Institutional inertia and institutional change

July 7th, 2014

José-Antonio Espín-Sánchez, Department of Economics, Yale University

“There is nothing more difficult to arrange, more doubtful of success, and more dangerous to carry through, than to initiate a new order of things” – Niccolò Machiavelli, The Prince.

The Western United States’ recent drought accentuates the importance of institutional and mechanism design. While inefficiencies tend to produce few consequences during times of abundance, resource scarcity amplifies them in such a way that the ramifications are large and persistent.

Effective institutional design can be geographically heterogeneous; each location has its own unique circumstances that merit contextualized approaches. For example, areas with their own unique crops, weather patterns, and degrees of urbanization might warrant different institutions. Unfortunately, effective institutions are unlikely to arise by chance since regions have their own inefficiencies that are often traced to historical precedents, regulations, or distributions of property rights that persist and, therefore, are a source of conflict.

A better institution does not mean that it makes everyone better off. Let’s say that water is diverted from agricultural uses in town A to residential uses in city B. If the citizens of B value the water more, then this institution is better. After the change, there will be winners (the citizens of B) and losers (the farmers). Luckily, since the new institution is “better”, what the winners are winning is greater than what the losers are losing. In an ideal world, the citizens of B will sign a contract with the farmers of A specifying that they will be compensated for their losses, i.e., they will buy the property rights. In this ideal world, everyone can become a “winner” if citizens of A are willing and able to sell water to citizens of B who are willing and able to buy the water at a price that is profitable for both sides. Unfortunately, reality is much more complicated and market imperfections and frictions can inhibit the efficient writing of contracts between buyers and sellers.

Institutional inertia

What could prevent a “better” institution being implemented? Transaction costs associated with institutional change are a major barrier. For example, farmers wanting to change the law will have to spend money and time lobbying congressmen.1 Customs are hard to change; farmers have to spend time in meeting and discussing alternatives before reaching an agreement. Only under the rare circumstances where transaction costs are low and an old institution’s poor quality, relative to a proposed new one, is accepted by both the public and government does change occur. Even more importantly, such an environment requires perfect commitment among all participating parties. In other words, each party must have an incentive to keep their promise. Institutional design must take into account the reality that participating agents will experience incentives to deviate from the original agreements by creating efficient commitment technologiesor, mechanisms that incentivize promise keepingin order to succeed.

The problem of commitment is fundamental. A second theory suggests that, if the winners cannot credibly commit to compensate the losers after the change, the losers will try to block the change if they have the political power. 2 In other words, once the change has taken place, the winners are tempted to renege on their promises and not pay a penny to the losers. The losers, anticipating this behavior, will block the change in the first place. Hence, we will expect institutional change to happen only when the potential winners have more political power than the potential losers.

There is yet a third theory that can explain institutional change even in the absence of technological or political change.3 In this theory, institutional change might result from an increase in the ability of the potential winners to credibly commit under the reform. Unlike the previous hypothesis, this one does not require a change in the distribution of political power or the distribution of property rights for the change to happen.

Mula, Spain: A case study for water resource institutions

In a recent paper4, I study a historical transition in water management institutions to see the extent to which commitment plays a role in blocking or facilitating reform. In 1242, the Christian Kingdom of Castile signed a peace treaty establishing the peaceful annexation of the Muslim Kingdom of Murcia. However, the Muslim governors of the cities of Mula and Lorca rejected the agreement and rebelled against Castile. The Castilians soon gained control, clearly delineating and respecting property rights and institutions in all populations in the former kingdom except in the two rebel citiesMula and Lorcawhere they expropriated both water and land property rights. Land rights were sold to new settlers from Northern Spain; water rights were used to create a cartel, which sold water periodically through auctions. Mula and Lorca were the only cities that kept the auction mechanism, and they did not change until the 1960s.

The irrigation community in Mula (Spain) switched in 1966 from a market for water to a system of fixed quotas with a ban on trading as a way to allocate the water from the river. As shown in Donna and Espín-Sánchez5, quotas are more efficient than the market in this particular case, but they require an egalitarian distribution of property rights with recipients who can commit towards payment. Because each farmer must own the property rights of his share of water, a transition to this system is challenged by a hold-up problem.F1

Since farmers are penniless, some contract that specifies a future payment must be signed with the former owner of water property rights: sharecropping, debt, etc. Debt contracts are usually used to facilitate these relationships. However, under the debt contract farmers will not work as hard as they should, since most (if not all) the output will go to the lender. Even worse, farmers with large debt burdens will choose to put in little effort since they are likely to believe that they will not be able to repay in the future. The problem is that if the farmers do not work hard enough, they will not produce enough to pay the debt. Yet, lenders will anticipate this and, therefore, not agree to the sale. This institutional inertia for reform is arguably one of the major reasons why the same institution persisted in Mula (and other Spanish cities) for over 700 years. If farmers could commit to work hard after signing the debt contract, then they would have to work hard and re-pay the loan.

These conditions changed in the 1960s when Spain experienced an economic boom and the foreign policy of its government changed through the opening of borders and new trade contracts with the EU and U.S; this led to two main changes in behavior among farmers. First, farmers saved more during the 1950s and 1960s, relative to the prior decades, in order to pay an initial instalment of upfront cash. Second, because of broader environmental changes and improved credit worthiness of farmers, credit lines were relaxed for them. More relaxed credit constraints on farmers means that they have to borrow against less of their future income. Furthermore, greater upfront payment means that there is less of an incentive to default. These factors increased the incentives for farmers to exert effort and payback the loan. For the first time in centuries, the farmers in Mula were able to credibly commit to pay back the loan for the water rights purchase.F2

Policy implications

What can we learn from this example? First, poor farmers cannot make optimal investment/institutional decisions because they cannot credibly commit to payback the “losers” in a reform, even if they are the “winners”. Second, under an inefficient institution, farmers cannot get the savings needed to buy the property rights they need to change the institution. Hence, they could be stuck in a vicious cycle for centuries. Third, one way to break this cyclealbeit with major caveatsis with government intervention through subsidized or guaranteed loans.

Yet, relaxing credit constraints (among other interventions) can have many unintended consequences, demonstrated by government intervention with Fannie Mae and Freddie Mac that propagated the United States housing bubble. If the loans are given to farmers without enough upfront payments, they are likely to face commitment problems whereby they take the loans and fail to implement the agreed upon terms. In these instances, the farmers are unlikely to work hard enough and will instead default, creating a major loss for the taxpayers. For the government policy to work, it needs to be addressed to solvent farmers that only need a little “push” to get out of the vicious cycle, and not as a populist “free credit” measure.

Footnotes:

F1. A hold-up problem characterizes the situation where neither party wants to proceed in fear that they will increase the bargaining power of the other agent in a way that is disadvantageous to them.

F2. Note the difference between liquidity and insolvency. The reason why the market is inefficient is because the farmers might not have cash to pay for the water during a drought, i.e., illiquid. The reason why the farmers were not able to commit to buy the water property rights is because they did not have collateral to use as upfront payment, i.e., they were insolvent. In the 1960s, due to the savings and better credit conditions they were no longer insolvent, but due to the seasonality of farming and the extreme volatility they were still illiquid. The amount of savings they have was about 15% of the value of the water property rights, but the amount of money they would need to buy the water during a drought would be close to 80% of the value of the property rights.

References:

North, Douglas C., and Lance E. Davis. (1971). Institutional Change and American Economic Growth, Cambridge University Press. Acemoglu, Daron. And James A. Robinson. (2008).Persistence of Power, Elites, and Institutions. American Economic Review, Vol. 98, No. 1, pp. 267-293. Grief, Avner. (2006). Institutions and the path to the modern economy: Lessons from Medieva Trade. Cambridge University Press. Espín-Sánchez, Jose-Antonio (2014). .Institutional Change and Institutional Inertia. working paper. Donna, Javier. and Jose-Antonio Espín-Sánchez. (2014). The Illiquidity of Water Markets. working paper.

Jose-Antonio Espin-Sanchez, Ph.D. Economics (Northwestern), is an Assistant Professor at the Department of Economics at Yale, specializing in economic history with a background in economic theory, industrial organization and empirical structural estimation methods. His current work is centered on traditional irrigation communities in Murcia, Spain. Some of the towns in Murcia used auctions to allocate the water from the river while most others allocated the water through fixed quotas. He recovered data from the auction period and used structural estimation techniques to recover the demand parameters. In addition to that he works diverse areas of economic theory such as auction theory, mechanism design, political economy and corporate finance.

The views expressed in this article belong to the individual authors and do not represent the views of the Global Water Forum, the UNESCO Chair in Water Economics and Transboundary Water Governance, UNESCO, the Australian National University, or any of the institutions to which the authors are associated. Please see the Global Water Forum terms and conditions here.