Private order and public institutions.

• Author: Katz, Ellen D.
• Position: Response to article by John McMillan and Christopher Woodruff in this issue, p. 2421

Comments on McMillan and Woodruff's `Private Order Under Dysfunctional Public Order'

In Private Order Under Dysfunctional Public Order,(1) John McMillan and Christopher Woodruff describe the private institutions that order commercial transactions in developing economies where commercial actors view the formal legal regime as unreliable. Presenting evidence from surveys of market participants in several Eastern European countries and in Vietnam, McMillan and Woodruff depict a system of private order that requires formal organization and the creation of institutions to share information and coordinate multiparty responses. These institutions do not simply offer a viable alternative to public procedures, but also enable commercial transactions to occur where the vacuum in public order would otherwise preclude valuable trades. In conclusion, however, the authors allude to the reliance of some private-order institutions on practices of exclusion, collusion, and physical violence that yield economic inefficiencies. This "downside" to private order, they assert, means that while private order in developing economies "can usefully supplement public law, [it] cannot replace it."(2)

This assertion is correct but incomplete. McMillan and Woodruff rightly note that private order is not a substitute for public governance, and that public-order institutions are needed to facilitate internalization of the negative externalities that private order produces. But public order serves a much broader and deeper function. Democratic public-order institutions, when accompanied by public-order norms of transparency and accountability, offer processes and policies of greater legitimacy and fairness than can private-order institutions. While the goal of the public realm ought not be to supplant private-order decisionmaking, the inclusiveness of democratic decisionmaking ultimately means that public order should be seen as the preferable form of governance, even if public order does nothing more than ratify the existing private-order system.

These comments will discuss the difficulty in structuring public institutions in a developing economy where a vibrant, though perhaps problematic, system of private order operates, and will address the role of public order more generally as a source of legitimacy for governance of any kind.

1. THE DOWNSIDE OF PRIVATE ORDER

   A substantial literature celebrates the benefits of private order.(3) Private order often provides greater efficiency and involves lower transaction costs than do public-order regimes. Many believe it achieves better results; that is, participants in the private-order regime view outcomes arising thereunder as preferable to those that might be produced by public-order mechanisms. Private-order institutions are often well-situated to monitor market conduct, and their decisionmakers remain close to and thus well-informed about industry practice. Private-order adjudicatory practices accordingly may produce more nuanced decisions than do public-order ones, particularly given the former's broader freedom to consider evidence that would generally be inadmissible in traditional law courts.(4)

   The very features of private order that have prompted so much celebration may also explain the problematic facets of private order that scholars have increasingly identified.(5) Private-order institutions may rely on exclusionary entry barriers, which may be grounded on race, gender, ethnicity, or other characteristics; coordination among firms, which may yield collusive anticompetitive practices such as price-fixing; and graduated forms of coordinated sanctions, which may include physical violence and other forms of criminal activity.(6)

   Some of these so-called "downside" practices are evident, perhaps unsurprisingly, in the celebrated strategies used by various communities to prevent overuse of commonly held resources. Numerous studies challenge the notion that the tragedy of the commons is inevitable by identifying mechanisms through which communal resources can be managed in a sustainable manner.(7) Most notably, a successful commons generally does not provide open access, and thus is not really a commons at all, for sustainable management typically requires some mechanism to limit access to prevent overexploitation of the so-called communal resource.(8) Whether entry depends on membership in a social or ethnic group, or on other considerations, participation becomes notably and necessarily exclusive rather than inclusive. While norms of exclusion may yield benefits for the community and even for the environment,(9) their particular instantiation may rest on irrational or otherwise objectionable discriminatory factors.

   Communities managing a shared resource may also rely on an escalating series of sanctions to penalize participants and outsiders who breach management norms.(10) Penalties progress from gossip to vandalism to other forms of violence, raising concerns regarding accountability and public order generally, and calling into question the purported efficiency of private-order norms governing punishment.

   Poorly structured public-order institutions may explain why less than optimal private-order practices evolve.(11) As Curtis Milhaupt and Mark West note, governmental failure "to get the [public] institutions `right'" not only increases the costs for private actors seeking to utilize state procedures, but also contributes to what they term "dark-side public ordering."(12) Poorly structured legal institutions provide fertile ground for thriving criminal organizations that promise to provide and protect property rights more effectively than does the state. Just as an existing system of private order can dampen the incentive of public officials to create and nurture valuable legal institutions, badly designed legal institutions can inhibit vibrant private order and cause it to produce negative externalities.(13)

   Milhaupt and West, for example, demonstrate the link between various modes of organized criminal conduct in Japan and specific deficiencies in Japanese public-order institutions. They point to the significant holdout problems resulting from the virtual life estate Japanese law grants tenants, under which eviction becomes virtually impossible in practice. This has given rise to the jiageya, or "land fixers," a class of private individuals employed by real estate developers and tenants alike to make threatening telephone calls, to organize disruptive activities, and otherwise to use physical violence to prompt evictions and resolve disputes.(14)

   Where public-order institutions are inadequate or even wholly absent, participants in unregulated private-order institutions may find that refraining from downside practices simply constitutes bad business. Absent a state-imposed penalty or other type of sanction, fixing prices or limiting participation to a restricted group may well present the most rational and efficient course of action, at least from the perspective of institutional members. This is not, of course, to say that all problematic facets of private order stem from purely rational behavior. Less than optimal private-order norms may result from information lags, changing technologies, moral considerations, cognitive biases, and even envy.(15) But whether rational or not, private downside practices persist where neither the private institutions nor their members bear the immediate costs of the practices employed, and, even if long-term efficiency suffers, the individual benefits reaped outweigh (again from the individual's or individual institution's perspective) any aggregate loss in overall welfare. Consequently, private-order institutions will continue to engage in these practices absent a mechanism, be it public or private, to force internalization of the negative externalities produced.(16)

2. FIXING AND FACILITATING PRIVATE ORDER

   Private order's downside leads McMillan and Woodruff rightly to conclude that "[w]e thus need public order to limit these abuses of private order."(17) How best to structure public-order institutions to accomplish this purpose is hardly self-evident, but three rudimentary principles should guide the effort.

   1. Developing vs. Developed Economies

      Private-order institutions exist in both developing and highly developed economies.(18) In one sense, private order responds to a similar problem in both societies, namely a dissatisfaction with the existing public order as a mechanism to govern private relationships and to resolve disputes. Whether that...