Governance and Innovation

A historical view

Maria Brouwer

• Publisher: Routledge
• Year: 2008
• Print ISBN:
  9780415437059
• eBook ISBN:
  9781134075355
• Topic: Business
• Subtopic: Business General
• Index: Business

"This provocative book applies law and finance theory to a wide range of issues bearing on corporate governance and business history. Brouwer's analysis should hold particular interest for students and scholars interested in comparative governance."Joseph A. McCahery, Professor of Corporate Governance and Innovation, University of Amsterdam Center

1 Governance and prosperity

Institutional innovation

Institutions, as the rules of the game, structure human interaction. Institutions need to be distinguished from organizations, who are the players of the game. Institutional change emerges out of the interaction between organizations and institutions (North, 1990: 70). The type of organizations that emerge in certain periods and places is largely determined by rules and regulations (ibid.: 5). Institutional change also occurs when people break the rules in crime or by regime change. The type of institutional change thus depends on the type of organizations that come to the fore in a legal or illegal manner.

Organizations like the trading companies emerged in medieval Italy to finance maritime ventures. Liability problems arose that could not be solved by existing laws. New concepts like limited liability emerged out of discussions on how to solve the problems in a manner that satisfied all parties. Representative democracy emerged in city-states to curtail the authority and liability of political decision-makers. New organizations that undermine peace and prosperity are war gangs and exploitative autocracies.

North argues that institutions exist to reduce the uncertainties involved in human interaction (ibid.: 25). People will abide by rules, if they know if they are applied judiciously. Certainty in this area facilitates human interaction, but uncertainty can also have positive effects. Certainty about the coming of disaster will paralyze people, whereas uncertainty will prompt them to change the odds in their favor. Likewise, people will stay passive, if they fear the outcome of their actions, but will jump at new possibilities if they expect gains to outweigh costs. Traditional societies inflicted grave consequences on those violating tradition, which kept society stable though stagnant. Modern societies diverge from tradition and create room for initiative. Non-traditional organizations like cities and corporations have developed new codes of conduct that encourage experimentation and innovation.

North argues that institutional change is driven by transaction costs. The gains from trade that generations of economists have modeled are reduced by the costs of exchange. Transaction costs involve the costs of writing contracts, but also the problems of moral hazard. Parties to a contract want to maximize their own objectives regardless of how these affect others. Employees want to shirk; suppliers want to provide lousy products; employers want to exploit employees and sellers want to monopolize markets. Moral hazard increases the risk premium to transactions and curbs investment (ibid.: 33). But uncertainty due to moral hazard needs to be distinguished from uncertainty that springs from uncontrollable forces like competition. We do not want sports teams to control the outcome of a game; likewise we do not want companies to control the market. Ventures may fail beyond the fault of the parties involved; markets may clear at prices below costs; competitors may appear on the scene causing the demise of a company. Competition makes the outcome of investments uncertain but this type of uncertainty bolsters the trust in the fairness of the game, whereas uncertainty due to moral hazard can spoil the whole game. Investment is ultimately based on the expectation that parties to a contract will put in an effort to meet their obligations. Otherwise, we have to create a command economy, in which each person fulfills prescribed activities under close supervision. Such arrangements will hardly turn out to be profitable. Moreover, they will stifle innovation, which is based on investments in novelty. Innovation requires a discourse on how to improve things. Ideas will only carry weight, if people are deemed loyal to the organization. Organizations have developed several ways to cope with moral hazard. Novices had to swear an oath before they entered a monastic order. Guild members had to go through a period of training before becoming master. Modern business corporations have developed new ways of control, such as behavioral codes, performance pay, corporate training and rituals to cement a common corporate culture. Investment and trade thus assume that organizations find ways to curb moral hazard. This applies with the greatest force to organizations that surpass national boundaries. However, some eras were more conducive to international trade and investments than others.

The ebb and flow of globalization

Globalization involves a process of expanding world trade and increasing the mobility of production factors. Investors nowadays move their capital around the globe at lightning speed; people leave their hometowns to move to domestic or foreign cities to flee poverty and political turmoil.

Some people abhor globalization because of the alleged exploitation of people and the environmental damage it would cause. It is argued that globalization widens income differences both within and between nations (Hardt and Negri, 2000). Large multinational corporations would replace indigenous industries. Local communities would lose their cultural identity and submerge in Western mass culture. Others contend that globalization creates opportunities for the many who have been excluded from prosperity up till now and consider it the ultimate vehicle of emancipation.

Globalization is also assumed to affect politics. Nation-states are assumed to wither away and a new empire would emerge that obeys the dictates of the large multinationals and pushes democracy aside (Forrester, 2000). Others argue that small ethnic enclaves and city-states are arising in the aftermath of the collapse of the Soviet Union (Kaplan, 2000). The political effects of globalization are thus not undisputed. Some see nations disappearing due to emerging empire, whereas others foresee political fragmentation due to waning empire.

History shows periods of rise and fall of long-distance trade. Trade was more extensive in ancient Greek and Roman times than in the early and high Middle Ages (400–1000 AD). Trade peaked in the nineteenth century and declined after World War I to rise again after World War II. The 1913 level of trade was only restored in 1973 (Krugman, 1995). Historically, trade surged, when cities grew, whereas the decline of cities coincided with a decline of (long-distance) trade. This applies to the cities that arose in the river valleys of Sumeria, Mesopotamia and Egypt. Maritime civilizations such as those of Phoenicia and Greece endorsed the rise of autonomous city-states. Greek city-states obtained autonomy after the Mycenaean Kingdom fell apart. Trade flourished in Athens of Antiquity and Athenian colonies were established along the Mediterranean coast. Some Greek city-states spawned democratic government, such as fifth-century BC Athens. Not all Greek city-states, however, furthered commerce and democracy. Corinth was ruled by a small aristocracy; Sparta by two kings and five ephors. Trade played a minor role in the economies of both Corinth and Sparta (McNeill, 1963: 202). However, Athenian democracy was not stable; Athens repeatedly altered the ‘rules of the political game’. Tyrants overthrew democratic government and installed autocratic rule. Oligarchs threatened Athenian democracy in 411 and 404 BC in an attempt to reduce progressive taxation. Inter-city warfare also undermined city-states. Athens was beaten in the Peloponnesian War after Sparta had concluded an alliance with her enemies (431 BC). Military defeat brought the end of Athenian glory. Many colonies chose Sparta’s side and the ones that had supported Athens were overrun by Sparta’s allies. The feelings of solidarity that had characterized Greek city culture disappeared in the wake of defeat. Thucydides recorded how Athenian society was divided into camps of friends and enemies. Sophists and other Greek philosophers put Athenian leadership under heavy scrutiny after the defeat. Plato (427–347 BC) wanted to cure Athenian society by abolishing all economic and social change. Everybody in his Republic carried out his hereditary duties as slave, soldier or aristocrat. The slaves labored, the soldiers fought and the aristocrats ruled. Freedom of speech was limited. Plato’s idea of social and cultural ossification to ward off change was not novel and was practiced by many later civilizations that preferred stability to innovation. Greek cities lost their independence in the Hellenistic period. The freedom of the cities of Antiquity was swept away by a bureaucratically organized world (Weber, 1978: 335). Overseas trade declined and the countryside gained political weight.

The example of Athens illustrates how city-states rose and fell due to internal and external causes. The same applied to old imperial civilizations, whose existence was threatened by recurrent barbaric invasions and cultural ossification. The need for river regulation and an irrigation policy in the Near East and in Egypt, and to a lesser degree also in China, caused the development of royal bureaucracies (ibid.: 1261). The bureaucracy was charged with construction tasks and with the organization of the army. The Mesopotamian King Hammurabi, whose empire extended from the Mediterranean to the Bay of Bengal, founded the first royal bureaucracy and codified existing law (the famous Hammurabi Code). His royal judges, tax collectors and garrison commanders were sent all over the empire and he communicated with them by way of written reports. The development of a written language and of codified law greatly facilitated trade. Merchants could reckon on a universal judicial system and on royal military protection. The market mechanism arose as a new coordinating device distinct from command, but this period of economic and cultural bloom was brief. Stagnation set in round 1500 BC, when officials were required to undergo long periods of training, which ‘could scarcely fail to produce in each successful pupil a thoroughly conventional mind. Schools became jealous corporations, guarding both professional standards and professional privileges with an impartial rigor. Science – especially mathematics – which had flourished under Hammurabi, came to a standstill.’ (McNeill, 1963: 60–1).

Sailors from Phoenicia ventured as far as Britain and the Atlantic coast of Africa. However, Babylonian culture was deeply conservative and the cultural bloom of Hammurabi’s days was never restored (ibid.: 136). Literature was only available in old styles of writing. Simplified scripts were developed for commercial purposes but were not used by the ruling elite. The Mesopotamian valley civilization reached its end, when nomadic tribes invaded the empire, which then broke up into many smaller states. Imperial rule was re-established, when local warlords submitted to a successful leader. Hammurabi’s laws were re-established and trade revived.

The Persian Empire succumbed to barbarian attacks in 200 AD. Nomadic tribes also overran India and China on several occasions; most notable were the raids by Genghis Khan. The same applies to Ancient Rome, whose decline was hastened by Hun invasions. Nomadic steppe peoples distinguished themselves from civilized societies by their lack of investments in infrastructural works, such as temples and palaces. However, nomadic societies were capable of military and organizational innovation. Warriors were not highly esteemed in oriental literate civilization, but military prowess was considered the main virtue of a man in the nomadic war bands. Many civilizations could not overcome the steppe peoples, once they had organized themselves in a confederation of tribes. A charismatic leader such as Genghis Khan could overcome tribal differences and organize people under his leadership. The horse-mounted nomads constituted a rather egalitarian society during periods of war. This changed, when they settled down in the conquered territories and changed to more permanent organizations.

Both city-states and imperial bureaucracies established institutions conducive to trade. This does not apply to feudalism. Feudalism was first introduced by the Parthans in 400 BC, who established military aristocracies to supervise provinces. Aristocratic titles were first granted to the most courageous and successful warriors, but became hereditary later on. A peasant village provided sufficient income to a lord, who – in turn – defended his subjects against nomad attacks. Feudal organization was not conducive to long-distance trade due to contributions in kind made by its subjects. Feudal military organization was better equipped to ward off foreign invasions and suppress domestic rebellion than a bureaucracy. Feudal lords were eager to expand their territory. However, feudal strife would weaken stability and create tensions between emperor and local rulers. Mercenary and slave armies were sometimes used to counterbalance local feudal military power. Religious authority was also invoked to strengthen central authority. Another device to overcome the inherent tension between centralization and decentralization was to move the aristocracy to the capital for at least part of the year.

The feudal model was adopted by the Byzantine, Carolingian, Arab and Ottoman Empires. The military success of Islam was due to the confederate tribal factor, which remained important in the first centuries of Moslem rule. Islam rewarded its warriors in a feudal manner and adopted feudal organization and ethics (Weber, 1978: 624–6). Several Moslem empires or caliphates existed. The last was the Abbasid Caliphate – located in Baghdad – which lasted from 750 till 1258, when it fell due to Mongol and Turkish invasions. The Moslem world then fragmented into many local lordships. The period of political fragmentation ended, when the Ottoman Empire espoused Islam. The exploitation of feudal fiefs constituted the most profitable enterprise in the Ottoman Empire and the locus of power resided in the countryside. Only a few towns in Anatolia and Iran approached the autonomy of the free towns of Europe during the same age (McNeill, 1963: 496). Central power was supported by a slave army of converted Christian boys from the Balkan, the Janissaries.

Trade flourished in the Roman Republic, but the Empire replaced trade privileges by the distribution of land to the military. Land ownership became hereditary in imperial Rome and tributes to the state took the form of either compulsory contributions or compulsory labor. The entire grain harvest was distributed to the cities according to their needs; surpassing the market mechanism.

Trade revived in the late medieval and Renaissance period, when city-states such as Venice, Florence, Antwerp and Amsterdam prospered due to overseas trade. European globalization developed by fits and starts after 1500. The Italian city-states were succeeded by Holland and Britain as the main maritime powers, which – in turn – were superseded by rising powers like the United States, whose growth surpassed that of Great Britain in the nineteenth century.

International trade peaked in the nineteenth century and declined after 1913, when protectionism and mercantilism recurred. Capital also flowed freely between the continents in the nineteenth century and World War I constituted a watershed in this respect. The recent wave of globalization thus does not constitute a new phenomenon. Each new wave of globalization has occurred when new organizations emerge that thrive on trade.

Both political fragmentation and integration can spur trade. The decline and fall of the Mycenean Empire and the Roman Holy Empire gave rise to city-states that reinvigorated trade. The British Empire promoted trade in the nineteenth century. The question whether either a strong empire such as the British Empire or a weak empire such as the Holy Roman Empire promotes trade and growth has not been answered unequivocally. The answer varies according to time and place, depending on the new organizations it spawns.

The end of history?

The collapse of the Soviet Union in 1989 inspired some people to predict the end of the ideological quest for dominance. Liberal democracy had become the uncontested government of choice of millions of people around the globe, preferred to monarchy, communism and fascism (Fukuyama, 1992). People were to be organized in nation-states, whose relations were peaceful and based on the principle of mutual recognition. Autocratic regimes based on ideologies like communism and fascism had proved to be unsuited to cope with the exigencies of post-industrial society. Hence, there is no alternative to liberal democracy and capitalism in our times. Democracy expresses the equality of all citizens and therewith calls for the end of dominance both within and between nations, in Fukuyama’s view. The desire for recognition and prestige had driven people into bloody battles for domination in the past, making masters out of victors and enslaving the conquered. This Hegelian interpretation of history leaves no other distinction between people than that of victor and victim. However, the French and American Revolutions created opportunities for all people to become equal citizens in a democracy. Liberal democracy replaced the irrational desire to be recognized as greater than others with a rational desire to be recognized as equal (ibid.: xx). With equal and reciprocal recognition the reasons for tyranny and imperialism would end too, as nobody wanted to impose their will on others. Without the desire for superiority, history would witness its ‘last man’: a person without ambition. The end of history would thus entail the end of progress.

Fukuyama’s Hegelian analysis of people’s motives is somewhat limited, in my opinion. The same applies to his analysis of democracy. I want to argue that although liberal democracy is based on the ex ante political equality of individuals, this does not need to imply that each person has equal authority. Some people rise to leadership, whereas others lack decision-making power. Some people gain wealth, whereas others do not. Fukuyama limits ‘recognition’ to the military powerful, whose superiority is ‘recognized’ by weaker people, but such ‘recognition’ is shallow, as it is involuntary. ‘Recognition’, in a liberal sense, refers to political and corporate leaders that are chosen. Democratic political leaders are chosen by the many, whereas entrepreneurs are initially chosen by a few investors. Investors in art and business gain, if they discern value before others do. Such ‘recognition’ is the main source of capitalist profits. It requires that investors hold different views on the value of a certain person or project. We could argue that ‘recognition’ is the essential ingredient of capitalism, which created a new peaceful game creating winners and losers, but benefiting all.

Investment decisions are tested by the market, which can prove them wrong. An investor can refuse to invest in a certain venture, but is proved wrong, if other investors turn it into a success. Employers can refuse to hire certain workers, but will pull their hair out, if they become the star of their competitors. Economic theory points out that homogenous labor receives equal rewards but human capital is heterogeneous from the perspective of a business organization that wants to select those individuals that fit its organization best. Education is only an imperfect predictor of the value of human capital for a certain organization. Business firms, therefore, turn to unorthodox ways to select their favorite employees as Google did, when it developed an algorithm to select its employees, instead of relying on interviews and educational achievements. Liberal democracy is thus all about diversity and not the bland, homogenous soup of Fukuyama’s description.

Liberal democracy can only achieve higher per capita growth, if its innovative powers exceed that of other governance systems. Innovation involves the introduction of novelty in economic life, whose value exceeds that of former ways of doing things. Successful innovation generates profits for investors and value for consumers. Liberal democracy has to be better at discovering the best people with the best ideas to out-compete other governance systems. Market competition forces firms to look for yet undetected human capital. The discrepancy between ex ante valuation and ex post realization generates profits and losses. Economic competition makes social positions volatile and therefore differs from feudal and bureaucratic governance, where a person’s fate was largely determined at birth. Only a few individuals could improve their position by joining the military or entering the royal palace. There were wars and battles, victories and defeats, but the greater part of the population remained unaffected by these changes. They tilled the land according to time-honored traditions, on subsistence incomes. Surpluses accrued to local and far-off rulers; shortages caused famines. Traditional societies largely lacked incentives for innovation and can be described more as a population of last men than our modern post-industrial society. Liberal democracy that offers incentives to individuals to improve their lives can better be described as a society of first men and women.

Fukuyama’s analysis rests on the premise that the ‘best’ political system wins the contest, which ends the game. He argues that fascism was defeated together with Hitler, after which fascism lost its appeal and legitimacy. The collapse of the Soviet Union points to the economic defeat of communism. However, Fukuyama’s argument entails that democracy could also lose its appeal and be superseded by a new ideology or a militarily superior power. His argument of the end of history thus depends crucially on both the economic and military superiority of liberal capitalism. Arguably, capitalism won the race for production figures during the years of the Cold War, but has not yet won the hearts and minds of everyone.

The stability of democracy

Francis Fukuyama predicted the end of history and the permanent success of liberal democracy. However, democracy has proven to be a rather unstable form of government. This applies to antiquity but also to modern democracies. History does not seem to support the hypothesis that democracy entails the ‘end of history’. The French Revolution did not mark the beginning of the end of history for France, but brought Napoleon and his drive for imperial power. The American Revolution did not prevent the occurrence of the American Civil War. The road to the end of history also made many detours in the twentieth century, when many European nations fell prey to autocratic regimes of both the Right and the Left. Fascism was based on the denial of the equality of all men and assumed the existence of a master race. Communism was based on the equality of all men, but some were more equal than others. Political leaders wanted to replace the vagaries of the market by state control of the economy and incomes. Consequently, people’s lives were put in the hands of a single authority, which turned out to be more interested in finding hidden enemies than hidden talent.

The relationship between democracy and prosperity is also puzzling. Democracy was found to be positively related to per capita income (Lipset, 1959). The relationship between democratization and economic growth, however, is less obvious (Acemoglu et al., 2005). The positive relationship between democracy and income can be explained by the fact that, historically, democracy was the preferred governance model of commercial societies. Democratic government first arose in commercial city-states such as Athens, Venice, Genoa, Florence and the cities of the Low Countries. These governments were ruled by wealthy merchants, who wanted to preserve the rules of the game and protect property rights.

The twentieth century featured many rapid movements from democracy to dictatorship and back in many countries. Many newly established democracies were unstable and fell prey to coups and revolutions. The history of Argentina is a case in point. Democracy was set up in A...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of tables
• Preface and acknowledgments
• Prologue
• 1 Governance and prosperity
• 2 Entrepreneurship and economic development
• 3 Organizations and uncertainty: the management of perceptions: from medieval Italy to Silicon Valley
• 4 Entrepreneurship and the state
• 5 Valuation and authority in failing firms: the role of reorganization in US and European bankruptcy law
• 6 Performance pay and uncertainty in entrepreneurial and bureaucratic firms
• 7 Executive pay and tenure: founding fathers, mercenaries and revolutionaries
• 8 Decision agents in corporate and political democracies: Venice, Florence and the Low Countries
• 9 Democracy and dictatorship: the politics of innovation
• 10 Waning and emerging empires
• Notes
• References