Solomon's Knot

PRINCETON UNIVERSITY PRESS

Contents

Chapter One

A grand master asks the tournament organizers to pay him by placing one penny on the first white square of a chess board, two pennies on the second white square, four on the third white square, proceeding until all thirty-two white squares are covered. The initial penny would double in value thirty-one times, resulting in more than $21 million being laid on the last white square. Growth compounds faster than the mind can grasp. Compounded over a century, 2 percent annual growth increases wealth more than seven times, which is roughly the growth rate of the United States in the previous century, and 10 percent annual growth increases wealth almost fourteen thousand times, which is roughly the growth rate of China in the last thirty years.

From the perspective of two centuries, the wealth of the richest countries has risen above the poorest like Mount Everest rising above the Ganges Plain. The gap in wealth opened because the richest countries grew richer, not because the poorer countries grew poorer. Most poor countries today are somewhat richer relative to their past and much poorer relative to the rich countries of the contemporary world. One scholar estimated income per capita for fifty-six countries in 1820. He found that the richest countries in the sample had income per capita of approximately $1,800 and the poorest had $400, for a ratio of 4½:1. We repeated this same exercise for 2003 and found the richest countries had income per capita of approximately $25,000 and the poorest countries had approximately $500, for a ratio of 50:1.

The question of whether growth is faster in rich or poor nations will determine whether living standards in the world converge or diverge. If poor nations grow faster than rich nations, the gap between them will close surprisingly quickly. The lifting of so many Asians out of poverty in the late twentieth century, especially by rapid growth in China and India after 1980, is one of history's triumphs. Conversely, if rich nations grow faster than poor nations, the gap between them will widen surprisingly quickly. Income per capita declined in sub-Saharan Africa by roughly 20 percent between 1970 and 1990, which is one of history's failures. Growth has resumed in Africa, but not at a rate that will overtake rich countries.

How does an economy grow? Through business ventures. A bold ship's captain in seventeenth-century England proposes to investors in a port town that they finance a voyage to Asia for spices. The voyage is inherently risky. Weather is uncertain and channels are uncharted. The Dutch prey on English ships, the English prey on Dutch ships, and other pirates prey on both of them. If, however, the captain returns to the English port with a cargo of spices, they will be worth a fortune. The ship's captain must convince the investors that he can do it. He needs a large ship outfitted for two to five years of travel. To convince them, he discloses secrets about how to get to Asia and what to do when he arrives. The captain must trust the investors with his secrets, and the investors must trust the captain with the ship and its supplies.

This is a double trust dilemma. To solve it, the captain and the investors form a new kind of firm invented in the seventeenth century for the spice voyages: a joint stock company. The participants—tnvestors, captain, and crew—are legally entitled to shares of the hoped-for cargo. Some participants have larger shares than others, depending on their contributions. With these legal arrangements, the investors stand to gain more from the success of the voyage than by selling the captain's secrets. Similarly, the captain stands to gain more from the success of the voyage than by stealing the ship and its cargo. Self-interest enforces the commitment of the parties to the voyage.

Unlike so many other ships that sail for Asia, this one returns safely after two years. The townspeople spot the vessel sailing toward the harbor and the investors rush to the dock to keep watch over the cargo. They immediately hold a meeting of shareholders called a "general court." It divides the cargo among the shareholders, they leave the dock with their spices, and the company dissolves.

Similarly, an engineer in Silicon Valley in 1985 has an idea for a new computer technology. The engineer cannot patent the idea until he develops it. Developing it requires more money than the engineer can risk personally. He drafts a business plan and meets with a small group of investors. The engineer fears that the investors will steal his idea, and the investors fear that the engineer will steal their money. Besides the fear of betrayal, developing the idea is inherently risky—it might fail or someone else might patent the idea first. If the innovation succeeds, however, it will be worth a fortune.

The engineer cautiously explains his idea to the small group of investors, who accept his invitation to incorporate and appoint him as chief executive. They distribute shares of stock among themselves according to their contributions, and the shareholders elect a board of directors that carefully balances their interests. With this legal arrangement, self-interest causes the investors to keep the engineer's secrets and the engineer to use the money as promised. Unlike so many other start-ups, this one succeeds after five years and the firm acquires a valuable patent. The engineer and the investors subsequently dissolve the company by selling it for a lot of money to a large, established firm.

Seventeenth-century spice voyages and twentieth-century technology start-ups involve secrets, up-front investment, high risk, and high return. Many business ventures have these characteristics in muted form. To grow quickly, a business venture must combine new ideas and capital. An ancient motif on this book's cover depicts two interlinking rings called "Solomon's knot." Sailors particularly favored this kind of knot for strength and durability. Like the two rings, King Solomon held together two Jewish kingdoms, according to the Bible. Similarly, ideas and capital must unite to develop innovations and grow the economy.

In every country, growth occurs through innovative ventures, but the form of innovation differs. Innovations in Silicon Valley usually have a technological basis, such as new computer chips or programs that were previously unknown to the world. Technological innovation often requires research universities and similar institutions found especially in developed countries. The relative weakness of research universities and similar institutions in developing countries today limits their capacity for technological innovation. Technology mostly flows from developed countries to developing countries through international trade, investment, and educational exchanges. The flow hastened in the last century when major wars abated, communism collapsed, and tariffs and transportation costs fell.

Instead of improving technology, many innovations improve organizations and markets. Philip Knight began the Nike Corporation by making running shoes with soles formed on the family waffle iron and selling them out of the trunk of his car in 1972. In 2006 the company reported $15 billion in worldwide sales of sports equipment and clothing. Knight obviously discovered something new, but what was it? The business of Nike is research and marketing. It thinks up new products, contracts with other firms to make them, and then markets them through extensive advertising. Nike does not manufacture anything. Its main facility in Beaverton, Oregon, is a "campus," not a factory. Instead of manufacturing, it contracts with foreign companies to make the goods that it sells. This new organizational form has spread dramatically in the United States as more and more companies "outsource" manufacturing and focus on research and marketing. Other examples of recent innovations in markets and organizations in the United States include debit cards, hostile takeovers, networks of innovators, and team production (imported from Japan).

Innovation in developing countries mostly takes the form of improving organizations and finding new markets, especially by taking organizations and markets that originate in developed countries and adapting them to local conditions. Before buying edible oil, African consumers smell and taste it to assure themselves of freshness, which requires selling it in open containers. Closed containers, however, have many advantages, including lower shipping and storage costs. Bhimji Depar Shah figured out how to sell oil in closed containers and retain the trust of African consumers. He started an edible oil company in Thika, Kenya, in 1991 that developed into a business empire. The company's homepage reads: "Integrity is what all our people value and uphold ruthlessly which enables trust leading to empowerment." Selecting reliable salespeople and dispersing trustworthy workers around Africa required innovation in organization like Phil Knight accomplished at the Nike Corporation.

Besides new organizations, adaptations often create new contracts. The textile business in Bangladesh relies on two new contracts: bonds for warehousing and back-to-back letters of credit. Bonded warehouses protect producers against theft or fraud in the chain of distribution, and letters of credit protect buyers against theft or fraud at the point of sale.

In business, adaptation is creative and risky. The adapter has an idea that is new to a developing country. Proving its worth in the marketplace requires risky investment. The investment often goes to building an organization embedding the new idea. The innovator must trust the investor not to steal his organization, and the investor must trust the innovator not to steal his money. If the adaptation succeeds, it attracts competitors, who diffuse the idea and reduce the innovator's profits. Adaptation in developing countries thus faces many of the same obstacles as invention in developed countries.

Instead of adaptation, some people imagine that developing countries can grow by imitation that is mechanical and safe. If growth were this simple, poor countries would already be rich. In poor and rich countries alike, new business ventures mostly fail and the investors lose their money, whereas a few succeed spectacularly and drive growth. Picking out the adaptation that will succeed in Africa is just as hard as picking out the invention that will succeed in Silicon Valley.

Nations are poor because their economies fail to innovate and grow. An economy can fail to grow because of military invasion as in Poland in 1939, or isolation as in the New Guinea Highlands in 1920, or civil war as in Somalia in 2000, or natural disaster as with the Sahara Desert's encroachment on farms, or a bursting financial bubble as in the United States in 1929 and 2008. In recent decades, however, many countries have enjoyed benign conditions for growth—peace, open economies, no natural disasters, no bursting bubbles. With these background conditions satisfied, law has big effects on growth. Good law engages business energy and advances the economy, whereas bad law suppresses business energy and retards growth.

Sustained growth in developing countries occurs through innovations in markets and organizations, innovation poses a problem of trust between innovators with ideas and financiers with capital, and the best solutions are necessarily legal. Nonexistent, weak, or underenforced laws hobble economies, as some examples illustrate.

African Diamonds: Diamond miners in central Africa use hand tools to dig in a riverbed under the guard of teenage soldiers with Kalashnikov rifles. The miners sell the diamonds to a military officer at a small fraction of world market prices. The diamonds subsequently pass through various intermediaries until they reach Europe. Finally a courier arrives at the central railway station in Antwerp, walks quickly to one of the nearby gem shops where the merchant examines the diamonds and pays in cash, and the courier leaves the city by train within an hour.

In central Africa, producing and transporting diamonds in recent years occurred in conditions that approached anarchy. Central Africa produced few diamonds and got paid much less than the world price for them. If anarchy were replaced by secure property rights, central African nations could produce diamonds with better technology, export them through the regular channels of trade, and receive the world price. And the profits would not go to thugs who commit unspeakable cruelties and heinous abuses of human rights.

Moscow Security: A man opens a small shop selling household goods in Moscow in 1992. A month later three young men visit him with copies of his bank records. Using these numbers, the men calculate a monthly fee that he must pay them to "protect his shop from hooligans." If he does not pay, they will destroy his shop. The shopkeeper pays and his business succeeds.

Unlike diamond thieves, Moscow criminals who sell security do not want to take everything from their clients. Selling protection presupposes something to protect. In this example, the Moscow criminals impose a "security tax" that leaves room for the shopkeeper to succeed. When organized criminals provide security, however, the "tax" is much higher than when a successful state provides it. (Not to mention the dangers of competing "protectors.") When providing security, the Moscow criminals burden business more heavily than a successful state. Security is a "natural monopoly," which means that states can provide it more cheaply and reliably than private parties. Private security of property is better than anarchy but worse than effective state law.

Indonesian Textiles: In Jakarta in 1987, a businessman manufactures cloth, makes the cloth into dresses, hand-decorates them, and exports the finished product. The entire process occurs inside a single factory where cotton and silk come in the door and decorated dresses go out the door. Managers in the factory are mostly relatives of the owner. Rural households outside Jakarta would do the hand-decorations at lower wages than factory workers in the city. The businessman, however, is unwilling to leave the dresses in rural households in exchange for a promise to decorate them.

The Indonesian businessman in this example gathers everyone needed to produce a particular product into a single factory, where his relatives can monitor them. In countries with weak legal institutions, economic cooperation usually involves people with personal ties, especially relatives and friends. Most people, however, do not have enough relatives and friends to achieve the scale of activity required for affluence. Weak contract law can keep trade local and organizations small. Property and contract law lower the cost of monitoring and extend cooperation to strangers, which facilitates dispersed production, larger organizations, and wider markets.

Mexican Loan: A poor man in Mexico City needs a loan to buy a refrigerator for storing food that he sells on the street. Before loaning the money, the lender needs security against the debtor's failure to repay. The legal process for repossessing the refrigerator from a defaulting debtor is too slow and unreliable. Instead, the lender requires the borrower to provide telephone numbers and addresses of his family, friends, and business associates. If the borrower falls behind in payments, the lender will use the borrower's family and friends to pressure him to repay the loan, and, if necessary, the lender will use their influence to repossess the refrigerator.

The impracticality of collecting debts through courts plagues businesses in poor countries. Mexican debtors often gain by stringing out the legal process because courts assess low interest rates on delays in collecting court judgments. High-cost debt collection can dry up loans to small businesses like the Mexican street vendor. In this example, however, the parties found a way around debt collection through the courts: rely on family and friends. One of Mexico's richest businessmen, Ricardo Salinas, began to build his fortune by figuring out how to collect debts from poor people who buy consumer durables, so household appliances became available to more people.

A different kind of financial problem known as the "soft-budget constraint" exists in countries with a socialist tradition:

Chinese Steel: In 2000, the government privatizes a steel company in northern China by creating stock and divides it three ways. 33 percent is sold to the public who can resell freely ("tradable" shares), 47 percent is allocated to the government, and 20 percent is allocated to insiders who cannot sell ("nontradable" shares). After privatization, the steel company keeps losing money. Its managers, who have political influence, pressure a state bank to finance its losses by buying its bonds, which are commercially unsound.

(Continues...)

Excerpted from Solomon's Knotby Robert D. Cooter Hans-Bernd Schäfer Copyright © 2012 by Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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