A public choice approach to private ordering: rent-seeking at the world's first futures exchange.

• Author: Yadlin, Omri
• Position: Response to article by Mark D. West in this issue, p. 2574

Comments on Mark West's `Private Ordering at the World's First Futures Exchange'

The literature on private ordering systems has expanded exponentially over the last decade. Yet, very few scholars have actually attempted to define the term "private ordering"(1) -- a failure that sometimes leads to confusion. Some scholars identify private ordering with non-state ordering. According to this view, the private legal systems Robert Ellickson, Lisa Bernstein, McMillan & Woodruff, Mark West, and others have investigated are "private" simply because their norms are not manufactured or enforced by the state. The alternative view emphasizes the decentralized feature of private ordering systems. Robert Ellickson, for example, studied "how people manage to interact to mutual advantage without the help of a state or other hierarchical coordinator,"(2) implying that any form of centralized coordination, even if not controlled by the state, renders the system less private. Similarly, Bob Cooter has attributed the superiority of private ordering to its decentralized structure and the fact that its lawmaking processes are subject to competition.(3) The second approach would treat a nonstate legal system like that of the National Grain and Feed Association (NGFA)(4) as "private" only if (a) it competes with other associations, or (b) its substantive law gives priority to the law that merchants write in their contracts. The mere fact that the organization is a nonstate entity is not a sufficient condition for it to be "private." The opposite may also hold -- a piece of legislation produced by the state may give rise to private ordering. The Clean Air Act, for example, is certainly the product of a centralized lawmaking process, but it generates a private ordering system: instead of dictating pollution standards, it assigns property rights, thereby allowing the market to dictate standards.(5) Similarly, United States corporate law is produced and enforced by states, but it may still be considered "private ordering" because (a) states compete, and (b) states largely give priority to corporate bylaws.

Mark West's fascinating article provides an interesting case study for demonstrating the tension between these two approaches. In Private Ordering at the World's First Futures Exchange,(6) West tells a remarkable story about the Dojima Rice Futures Exchange. The governance rules of this futures market, which began its operation in the late seventeenth century and survived until World War II, resemble those of any modern futures exchange, including clearing houses, brokers, margin accounts, and trading rules designed to contend with manipulative practices.

Dojima's most striking feature, though, was its ability to function smoothly despite the government's refusal to enforce futures contracts. But for a twelve-year hiatus (1773-1784), the futures market was forced out of the Japanese legal system. West surmises that the government vigilantly designed this force-out policy to facilitate Dojima's efficient private ordering system. On the basis of pricing data from 1755 to 1827, West concludes both that Dojima's private ordering system was efficient and that the twelve-year experience of public enforcement did not improve the market's performance. He then argues that the data provide support for contemporary theories of private ordering, in particular the conjecture that private ordering of over-the-counter derivative markets can be superior "when parties `are involuntarily shut out' of the legal system."(7)

Notwithstanding my admiration for West's contribution to our understanding of the historical evolution of futures markets, I am skeptical regarding his empirical and theoretical claims. Whereas West claims that the government instituted its forcing-out policy to facilitate the development of Dojima's private ordering and to promote market efficiency, I question both the efficiency of the system and its private nature.

In the first part of these comments, I show that West's findings do not support his claim that Dojima's governance rules were efficient. At most, he demonstrates only a very weak form of information efficiency. In the second part, I offer an alternative, public-choice explanation for the evolution and persistence of the Dojima legal system. I argue that the force-out policy was more likely implemented to preserve the monopoly power of a small group of traders and that of the government itself. A careful analysis of West's database, presented in the third part, provides support for this rent-seeking explanation and undermines West's efficiency rationale. In particular, I show that the Dojima market performed better during the twelve years of public enforcement. All this, along with the fact that trading in the market was contingent upon government licensing, suggests that the Dojima market was controlled by a centralized lawmaker with monopoly powers subsidized by the government's force-out policy. Thus, although formally, Dojima was not a state entity, it does not comply with any of the material conditions for entering the "private ordering" club.

PART A: MARKET EFFICIENCY

Mark West tests the efficiency of the Dojima exchange by measuring correlation between rice futures and spot prices. As shown in Table 1 below, the correlation figures are indeed high. More importantly, West's data suggest that correlation during the public enforcement era (1773-1784) was slightly higher than the correlation exhibited after the 1773 edict was lifted, but slightly lower than before the edict was introduced.(8) On that basis, West concludes that legal intervention did not improve the efficiency of the Dojima market.(9)

[TABULAR DATA 1 NOT REPRODUCIBLE IN ASCII]

But what notion of efficiency does correlation test exactly?

Finance theorists define three levels of market efficiency: weak, semi-strong, and strong. The efficiency levels differ in the type and amount of information reflected in the market price. In the weak form of market efficiency, prices reflect all information contained in the record of past prices. In the semi-strong, prices reflect all publicly available information. Lastly, markets are said to exhibit a strong form of efficiency if prices incorporate "all the information that can be acquired by painstaking analysis of the company and the economy."(10)

Based on the correlation figures shown in Table 1 above, the most favorable...