.

We turn in Chapter 2 to the emerging nation-state in England, and see how competitive markets helped England solve a fundamental conundrum – how the state can obtain a monopoly of military power within the country, and yet give up its powers to act arbitrarily and outside the law. This is essential for markets to be confident that private property is protected. We will see the importance of an efficient commercially-minded gentry as well as independent businesspersons in aggregating power through Parliament and imposing constitutional checks on the monarchy. Once the state was constitutionally limited, the way was open for truly competitive markets – individuals no longer needed the anti-competitive feudal structures such as guilds that also served to protect them against the state. At the same time, both widely-held private property as well as competitive markets were necessary to create an independent private sector that could protect property and constrain the state. In sum, the constitutionally limited state freed markets and free markets limited the state.

      Once the markets were free of the fear of expropriation by the state, they flourished. As we will see in Chapter 3, the market pillar was dominant as countries experienced the First Industrial Revolution but often to the detriment of the community. The fight for broader suffrage was, in many ways, a fight by the community for more democratic power, this time to protect labour, not just physical property. The empowered community then, through movements like those of the Populists and the Progressives in the United States around the turn of the nineteenth century, played its role in restoring the balance by pressing the state to keep markets competitive and opportunity alive for the many.

      The democratic community may not always want markets. In Chapter 4, we will outline three situations when the community does not push for competitive markets – when market players or practices are deemed illegitimate and the state seems a better alternative, when the state is weak and the community is easily bribed to stay apathetic, and when neither the state nor the community offer people the capabilities and the support they need to participate in volatile, changing markets. For people to desire markets, an effective state together with an engaged community have to create mechanisms that will provide people the capabilities and support that will allow them to benefit from markets. We will see how the balance came together in the liberal market democracies that emerged across the developed world by the early twentieth century. We will cover a thousand years of the evolution of the pillars in four chapters – a little too fast for the historians, but just right for our purpose, which is to give a sense of what problems they solved.

      History’s lessons are important. They will give us a sense of why each pillar matters and how the pillars fit together to produce the liberal market economy. Patterns of their interaction reproduce, not exactly but recognisably. Nevertheless, readers who want to jump ahead to recent times might skim through Part I and go to Part II, where we move quickly through the post World War II–era to explain the genesis of today’s problems. They could then come back to Part I for a historical perspective.

       1

       TOLERATING AVARICE

      In this chapter, we will see how the markets and the state separated from the medieval manor community and became powerful pillars in their own right. We will follow these developments through the use of the quintessential market contract: debt. The Catholic Church will play a cameo role in this story, initially filling the vacuum left by the absence of a strong state, then competing with the state to both protect and exploit people. Crucially, though, for our narrative, the Church managed to stand up to the state, armed only with the power of religion. It established the idea that there was a higher legitimacy that constrained state actions, over and above temporal power. As we will see, this was an important step toward a constitutionally limited state, which in turn was necessary for markets to have full play.

      THE DEBT CONTRACT

      Unlike the favours we have been discussing between members of a community, a loan contract is an explicit commitment by a borrower to repay the loaned amount with interest at a prespecified time, failing which the lender will be able to use the force of the law to recover the value lent. Typically, she will do so by seizing pledged collateral. If the security offered by the borrower is valuable – such as a farmer borrowing against his land – the lender need not know very much about the borrower or monitor his activity closely. By making terms explicit, the debt contract frees the lender from dependence on the whims or fortunes of the borrower. No longer is it the borrower’s choice whether to repay and when to do so – he must pay on the contract’s maturity or face the stipulated penalties, which in some societies were as harsh as slavery or death. Since the debt contract is written down, it is not dependent on the frailty of human or community memory. Favours can be forgotten – debt cannot.

      Debt is thus an arm’s-length exchange of money for interest, untrammelled by the need to maintain social ties. This can draw in lenders from outside the community. In fact, such lenders may be the best at getting repaid because they will not sympathise with a borrower who has fallen on hard times, unlike a lender from within the community. Shylock, who hated Antonio, Shakespeare’s merchant of Venice, was, in a sense, the ideal lender, since he was perfectly willing to take his pound of Antonio’s flesh if Antonio did not repay the debt. Because Antonio then had every incentive to repay, Shylock was willing to lend.

      These attributes of debt – that it is explicit, often secured by collateral, and impersonal – seem to favour the lender. They also make it much easier, though, for a potential borrower to get a loan at a low interest rate in competitive environments – somewhat paradoxically, the harsher the debt contract and the more it seems weighted in favour of the lender, the greater and broader the borrower’s access to finance. If, in contrast, sympathetic courts were to suspend the lender’s power to recover whenever the borrower was in difficulty, lenders would not be eager to lend to anyone who was even moderately risky, and lending would dry up. The few loans that would still be made to risky borrowers would be at sky-high interest rates. So it is from the very harshness of the debt contract, and the lender’s ability and willingness to enforce it, that the borrower gets easy access to funds. None of this is to say that borrowing is appropriate for everyone who wants money, or that debt forgiveness is bad, only that the debt contract is fit for its purpose.

      In the relationships we have discussed so far, one member of the community does a favour to another without the expectation she will be repaid in full measure. In the typical debt contract, the terms including the interest rate are calculated so that both sides are satisfied if the contract is adhered to, even if they never see each other again. A relationship leaves possibilities open-ended; the debt contract calculates them to closure. A relationship requires parties to have some empathy for each other or some sense they are part of a larger, longer-term whole; the debt contract is entirely self-contained. It is in these senses that the debt contract represents the quintessential individualistic arm’s-length market transaction.

      Despite the usefulness of debt, lending for interest, otherwise known as usury, has been proscribed by many religions and cultures. Usury laws capping interest rates prevent the equalisation of benefits to both borrower and lender. The lender gets less than what he might obtain in a free market. Why did such laws emerge?

      THE PROHIBITION ON USURY

      Societies have often prohibited lending at more than a specified moderate rate of interest. The Arthashastra, attributed to Indian Emperor Chandragupta Maurya’s adviser, Kautilya, and written around 300 BCE, has detailed prescriptions on the maximum rate of interest that can be charged for different kinds of loans. The ceiling was 1 1/4 per cent per month or 15 per cent per year for ordinary loans to people, intended to finance consumption or emergency needs.1 It went up to 5 per cent per month for ordinary commercial loans, 10 per cent per month for riskier commercial transactions that involved travel through forests, and 20 per cent per month for trade by sea.