This is an extract of the John Bonython Lecture delivered by Ray Ball in 1996.
John Bonython was an entrepreneur, an early, staunch and active supporter of the Centre for Independent Studies and its classical liberal ideals, and an Australian. It is a very special privilege for me to deliver the 1996 John Bonython Lecture that carries his name, particularly in the presence of members of his family, such distinguished company, so many old friends, and my dear wife.
I want to talk about one of life’s central paradoxes: that we, who owe so much to our membership of a civilised society, nevertheless take its most precious institutions – the institutions on which our civilisation is dependent – for granted. I shall refer to institutions in a generic sense: as any supra-individual source of systematic human behaviour. Social institutions therefore encompass morals, traditions, laws, languages, families, schools and universities, churches, not-for-profit organisations, partnerships, corporations, money, banks, constitutions, governments, police and defence forces, government administrative and regulatory bodies, and of course markets.
The theme I shall seek to convey to you is that the prosperity, liberty and general well-being that we currently enjoy are due in no small measure to the complex and unplanned – but nevertheless orderly – evolution, over a very long period, of the social institutions we have inherited. And, conversely, the prosperity of our successors depends on our willingness to allow – or, better still, encourage – continuation in the evolution of our human process of experimentation, innovation and evolution of our institutional structure.
A second theme is that most of us are rationally unaware of the extent to which our present and future prosperity are due to the institutions of our society. We have little knowledge of the rationale behind the existence of particular institutions (for example, why have professional partnerships historically dominated in ethical businesses such as medicine, law and auditing, whereas not-for-profit organisations have dominated in charities?). We have little knowledge of the rationale behind particular features of particular institutions (why do public companies, which have come to dominate manufacturing, have limited liability, and why do the many languages of the world exhibit so many similarities?). I shall make the argument of F.A. Hayek that our ignorance of the rationale behind the institutional structure of society is totally understandable, completely expected. This second theme is central to the mission of the Centre for Independent Studies, because our ignorance of the rationale behind institutional structures is the seed of our temptation to plan it. Our future prosperity depends on our ability to avoid the understandable but costly temptation to interfere with what is an unplannable process.
The third theme tonight is that the nations that historically have given planners a major intervening role in their society have experienced substantially lower standards of living, health and liberty. What is worse, they have discovered, after the fact, that they have suppressed and therefore lost the benefit of a prolonged period of institutional evolution, a loss that is very difficult to recover. The process of unwinding the effects of planning certainly involves dismantling the instruments of control, known as deregulation, but in my view it also requires a process of institutional regeneration. The process is neither immediate nor easy nor predictable. It requires prolonged intellectual support, which is why we are here tonight.
I. Liberty, Institutional Innovation and Prosperity
The connection between liberty, institutional innovation and prosperity is not widely understood. This is not intended as a criticism in any sense, for it is to be expected. In a free society the institutional structure that we inherit has evolved over an extended period of time, through unplanned human action, so individual humans understandably take their most precious institutions for granted. I shall return to this theme later.
For the moment, I wish to reflect initially on the historical evidence and then on the contemporary world, to gain some insight into the contribution of institutional structure to liberty and prosperity.
The Historical Evolution of Western Social Institutions
Prior to the Middle Ages, life was wretched by modern standards. Living standards in Western Europe were comparable with those elsewhere in the world, notably in China and the Islamic countries. The predominantly feudal institutional structure made little or no distinction between political and economic processes. For example, the manorial system vested in the lord of the manor, and the hierarchy below him, all authority over the production and consumption of goods and services (decisions we have come to view as ‘economic’), and also all authority over the military, police, justice, public works and other governance tasks (decisions we have come to view as ‘political’). The hierarchy was quite rigid, and there was a comparative absence of institutional innovation. Customs and rules predominated. Most people worked by compulsion in the fields, on allotted strips of land, with much of their output accruing to the lords, in a deeply oppressive society. We often romanticise a world of knights and fair ladies who lived in huge castles, but the reality for most people was an impoverished, short, ignorant, illiberal life spent working and living (in extremely primitive conditions) out in the fields.
The breakout occurred in Western Europe. Over a period of approximately two centuries, the West underwent a series of institutional transformations that provided substantially more separation of the political and the economic spheres. Perhaps the single most important institutional innovation was the autonomous city-state, including Venice, Florence and Genoa. The cities evolved a political structure that provided and enforced laws governing property rights, trading and taxation among other things, and an economic structure in which voluntary trading occurred. Trade spurred invention, my favourite example of which was clockmaking. The political ambit of the cities was insufficient to constrain competition among them for merchants, or competition among merchants for business.
By the end of the sixteenth century, feudal organisation had given way to a more market-oriented structure, with money, prices, and autonomous trading. Since that initial separation, comparatively speaking, of the political and economic spheres, the West has enjoyed an prolonged, gradual and incremental process of institutional evolution, and at the same time has experienced a gradual, incremental increase in prosperity, liberty and general well-being. In terms of most such measures of the human condition, it has left China and the Islamic countries way behind.
The broad message in Rosenberg and Birdzell’s sweeping account is that we owe our prosperity to being the inheritors of a very long history of institutional innovation: that is, to our membership of a society that has created greater separation between the political and economic spheres, and consequently has been tolerant of institutional change.
The Contemporary World: Institutions Matter – Not Resources, Education or Technology Per Se
The evidence is abundantly clear that it is institutional structure – not an endowment of ‘natural resources,’ education or technology per se – that differentiates the wealthy nations from the poor. A cursory glance around the contemporary world reinforces this conclusion.
The former Soviet Union and its Eastern European allies, and countries throughout Africa and South America, have access to enormous quantities of resources, yet their people by and large are poor. In comparison, Switzerland, Japan, Singapore and Hong Kong are resource-poor, yet their people are wealthy. Other things being equal, the possession of ‘natural’ resources obviously is desirable. But it does not guarantee prosperity.
Nor is it education or technology that makes nations prosperous. The former Soviet Union is a clear case in point. In almost all branches of technology, the Russians have scientists who are at (or near) the cutting-edge of knowledge. They visited resources on their education system. Yet they are poor. I have heard many people ask: ‘How can the Russians know how to put men and women into space, yet not be able to produce a decent standard of living?’
The answer is that social institutions – not natural resources or education or knowledge of technology per se – are what differentiates the poor from the rich, and the free from the unfree. It is the structure of institutions that enables individuals to adapt, innovate and invest.
II. The Classical Liberal View of Institutions
This simple point – that we owe much of what we hold dear to our inheritance of a tradition of institutional innovation – is so fundamental and so poorly understood, in my view, that I would like to expand upon the reasons for my choice of it. I will try to convey some sense of the classical liberal view of institutions.
Human Action Distinguished from Human Design
Most of us are unaware either of the history or the rationality of our rich institutional inheritance, in large part because of its complexity, but also because no single human being or major role in creating it. The great Austrian economist and philosopher F.A. Hayek – 1974 Nobel Laureate in Economics and whose influence on the ideals promulgated by the Centre for Independent Studies is without parallel – argues persuasively that one should expect us to be rationally ignorant of most of the institutional structure around us, and of the rationality implicit in its evolution. Institutions, says Hayek, are created by human action, not by human design. He refers to ‘the astonishing fact, revealed by economics and biology, that order generated without design can far outstrip that consciously contrived’.
Who, one might ask, designed the joint stock corporation, the institution that has come to dominate manufacturing and services industries in the Western world over the twentieth century? Who designed its organisational structures, compensation schemes, controllership functions, production and inventory control techniques, marketing techniques, contractual arrangements for protecting suppliers of long-term debt from wealth expropriation, stock markets, double-entry bookkeeping, accrual accounting, audited accounting reports to the public, dividend policies, and many among other extremely long list of features? The answer of course is: no one.
While managers and scholars might be capable of providing rationales – after the fact – for some of these institutional details (I fancy that I earn my living just that), and while some individuals might attempt to take credit for the design of particular techniques, the fundamental reality is that institutional details evolve as a consequence of human activity and not arise from individual, rational design.
An Example: Why Do Public Corporations Have Limited Liability?
One prominent feature of twentieth-century joint stock companies – limited liability – illustrates this important point well. Limited liability means that the most shareholders can lose is their investment in the company. Their liability is limited to their investment, and they have no further liability to meet the company’s debts in the event it has insufficient assets to do so. In contrast, the owners of an unincorporated business or of a company with unlimited liability are fully liable for its debts, regardless of how much they have contributed to the business. Why has limited liability become a standard feature of the modern corporate form, that plays such an important part in a modern economy? After all, joint stock companies without limited liability were a popular institutional form with British merchants as early as the seventeenth century, and limited liability did not emerge as an important institutional feature until the nineteenth century.
The typical explanation heard among managers – that limited liability allows companies to raise equity capital more cheaply because shareholders by virtue of limited liability are exposed to less risk – is ruled out by the famous Miller-Modigliani theorem. This theorem tells us that if limited liability reduces the risk-bearing by shareholders of equity capital and thus makes equity financing cheaper, then it does so by transferring precisely that same amount of risk onto the suppliers of debt, who now have less chance of being repaid, and thus makes debt financing correspondingly more expensive. The two effects precisely cancel. The risk that the company will perform so poorly that its assets become insufficient to meet its debts is not altered by limited liability; it simply is redistributed among classes of investors. Cheap equity capital is not the explanation.
The most likely explanation for limited liability is considerably more sophisticated, and complex, and is due to Armen Alchian (1984). It is based on the efficiency of making agreements (known as the ‘cost of contracting’ theory of institutions). Suppose you want to contract in some way with a small unincorporated business that has two partners, and you want to know how financially secure your transaction will be. Perhaps the business wants to borrow money, and you want to lend to it. To determine the security of the transaction you need to know the financial position of the business and also, because the partnership has unlimited liability and you thus have access to the assets of the partners, you need to know the financial position of every partner. Now suppose you want to contract with an organisation that has not two but 50,000 investors. If they are personally liable for its debts, then you now need information on 50,001 financial positions!
Worse still, because people transact with each other, one person’s assets can be another’s liabilities, and to calculate correctly the net amount of security you need information on 50,000 possible financial transactions. Furthermore, investors can trade their shares on the stock market, so you will need to update the information almost continuously. With unlimited liability, the cost of contracting – in this case, the cost of determining the level of security involved in a transaction – would be prohibitive. So the efficient solution is to eliminate investors’ liability for the company’s debts, and adjust the lending rate to reflect your higher risk. (Recall that the Miller-Modigliani theorem tells us that this is precisely offset by a reduction in the cost of equity, or share, capital.) The economic gain is an enormous reduction in costs of contracting to provide capital, or any other resource (labour or materials, for example) to the company.
Now limited liability is but one feature, among many, of one type of institution at one stage in its evolution. To most of us, it is not a particularly exciting concept, so I thank you for tolerating my long discourse on why companies use it. I have dragged you through it for a purpose: to show how this specific institutional feature originated, became popular, and survived because it made complex contractual relationships among people more efficient, made the production of a range of goods and services less expensive, and thus made people more wealthy – but without individuals reasoning through or being aware of its fundamental economic rationale at the time.
The Impossibility of Successful Central Planning
Socialism involves the belief (Marx strove to elevate it to a science) that central planning can achieve an allocation of resources that is more efficient, and is more consistent with some poorly-specified notion of ‘social justice,’ than the allocation that can be achieved by individuals acting in a spontaneously-evolving institutional structure. Socialist regimes give to central planners the complex task of deciding which resources (including humans) will be allocated to which uses. Planning assumes that planners can and do know what society wants, including the abilities of individual reason alone to prevail.
Totalitarianism can be viewed in a similar fashion. Totalitarian regimes also tend to promise a higher standard of living and a fairer distribution of wealth. As in socialism, they typically expropriate resources and centralise resource allocation decisions into planning authorities. They implicitly believe in the capacity of individuals to reason their way through complex resource allocation decisions. The most important single factor distinguishing socialism and totalitarianism, in my view, is the absence of extensive academic literature, based on Marxist theory, lionising socialism – it is not germane to the point I am seeking to make tonight, which is that central planning under any of the guise of any ‘ism’ suppresses the evolution of complex institutional structures.
It now is a well-known fact that central planning has not succeeded. Evidence ranges from the collapse of the former Soviet Union, to the failure of the extremely well-funded and well-intentioned Great Society welfare programme to alleviate poverty (by U.S. standards) after three decades, to the unravelling of the once-flourishing Swedish model of ‘middle-of-the-road’ socialism.
The failure of central planning to achieve its objectives is too consistent to be an accident. And it has not been due to lack of will: the Russian experiment was imposed upon its people for seventy years. The failure of central planning is systematic in origin: due, in my opinion, to the simplicity of planned institutional structures, in comparison with the complexity of the tasks assigned to them. The problems of central planning tend to worsen over time, because planning rigidifies institutions, making them unadaptive to change as well as denying them access to evolutionary innovation.
The failure of central planning can be expressed in terms of information. In comparison, the price system makes better use of dispersed information held by individuals. Prices reflect all of the information used by all who transact, or choose not to transact, in the market. Hayek argues convincingly that socialism fails in comparison with a market economy because it encounters the limits of individual rationality: no individual or group of individuals can know or feasibly could know all the dispersed information that is contained in prices.
III. Deregulation as a Process of Institutional Regeneration
Before commenting on the reforms that are underway in Australia, particularly in the labour market, I would like to make some observations about the nature of those reforms. I will argue that the recent and almost worldwide surge of deregulation is best viewed as a retreat from central planning and an unleashing of institutional regeneration: that is, as a complex, unpredictable and prolonged process.
I hope that in the time available to us this evening I have been able to convey some sense of three closely-related themes. First, we owe a great deal of our prosperity, health, liberty and general well-being to the complex institutional structure that we have evolved over the centuries, not to ‘natural resources’ or education or technology per se. Second, complex institutions evolve primarily as a consequence of seemingly uncoordinated human action, not of rational human design, and thus we as individuals cannot possibly comprehend all of the rationality that is implicit in them. Third, our future prosperity (together with the benefits that prosperity endows) depends critically upon our willingness to avoid what Hayek termed the ‘fatal conceit,’ that is the temptation to believe that we as individuals – or even the best and brightest among us – can bring greater prosperity by interfering with or impeding the human process of institutional innovation.
I cannot improve upon the words of Hayek himself, taken from the concluding paragraph of his Nobel Memorial Lecture:
If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organised kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.
This, as I understand and interpret it, is the mission that the Centre for Independent Studies has chosen: the intellectual defence of a liberal society, devoted as far as possible to the avoidance of planning, and open as far as possible to the human process of institutional innovation that has brought us the prosperity we enjoy. It is why I am so happy to be associated with the Centre, and to have delivered the 1996 John Bonython Lecture to you this evening.
