Note from the Author: I owe the idea for this article to Professor Charles Whitehead, who raised it in our discussion on Ponzi schemes years ago.
Private ordering—rules of behavior without the backup of the law—has been hailed as optimally efficient and cost-reducing. One example of such private ordering has been the relationship among the diamond traders and the diamond exchange. Another example has been the rules established among farmers regarding the use of essential water allocation. Rather than follow the rules of law, the farmers have established their own rules and followed them. Others have followed these examples, all in praise of the virtues of private ordering. However, what about the limits of private ordering, and situations in which such ordering without law is costly and inefficient? The literature assumes that there is no need for law, or that law is applied, without explanation. The emphasis in the literature is on “privatization,” with one critical article on this emphasis.
Robert Cooter explained the role of the law as implementing the enforcement of promises when social and personal enforcement mechanisms fail. He notes that most enforcement of promises can be achieved not by law but by “relationships,” “repeat transactions,” and “reciprocity.” Law is necessary when one needs to make “strangers do what they say.” “According to the contract principle for economic cooperation, the law should enable people to commit to doing what they say. When this principle is implemented, strangers can trust each other enough to work together even when money is at stake. Then, enforcement requires effective courts or state administrators: “Deficient enforcement poses a far greater obstacle to contract law in developing countries than defective doctrine.” This Article outlines the limits of private ordering without law, and points to the situations in which law is essential to society. It notes when private ordering can be effective and beneficial to society and distinguishes it from situations in which private ordering will fail. For example, the diamond and water distributions industries established and enforced trust because the cost of verifying information and enforcement of promises are quite low. Situations such as the distribution and trading in securities and other financial assets, however, involve very high cost of information and enforcement. In such situations order without law fails, sometimes with disastrous results to trusting parties, such as the victims of Ponzi schemes.
Who should impose its rules? The private sector or the public sector (i.e., government)? Functionally, they are very similar. People who control institutions, however, are different, and their power and range are acquired and exercised somewhat differently. Essentially, the privatization of government functions, the order without law, means transferring power from one group to another and creating a different structure and balance of power.
The Article offers a short description of the arguments for “order without law” as efficient and low-cost. Section 2 analyzes “order without law” situations, and the conditions under which it can be achieved. Section 3 outlines the dark side of “order without law,” highlighting situations in which order cannot be maintained without law, and the reasons for the difference. Section 4 concludes with an explanation for the limits of “order without law.” As former Federal Reserve chair Alan Greenspan explained to Congress, he believed in “order without law” in the financial system and found, together with the entire country, when this order does not work.
1. The literature arguing for order without law as efficient and low-cost
In Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry, Lisa Bernstein described in detail the relationship among diamond dealers and the dealers and their exchange. She demonstrated the force of a handshake as the law, without the need of enforcement by the legal system. Diamond dealers trust each other. If they disagree, they choose a form of arbitration to resolve the issues among themselves. They do not necessarily know each other, but they do belong to the organization of diamond dealers and the diamond exchange. Enforcement of the “order” rules is strict and maybe ruthless. Those who violate the association’s rules are fully excluded from the diamond business. The organization’s internal rules are effective; costly legal apparatus is unnecessary. No court system is required, and no laws are enforced. Rather, internal rules and their enforcement guide behavior. In fact, it is the group’s cultural rules that are followed and enforced.
A similar structure has emerged among farmers. They established and enforced their laws, rather than relying on the legal system. Like the diamond dealers, the farmers have contract, tort, and fiduciary laws at their disposal, with court enforcement, but the farmers do not resort to the law and instead adhere to their own order and abide by their own rules.
Professor Cooter has expanded on this theory and generalized it, providing a general rule about order without law. He too, seems to assume that order can exist without law and put no boundaries on the theory. The Coase Theorem supports similar conclusions, holding that disagreeing parties can resolve their differences by negotiations, provided there are no transaction costs. Here, again the order without law is the conclusion, although Coase limits his theory to a world with no transaction costs. Bernstein, Ellickson, and others recognize the existence of transaction costs. Arguably, pursuant to their findings transaction costs are still far lower than the costs of the law and its enforcement.
2. Why can order be achieved without law in certain situations?
2.1 The common features of situations in which order can be achieved without law.
There are certain similarities among situations that can be resolved without laws:
First, all relate to personal relationships. Both the diamond dealers and the farmers know each other in person and deal with each other, at least from time to time, face to face.
Second, all the actors are experts in the subject matter with which they deal. The diamond dealers know much about diamonds. No one will be able to sell them glass or low-quality diamonds as high-quality diamonds.
Third, all dealings involve the direct parties to the deal. They are not the intermediaries that benefit from bringing the parties together for a deal, nor are they consumers. All are engaged in the business of dealing in diamonds or farming.
Fourth, most of the actors depend on each other and have “give and take” ongoing business relationships.
Fifth, the parties are locked into the organization. The membership is not large and alternatives to membership are rare. Exclusion from the diamond exchange means the death of the dealer’s business. Exclusion from the farmers’ group requires moving to another location.
Sixth, because diamonds and farming are special, the contract terms regarding these subjects can fit the traders. General contract laws may not apply as smoothly to transactions in these subjects as to contracts for other, more common goods and services. Here, these contracts represent a standardized community practice.
2.2 Under these circumstances, order without law can be effective. But why?
The obvious answer relates to the nature of trust. Trust is a reasonable belief that the other party is telling the truth and will abide by its promises. Reasonable belief does not include gullibility, e.g., purchasing the Brooklyn Bridge, nor faith, e.g., belief without proof or seeking proof. Trust provides an alternative to verifying that the other party is truthful and reliable. The more costly verification is, the more a party must trust the other party. The less costly verification is the less trust must be bestowed. The other party may not tell the truth or abide by his promise. Reasonable trust may have to involve combined verification and belief.
When the cost verification is relatively low, trust is not necessarily essential. Risk of breach of trust is low and the role of the law is less important or entirely superfluous, especially if the other party can verify the relevant facts with little cost. In such a case, law plays a negligible role or none at all.
Applying these principles to the cases in which order without law has been proven to exist demonstrates that the mix of trust and verification makes law superfluous and the cost of private ordering lower.
Arguably, if a party intends to close its business and retire, that party may be tempted to cheat the other party with whom the retiring party would deal for the last time. We are told that this behavior is “rational.” And yet, this possibility is highly unlikely. People are not usually “rational” that way. People who have worked together might cheat their counter parties on the last transaction before they retire. People do not steal from others if they have not done so as a habit, or cheat those with whom they shared years of business relationships and a history of trust.
In addition, enforcement of promises, for example, in the diamond industry, is low-cost. The trades involve strong community enforcement. Conflicts among the members are brought to arbitration or mediation, both forms of which are less costly than court litigation. Enforcement of obligations is backed by exclusion, which involves great hardship, both emotional and financial. There is therefore every reason for diamond dealers and the farmers to establish their own order rather than adopt the legal rules or resort to legal enforcement. Exclusion and compulsory arbitration are low-cost enforcement mechanisms as compared to legal enforcement. And in any event, the rules of the groups are more suitable than the general contract rules; they are standardized and unique to the business, thus reducing the information costs for the groups. It makes good sense to impose order without law under these conditions.
3. The dark side of “order without law”
3.1 “Order without law” has been applied to the financial system
As Chairman Greenspan conceded, the application of this “order without law” approach to the financial system was a mistake. Yet there are those who still believe it works Government interference in the “freedom of the market” is branded as “communism” and “socialism” and “inefficient.” Most importantly, order without law is hailed as the true governing format for the financial markets. An examination of the models of “order without law” shows their limitations and their dark side when applied to the financial system.
3.2 The financial system is fundamentally different from the models which formed the theory of “order without law”
First, unlike diamonds or water, financial assets are not real assets; they are promises to act or not act in the future. Their examination is costly. Paper or electronic messages stating “you are the proud owner of promises” are fundamentally different from ownership of gold, diamonds, or land. Financial assets are represented by easily manufactured notes or written materials. They promise to act or pay in the future. Verifying existing real assets like land is far cheaper than verifying future performance. Financial assets involve far more uncertainty, and the documents that represent the promises do not necessarily reveal the promisors, their feelings and intentions, their assets, and especially the possibility that they will change based on circumstances and intentions in the future. Verification of these elements is far less certain, as compared to trusting the promisors. Therefore, trust becomes crucial in the financial system.
Second, most participants in the financial markets such as buyers and sellers are not actively involved in the trades. Trading is not their main business. Unlike the diamond traders and the farmers, most participants in the financial system are passive and not experts in the business. Thus, trusting the salespersons is as risky as trusting the other party to the transaction, but when one party is an expert and the other is not the risk to the first party is far greater. Indeed, contract law acknowledges this critical difference by applying different rules to “merchants”—i.e., experts in their trade—and others.
Buyers and sellers in the financial system rely on others to determine the terms of the deal and the value of the assets they buy or sell. They rely on friends, or members of an affinity group, or on paid advisers. But not all the persons on whom the buyers and sellers rely are experts. Reliance on the affinity group members may be far riskier, especially if some or one of the members is dishonest. The same applies to reliance on salespersons, who benefit from the transaction on whom the buyers or sellers rely.
Advisers, or the other parties to the transaction, are intermediaries, whose business is trading in financial assets, and they differ in kind from the competitive farmers or diamond traders. They do not depend on each other in the same way the diamond traders and the farmers do. They can move their services to another state or country with ease.
Intermediaries who cheat are not subject to relatively quick enforcement of the rules. The buyers of financial assets have less clout over the intermediaries who cheated them, except to leave them after the fact. It is only when numerous buyers or sellers leave all intermediaries and bring the financial system to a standstill that serious concern arises. But by that time the harm is done to the system and sometimes to the economy. If the harm is done to an individual buyer or seller, the community of intermediaries is far less concerned than had the harm been done to another intermediary. In this environment, as costly as enforcement of law is, the danger of absence of order and the harm it might bring outweighs that cost.
Third, the parties to the deals do not know each other. They might know the intermediaries, but not very intimately. Although traders trust their intermediaries, they are not always successful in ensuring trustworthy intermediaries.
4. The limits of order without law
Simply put, order without law is not effective in the financial system. Investors bear a high cost for verification both of the quality and of the nature of the financial assets and the truth and reliability of the issuer and intermediary with whom the investors deal. The financial system is grounded in specialization. The underlying assumption in the system is that investors will not spend their time becoming experts, preferring instead to rely on others to determine the suitability of assets, as well as the reliability of the promises both of the issuers and the intermediaries regarding the investors’ interests. To be sure, there are calls for more transparency and more “investor education.” These may be based on false premises. Most investors should be able to trust the experts rather than spend their time becoming experts. Most investors are not in the business of trading and should be passive investors.
Offering information to the investors does not convert them into experts, especially in today’s complex financial markets. The costs of verifying the value of the financial assets and the trustworthiness of the counterparties and the intermediaries for investors are very high. Most importantly, the enforcement mechanisms available to investors are minimal both in terms of arbitration and in terms of exit. Exclusion of the other parties and the intermediaries is not as effective as it is in the diamond and farmer environments. Unlike the diamond dealers, the exclusion of the professional financial brokers requires a rigorous process, and the exclusion of the counterparty does not exist because the counterparty rarely has a say in the matter. It is bound by the intermediary.
Order without law is an important theory not because it justifies the situations in which it is effective but because it demonstrates how inapplicable it is to the financial markets. The theory has a limited impact in a limited type of relationship and is simply incorrect when applied to the financial system. In such a case it is pernicious and should be recognized for the dangerous trends that it might be used and its destructive consequences if it is followed.