The Power of the Elites: Self Limiting or Self Perpetuating?

June 5, 2015

Zahid Hussain

In a recent paper titled “The Financial Power of the Powerless Socio-Economic Status and Interest Rates under Partial Rule of Law” (May 11, 2015), Timur Kuran of Duke University and Jared Rubin of Chapman University make a very interesting point. They argue that credit costs depend on the enforceability of financial contracts. “Just as investors force the bonds of unreliable states to pay high interest rates, so in countries where individual commitments are poorly enforced rates on private loans tend to be high….Judicially favored groups pay more for credit precisely because their promises are relatively less credible….. Policies that limit the underlying judicial biases will lower the interest rates of the favored accordingly.”

The authors provide persuasive historic evidence from the literature on comparative economic history, focusing on intergroup differences in private credit costs, showing that these convey valuable information about the social institutions governing the enforceability of credit contracts. “Where women are less mobile than men, gender differences in flight risk translate into higher interest rates for male borrowers. Likewise, where the courts favor one religious community over another, the judicially advantaged community pays a price for its privileges through higher interest rates. In seventeenth and eighteenth century-Istanbul, not only men and Muslims but also elites paid a surcharge for credit. Evidently, competitive credit markets compensated lenders for the added risk they took when lending to privileged groups.”

The implication, the authors suggest, is restricting elite privileges is in the interest of the elites themselves.  They allude to the potential gains from leveling the playing field. The immediate beneficiaries could form a politically powerful constituency. Privileged groups can make themselves more creditworthy if they force the judiciary to hold them to their financial contracts. They recognize that reforms that level the judicial playing field can benefit elites as a whole, but they would have harmed individual elites with already negotiated contracts. “After contract negotiation, individual elites would do worse under impartial enforcement than under their traditional judicial privileges.” This is why there can be resistance to judicial reforms from privileged groups as well.

The unanswered question is why won’t the elites attempt to un-level the financial playing field?  The paper throughout assumes competitive financial markets which penalize the elites by charging higher interest rates because the credit contracts with the elites cannot be impartially enforced.  In that case, the elites have every incentive to use their political power to capture the financial system directly, by supporting the establishment of state-owned banks or by having their own banks, and indirectly, by capturing the governing boards of the private banks. That way they don’t have to cut their judicial privileges, whose benefits extend beyond partial enforcement of credit contracts, while ensuring that the financial markets do not take away what the judicial system gives to them. 

What has escaped the authors’ notice is that the elites are capable of putting in place governance practices in contexts where they don’t have to give up privileges to avoid punishment for costs such privileges impose on agents elsewhere in the system such as the financial markets.  Instead of establishing impartial courts, they can put in place partial financial systems.

The power of the elites must never be under-estimated. Yes, restricting elite privileges is central to the transition from the “natural order” to the “limited access order” before graduating to the “open access order” as articulated in North, Wallis, and Weingast (2009). But the reality is that the small clique can resist the emergence of self-enforcing institutions that expand the domain of the level playing field. This can explain why the transition even within a limited access order towards greater openness and contestability can take ages. It is therefore by no means clear, as the authors claim, why leveling the playing field in financial markets would be among the early reforms attempted. The privileged groups make themselves more creditworthy not by forcing the judiciary to hold them to their financial contracts but by forcing the financial markets to emulate the partiality of the judiciary.