, people, firms) and any given pair of entities will have its own set of institutions. So Liverpool and New Orleans cotton brokers had one set of institutions, Liverpool and Manchester brokers had another, while Liverpool and Bombay brokers a third. In some cases those institutions are “good”, fostering cooperation and trust, while others are “bad”, involving coercion. As is typical, institutions are really central to studying growth, but measuring or quantifying institutions without being extremely specific about the exact parties involved is probably hopeless.

Market Failures in Developing Countries

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I just came across a new World Bank paper by Brian Dillon and Chris Barrett about agricultural factor markets in Africa. Dillon and Barrett have written an “old school” development paper, meaning it reminds me of papers written in the 1980’s and 1990’s. They use observational data, and appeal to theory to motivate their empirical identification in an attempt to answer a classic development question. (This is going to be really distressing nomenclature to the development economists from that era, who were “new-school” when the field moved beyond the “old school” work by Lewis, Schultz, and others from the 1960’s and 1970’s. Sucks to grow up, I guess.)

They test for “household separation”, which means that the consumption decisions of a household (i.e. how much or what to eat) are completely divorced from the production decisions (i.e. how much or what to plant). If there are complete markets, then household separation is expected to hold. If you live in a modern Western country then you face effectively complete markets, and your decision about what to consume (a new TV!) is completely unaffected by what you do at work (accounts payable!). All that matters is that you make money producing, and then you spend that money on goods and services.

If markets are missing completely, or so unreliable as to effectively be missing, then household separation fails. The extreme case is easiest to think of. If a household is completely autarkic, and can trade with no one else, then it can only consume what it produces. The two decisions are inseparable. If they want a new TV, then they’d better have a source of rare earth elements in their back yard and a passion for soldering.

The importance of knowing if household separation holds or not is that it tells us something fundamentally important about why a developing area is poor. If separation fails because markets fail to exist, then this is like saying there is a lot of latent economic activity that is not being realized. Household A and household B would be better off if one specialized in raising goats and the other in rice, but because the markets for goats and rice don’t exist they each have to raise both. It’s a basic comparative advantage argument; households can be made better off (just like we argue countries can) by trading with each other. If you want to enact policies or take action to assist these households, then promoting functioning markets in outputs and inputs is the way to go. How do you do that? It could be by making institutional changes (making property rights clear so land can be easily exchanged), or providing insurance (so people can take the risk of producing for the market), or it might be as simple as paving a road (so that transport costs are low enough to trade with the next town over). It could be by promoting better information flows; one of my favorite development papers is by Robert Jensen about the positive effect of mobile phone introduction on the efficiency of the fish market in Kerala, India.

If separation holds, and by implication markets are functioning relatively well, then the implications for development are different. Households are able to buy and sell, so they are probably taking advantage of nearly all the gains from trade available. They can likely benefit more from increased investments in factors of production than households without access to markets. Here’s what I mean. When markets are (reasonably close to) complete, then endowing a household with a tractor and the technical training to keep it running is a huge change in their productivity. They can use it on their own farm and they can rent it out to others. It may make sense for them to become a full-time tractor operator in their village because with complete markets they know they can buy what they need using the proceeds of the tractor business.

In a non-separating economy without markets, giving a family a tractor and technical training is kind of a waste. If they’re well off for a developing country they’ve got 2 hectares of land (about 5 acres or just under 4 football fields). Yes, the tractor can alleviate some of the workload, but it’s overkill. You’d spend more than half your time just turning the tractor around trying to plow that small of a space. Moreover, the tractor would sit idle for the vast majority of the year. Without markets, most investments and improvements in technology are not worth it.

Okay, back to Dillon and Barrett. They use data from the Living Standard Measurement Surveys from 5 Sub-Saharan African countries to test for household separation. The logic of the test comes from a classic paper by Benjamin (1992). If markets are functioning efficiently, then the characteristics of your household (age, gender, education, number of kids) should be unrelated to the input usage on your farm. The production decision (I need three workers to plant rice) is separated from your household characteristics (I have five workers in my household). Those extra workers in your household can go work on someone else’s farm if markets exist. (And if you don’t have enough household labor, you can hire in laborers).

What they find is that across all five countries (Ethiopia, Malawi, Niger, Tanzania, Uganda) separation fails, meaning that there are significant failures in factor and/or output markets. In every country, the size of the household is always significantly related to the amount of labor used on that household’s land. It doesn’t matter whether the household is led by a male or a female, or where the household is located within the country. The failure of separation appears to be a general failure. One thing to note is that this doesn’t mean households fail to participate in markets at all; Dillon and Barrett find that nearly all households do make some transactions in labor and land markets. It is likely that the actual transactions costs (fixed costs, time costs, etc..) of participating in the market are so high that people don’t undertake all the trades that they would otherwise make.

So what does this mean? It means that development assistance is likely to be most effective if it promotes making markets more efficient; perhaps through encouraging better information flows like in the Indian fish-market example. Pure investment strategies (let’s give everyone a bag of fertilizer!) are unlikely to be as effective without the markets in place that allow people to take advantage of that investment.

Research like this is particularly valuable to people like me who want to study growth and development from a macro perspective. It reminds us (beats us over the head with?) that “developing countries” and “developing economies” are not the same thing. Market failures mean that developing countries are really a collection of myriad small economies, and therefore we need to be careful in thinking about things at too aggregate a level. This is also an example of where I think the “institutions” literature could really add value. Can we provide better theories or models of what precisely it means for markets to “fail”? What particular institutional details are important for markets to work efficiently?

Markets and Industrialization

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I just finished reading Karl Polanyi’s The Great Transformation, part of an effort to actually read through some classic texts in economics. He gives an account of the rise of capitalism in order to set himself up to describe the crisis in capitalism that he sees around him (he is writing in 1944 and for obvious reasons things don’t seem so rosy at that point).

His ultimate point regarding the role of the gold standard as a kind of organizing principle around which capitalism revolves is dated, but there is some value in thinking about how the flow of funds and trade between countries does have some distinct social implications. However, I found myself struggling with the description of industrial development he lays out as background for his discussion of the gold standard. He begins by highlighting the lack of money-based transactions in pre-industrial Europe, and how this indicates that markets did not exist.

Polanyi makes a common error, which is confusing money as a unit of account with money as a medium of exchange. When we talk about supply and demand, and equilibrium prices and quantities, we almost always talk in terms in some currency (e.g. the number of pizzas is 15 and they each are sold for $10, for a total value of $150). But this is using currency as a unit of account only. It is convenient to talk about dollars, but not necessary. I could just as easily draw supply and demand diagrams, and find out equilibrium prices and quantities using another commodity as the unit of account (e.g. the number of pizzas is 15 and they each are sold for 3 beers, for a total value of 45 beers).

So while modern economies use money to make exchanges in markets, that does not meant that an absence of money implies the absence of a market. You can have a fully functioning market even though no slips of paper or little metal coins are used in any transaction. Most importantly, the logic of supply and demand is perfectly valid even without money being used as the medium of exchange.

Further, the absence of observed exchanges does not imply the absence of a market either. It is quite possible to have a market in which the equilibrium outcome is for everyone to consume their endowment of goods. In fact, I think this is more likely to occur in very simple economies where the number and types of goods are limited. If we all produce one chicken and four sacks of wheat, and we all have similar preferences, then in the end we’ll all end up eating one chicken and four sacks of wheat. If we’re smart, we’ll make waffles and fry the chicken, but that’s a different topic.

In the chicken/wheat economy, there is an implicit price for chicken and a price for wheat, even though we don’t observe any transactions at this price. The absence of transaction data means it is hard to estimate what demand or supply curves look like, and therefore makes it hard to predict what would happen in the event of some kind of demand or supply shock, but the curves are still there.

Polanyi makes much of the shift from non-money to money exchanges, assumning that this suggests a move from autarkic production (all households acting individually) to market production (households taking prices as given). But the absence of money doesn’t mean autarky and an absence of markets, and so his underlying premise just doesn’t hold up. While there are still some fascinating passages to consider in the book, as a functional story of industrial development it isn’t terribly useful.