All Commentary
Wednesday, October 3, 2012

Clubs and Governments

Earlier this year the world lost one of its most original and insightful scholars with the death of Elinor Ostrom. Unlike some winners of the Nobel Prize for economics, Ostrom will be inspiring research and fresh thinking for many years to come. One of her central insights was that human beings have a huge capacity to create institutions that conserve scarce resources and prevent predatory behavior without relying on political power or market exchanges. This means we should move away from the simple dichotomies public versus private, State versus market, and government regulation versus market exchange.

In particular we should stop thinking we must choose between regulation (control by government) on the one hand and unregulated private action on the other. The reality is more complex. Rules and regulations govern many activities but can have all kinds of sources other than the State.

Nor do things end there. Another of Ostrom’s insights is that complex human institutions and social systems frequently are governed not by explicit rules or laws but rather by generally understood norms and expectations, with accepted penalties for violation. Again, these are created not by diktat or legislation but spontaneously, by human interaction, yet they bind and regulate the actions of individuals as tightly as any printed code or regulation—often more so.

A classic, and highly topical, example is provided by the history of financial markets and exchanges, particularly the London Stock Exchange. Not understanding either the history or Ostrom’s insight can lead to a damaging misunderstanding of both the recent past and the present. Such misunderstanding is found on both sides of the conventional argument.

The widely held view of the history of the exchange goes something like this: Up to 1986 the financial market in London was highly regulated, but then the Thatcher government freed it of regulation. For some this was the start of a golden era for the City of London, with rapid growth, the breaking of an “old boy network,” and a whole series of efficiency gains, while for others it was the beginning of disastrous unregulated dog-eat-dog competition. Both accounts misunderstand both the situation before the “Big Bang” of 1986 and the nature of what came afterward. Looking at London as one of Ostrom’s communities gives us a clearer picture.

The stock exchange, and the wider financial markets of the city, were indeed highly regulated before 1986. However, the regulations in question did not come from the British government. Rather they were created, articulated, and enforced in the classic way that Ostrom’s work recognized—by private action within a social group. The exchange was formed in 1773 as a private club and remained one up to 1986. The first modern stock exchange appeared in Antwerp in the Netherlands in the sixteenth century. In imitation the English Crown set up a Royal Exchange in London in 1571. During the later seventeenth century, trading in stocks and shares became an increasingly important activity and there were repeated attempts by the government to regulate it by statute. This drove much of the activity away from official exchanges and into the coffeehouses and streets, notably Exchange Alley near the new Bank of England. In 1773 about 150 stockbrokers formed a club that became the London Stock Exchange (as it remained until it became a public limited company in 1986). This involved the drawing up of formal rules to govern membership and trading, which were written down in 1812.

The rules governing the buying and selling of securities were extensive and explicit but were produced by the voluntary association of the members. It never had a statutory monopoly of such trade, so any group of investors or brokers could set up a rival. However, although regional exchanges existed in centers such as Manchester, Liverpool, and Glasgow, no challenger emerged. It also faced competition from exchanges elsewhere in Europe and North America, such as New York, Frankfurt, and Paris. The rules enforced by the London exchange stipulated among other things that commissions were fixed and that brokers could not trade on their own accounts. (They were price takers, not price makers.)

However, this was not the full story. The process that had produced the association and rules of the exchange also generated complex norms and expectations that governed the behavior of participants in the London market without being explicitly articulated. These were summarized in the saying that became the official motto of the exchange in 1923: “My word is my bond.” All kinds of major business deals would be undertaken with only the most minimal paperwork and legal paraphernalia; sometimes they were built on nothing more than a handshake. To break an undertaking or to knowingly give false information so as to mislead one’s counterparty to his disadvantage was simply unthinkable for most. Human nature being what it is, there were of course people who did not adhere to these norms, and scandals occurred. There were severe penalties for this, quite independent of any criminal or civil sanction. Essentially the offender would never be able to do business in the city again and would become a social outcast. This was much more effective than people today might imagine.

What happened in 1986 was not a matter of deregulation as commonly understood. Rather it saw the replacement of Ostrom-style social regulation by government regulation. An official government body—the Competition Commission—held that the rules of the exchange, despite their ultimately voluntary and non-monopolistic nature, restricted competition and were economically inefficient. The subsequent statutory action swept away all the controls and regulations that voluntary club action had produced.

However, it did not stop at that. A massive body of State regulation was created, which has governed ever since and has grown in both size and complexity. Most of the norm-based controls have gradually faded away, replaced by ever-more extensive and explicit written regulation. The problem of course is that the attempt to capture and cover every eventuality in this way is not only futile but counterproductive, since it creates opportunities for the unscrupulous to benefit by gaming the system, often by flouting the spirit of the rules while staying within the letter. The informal norm-based way of doing things is flexible enough to prevent this kind of behavior.

Human beings living in complex societies need rules and regulations to govern things such as access to resources and to ensure some do not take advantage of others. One form of governance is government regulation and legislation. But there are a number of alternatives, one of which is the private association that generates rules and enforces them on its members. Provided the club is not “closed” and does not have a State monopoly (that is, it cannot use force to shut down potential competitors), this can be much more effective. Moreover, the experience of dealing with other people in this way generates rules and expectations that are widely shared and understood even if unarticulated, and these on all the evidence are a more effective and humane check on predatory behavior than the most elaborate codes of government regulations.

  • Stephen Davies is a program officer at the Institute for Humane Studies and the education director at the Institute for Economics Affairs in London.