Voluntary Contract Enforcement

Most people believe that a market economy requires that governments enforce private contracts. Although some people may recognize that simple face-​to-​face trades are possible without external enforcement, most people argue that government enforcement is necessary when contracts are complicated, include commitments over time, or involve large groups. In many real-​world situations, however, enforcement of contracts by public courts is too costly—government courts are not perfect, after all—or impossible, inasmuch as government courts often lack jurisdiction across political boundaries or the desire to enforce contracts in sectors not sanctioned by law. The private sector, in contrast, has found numerous ways to promote contractual performance even when government enforcement is absent. From the discipline of continuous dealings in small groups, to reputation mechanisms or more formal private tribunals for large groups, numerous devices have emerged that have made possible contractual performance independent of government. Recognizing that private parties can overcome the potential problem of contractual performance brings into question whether government enforcement of contracts is necessary. This topic is of growing interest to libertarians.

Private contract enforcement has occurred in many historical and contemporary cases. The argument for government enforcement rests on the fact that, although both parties gain from trade, they have an incentive to cheat after having contracted with each other. Many economists point out, however, that the Prisoner’s Dilemma conditions are not ubiquitous and that the private sector often finds ways to eliminate them. In addition to morality having guided certain people to keep their word, private parties have profited by devising mechanisms to prevent even egoists from cheating.

If two parties know each other and have had repeated dealings, it may be in both of their interests to cooperate rather than cheat. Parties can gain more by establishing a trusting relationship over the long run than by cheating and thus ending a fruitful trading relationship. Thus, contracts can be honored with or without government courts. Adam Smith called this the discipline of continuous dealings, and modern economists have elaborated on additional mechanisms to make contracts self-​enforcing. Relying on the discipline of continuous dealings is easiest among small groups of people in which everyone has repeated interactions. However, contracts may be self-​enforcing even if parties do not expect to interact again. When parties are able to share information about the reputations of others, a breach may result in damage to one’s reputation in the wider community. Others will be less willing to deal with a known cheat, so it can be in everyone’s best interest to keep their word.

Recent research in law and economics has documented how the private sector has overcome the problem of fraud, all the way from small and homogenous to large and heterogeneous groups. In the diamond industry, for example, much is at stake, and transaction costs would be extremely high if people had to go to government courts after each transaction. The New York diamond industry has solved this problem by organizing trade in a small and homogenous group, as has been demonstrated by scholars. The New York Diamond Dealers Club has traditionally comprised members of the orthodox Jewish community. Disputes between members are submitted to the club’s arbitration system, which has many advantages, including speed of resolution, privacy, and judges who are industry insiders and can rely on custom rather than overly formal rules. Reputation and social sanctions enforce arbitration decisions without any use of coercion. Social sanctions take place in connection with Jewish religious and civic activities; in addition, dealers are required to have a reputation for abiding by the arbitration network’s decisions if they wish to conduct business. A party that does not abide by decisions will be ostracized and may even be removed from the trading community. Thus, a trader’s reputation serves as a bond that would be forfeited unless one is reliable. By requiring everyone to be a member of a tight-​knit group, the potential problem of fraud among diamond traders has been solved.

Reputation mechanisms can enforce relatively sophisticated contracts among less homogenous groups as well. An analysis of the world’s first stock market in 17th-​century Amsterdam, which by the end of the century included hundreds of traders who were fairly diverse socially and religiously, has demonstrated that such enforcement was possible. The government then considered most financial contracts as forms of gambling that could be used to manipulate markets, so it refused to enforce contracts for all but the simplest types of transactions. Although traders’ contracts were not sanctioned by law, parties to these contracts developed relatively sophisticated ones, including forward contracts, options, and short sales. The market was able to function because traders were able to share information about each other and boycott those who were unreliable. This multilateral reputation mechanism enabled sophisticated contracts with payments over time to occur although no formal rules existed.

As markets increase in size, mechanisms of enforcement that rely on the personal reputation of the participants often become more difficult. At the end of the 17th century and throughout the 18th century, England developed its own stock market, which expanded in speed and complexity to the point where stockbrokers had a difficult time tracking who was reliable. Brokers solved the potential problem of fraud by congregating in coffeehouses and transforming them into private clubs to create and enforce rules. One of their original solutions was to write the names of defaulters on a blackboard in Jonathan’s Coffeehouse so that others were informed that in was unwise to deal with them. Eventually, brokers contracted with the owners of the coffeehouse to make Jonathan’s a private club to exclude the unreliable. After a few iterations, the brokers successfully created a self-​policing club referred to as New Jonathan’s, which later became formally known as the London Stock Exchange. Only the more reliable traders were allowed to join, and those traders defaulting on contracts were expelled, thus creating an atmosphere of trust. Individuals may have had a hard time investigating the reliability of all of their trading partners, but the club’s ability to enforce rules for members and exclude nonmembers enabled brokers to mitigate the problem of fraud.

As the scope of trade expands, requiring that everyone involved in the trade fall inside the confines of a self-​policing club may become impossible. Authors such as Douglas North have argued that government enforcement has become necessary as trade moves outside of small groups, but state enforcement in fact has proved useless if a trader’s local jurisdiction lacks the ability to enforce rules on traders abroad. Bruce Benson has extensively documented how parties have solved this problem in the past and continue to do so today. In medieval Europe, for example, merchants who could not rely on civil law to adjudicate disputes developed the Law Merchant, a network of law and of arbitrators to which merchants could voluntarily submit if they wished to conduct business. By opting into this system, merchants who refused to commit themselves to following the agreed-​on set of privately developed laws and those who ignored the law merchant courts were boycotted by everyone else. The system has many similarities to arbitration today. Private enforcement will be effective even without government enforcement if the relationship is structured so that anyone attempting to ignore the judgment will lose. Requiring a party to post a surety bond or even to have a reputational bond are two ways to encourage parties to follow a private set of rules.

Many of these examples exist as pockets of privately enforced rules, although the state lurks in the background. Could private enforcement of contracts occur in the absence of government laws securing property rights or outlawing acts like violent theft? Many historical examples of order without law exist. Two examples of private enforcement mechanisms that functioned without any state enforcement that prevented violent theft of property are worth examining.

Peter Leeson has studied trade between European caravans and local producers in the West African interior in the late 19th century. The mobile European caravans were possessed of greater force than the largely immobile native producers of ivory, rubber, and wax. If the natives possessed a stock of desired goods, the Europeans’ superior power meant that they had the ability to raid rather than trade with the natives. This situation created a potential problem because if the natives knew their goods for trade would be stolen, they would have no incentive to produce these goods in the first place. Market participants recognized this problem and solved it by separating payment from exchange by a system of credit. Leeson explains that natives did not hold stocks of goods that the Europeans could plunder, should they choose. Instead, European traders paid for the goods in advance, after which the natives harvested the resources to be traded. When the Europeans returned, only the goods for which they had already paid were available, so there was nothing to steal. The use of credit allowed for self-​enforcing contracts between weaker and stronger parties even without government to enforce property rights and prevent violent theft.

Present-​day Somalia also presents a unique opportunity to look at contract and property rights enforcement in a large stateless society. Since the fall of Siad Barre in 1991, Somalia has had no national government. Yet a fairly developed nonstate legal system exists. Law enforcement is provided by a decentralized clan elder network. When a dispute arises, participants turn to a clan elder for a resolution. In cases where the parties are from different clans, both elders mediate or turn to an elder from a third-​party clan. Decisions are based on the Somali customary law, Xeer. The clans are not de facto governments. They have no geographic monopoly, and individuals are free to secede and join another clan without moving. Once decisions are rendered, enforcement is achieved through community action. Each Somali is a member of an insurance-​paying group; if a guilty party does not pay the required restitution, the other members of his insurance group are liable. Thus, they have an incentive to encourage the guilty party to make good on his debts. Enforcement also is achieved by a form of expulsion. Troublesome insurance group members can be expelled from their clan and insurance-​paying group. These members are not required to physically move, but they are no longer under the protection of the law, and thus others are free to steal from or even maim them. The threat of expulsion from the protective group helps ensure compliance with Somali law. Private solutions to the problem of contractual compliance surround us. Although we have mentioned several examples of nonstate contract enforcement, many different private solutions exist. Scholars have uncovered and documented more examples in recent years, yet much work is left to be done. Libertarians can be encouraged by this research. Although limited government libertarians have claimed that government enforcement of contracts is an absolute necessity, recent research has shown that this view is overly pessimistic and that market solutions are far more robust.

Further Readings

Benson, Bruce. The Enterprise of Law: Justice without the State. San Francisco: Pacific Research Institute for Public Policy, 1990.

Bernstein, Lisa. “Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry.” Journal of Legal Studies 21 no. 1 (1992): 115–157.

Caplan, Bryan, and Edward Stringham. “Privatizing the Adjudication of Disputes.” Theoretical Inquiries in Law 9 no. 2 (2008).

Friedman, David. Law’s Order. Princeton, NJ: Princeton University Press, 2000.

Klein, Daniel. Reputation. Ann Arbor: University of Michigan Press, 1997.

Leeson, Peter. “Trading with Bandits.” Journal of Law and Economics 50 no. 2 (2007): 303–321.

Powell, Benjamin, Ryan Ford, and Alex Nowrasteh. “Somalia after State Collapse: Chaos or Improvement?” Independent Institute Working Paper no. 64 (November 30, 2006).

Stringham, Edward, ed. Anarchy and the Law: The Political Economy of Choice. Somerset, NJ: Transaction, 2007.

———. “The Emergence of the London Stock Exchange as a Self-​Policing Club.” Journal of Private Enterprise 17 no. 2 (2002): 1–19.

———.“The Extralegal Development of Securities Trading in Seventeenth-​Century Amsterdam.” Quarterly Review of Economics and Finance 43 (2003): 321–344.

Telser, L. G. “A Theory of Self-​Enforcing Agreements.” Journal of Business 53 (1980): 27–44.