1st Prize in VSP 2023: The Rule of Law. Its Meaning and Purpose.

Where does Friedrich Hayek fit in contract theory?

Babatunde Valentine Onabajo

ABSTRACT

This paper examines the views of the 20^th century Austrian economist and political scientist Friedrich Hayek within the context of contract theory. Contract theory is the branch of economics that studies contracts, particularly their design and application. Contract theory falls within the broader category of economics known as “law and economics”, which is the field that studies the relationship between the two categories. As far as contract theory is concerned, Hayek is seldom mentioned, despite his influence in explaining why market economies are superior to centrally planned economies in determining prices and allocating scarce resources. This is unusual because without contracts, the market system would not exist, and therefore their study is warranted. This paper examines various aspects of Hayek’s work and his relationship with contract theory. After explaining what is contract theory and the importance of spontaneous order according to Hayek, the next section examines the importance and role of a judicial system in a market economy as Hayek sees it. After this it will proceed to elaborate on what Hayek calls a “Rule of Law”, which is a constraint that limits a government according to a set of rules and prevents it from infringing upon the ability of individuals to interact freely. It will then conclude. It is hoped that this paper successfully outlines Hayek’s position within the field of contract theory.

Introduction

At times, economists have explicitly recognised the importance of laws and a legal framework with regards to economic activity. Adam Smith, the famed 18^th century Scottish moral philosopher who is regularly regarded as founding the modern discipline of economics[1], once remarked that: “If there is any society among robbers and murderers, they must, at least according to the trite observation, abstain from robbing and murdering one another”. Smith went on to add that, “Beneficence, therefore, is less essential to the existence of society than justice. Society may subsist, though not in the most comfortable state, without beneficence; but the prevalence of injustice must utterly destroy it”. Centuries later, Milton Friedman, arguably one of the most well-known economists to emerge from the University of Chicago, echoed similar sentiments in observing why privatisation seemed to not work in the Soviet Republic: “It turns out that the rule of law is probably more basic than privatisation. Privatisation is meaningless if you don’t have the rule of law”. In more recent times, the development economist Hernando de Soto argued that capitalism has worked in the Western world compared to other regions of the world such as Latin America because of the legal framework which recognises private property (Soto, 2006).

However, the aforementioned observations are, for the most part, exceptions to the norm. Economists have generally not focused on the existence of laws or the legal framework and usually take it as a given. Economists, particularly of the neoclassical[2] hue, are more concerned with the price and quantity of a given good or service with regards to microeconomics, and the general price level and Gross Domestic Product (GDP) with regards to macroeconomics. But this misses out a significant part of economic life, such as parties reneging on a contract, dispute resolution and even what incentivises a person to agree to a contract in the first place.

Contract theory, the branch of economics that studies the use, design, application and consequences of contracts, emerged primarily in the 1970s to explain some of the shortcomings of the standard economic paradigm that was mostly concerned with price and quantity. The first is that the standard paradigm could not explain why resources are even chosen to be allocated by the market mechanism in the first place, which is an institutional entity. Similarly, the standard paradigm did not consider that there are also costs to operate said market; the market does not operate on thin air. Furthermore, the standard paradigm could not explain the fact that market participants also trade in a bilateral manner even away from the “market equilibrium”, which is defined as where the supply curve and the demand curve meet.

It would not be accurate to think of contract theory as one homogenous lump. In reality, it could be said that there are three broad strands of contract theory, and these strands may be said to exist due to the fact that there are different justifications given for the existence of private property[3]. These strands are usually given as follows: incentive theory, incomplete-contract theory and transaction-costs theory. Incentive theory is somewhat similar to the standard economic paradigm, namely neoclassical economics, in its view that market participants have complete and perfect information as well as a complete and ordered preference set. Where incentive theory differs from the standard neoclassical school of thought is that the contracting parties do not have access to the same information in relation to some variables, such as the innate and hidden preferences of the other contracting party. In the literature, this gives rise to either of two problems, namely, adverse selection[4] or moral hazard[5], and the job of the underinformed party is to create a mechanism in which either hidden-yet-relevant information is disclosed to him or her to ensure the optimality of the transaction, or alternatively, to create a mechanism to ensure the behaviour of the other party is compatible with the preferences of the underinformed party. Incomplete contract theory is not as developed as incentive theory (Brousseau, E. and Glachant, J.-M., 2002). Incomplete contract theory, like incentive theory, is somewhat similar to the standard economic paradigm but a key feature of incomplete contract theory is that, in the event of dispute resolution, a judge adjudicating over a contract is unable to account for some relevant feature of the contract. Parties that anticipate this are less inclined to want to commit to the contract, giving rise to what is known as the “hold-up problem”. The final strand of contract theory – namely, transaction-costs theory – may be said to be the most far-removed from the standard economic paradigm. With the transaction-costs theory, parties to a contract have bounded rationality, that is to say, they act on limited information and may be susceptible to decision-making flaws explored in literature elsewhere like behavioural economics such as low attention spans. What is more, when it comes to adjudicating a contract, even judges or other third-parties operate on limited information. In transaction-costs theory, contracts extensively rely on default clauses as a way of navigating through uncertainty and contracts, especially those over a long time-period, are typically renegotiated to ensure that preferences are aligned in the context of new economic and social circumstances. Of the three strands of contract theory, Friedrich Hayek’s views may be said to be closest to the transaction-costs theory, as will be explained below.

What is contract theory, and why is it important?

In the information world we live in, many of us have no doubt faced the experience at one point or another of being shown a very long “Terms and Conditions” or “End User Licence Agreement” (EULA) which we must agree to prior to being allowed to install a piece of software. Unknowingly, this is also our first foray into contract theory. Contract theory is the discipline of economics that studies contracts. Whilst lawyers typically define contracts as the “meeting of minds creating effects in law”, an economic view of contracts is slightly broader and looks at how two or more parties make an agreement and commit to some kind of behaviour. In the literature, contracts are usually categorised into two forms: complete contracts and incomplete contracts. Complete contracts are contracts that are an agreement between two or more parties as mentioned previously but can account for every future possible contingency. Incomplete contracts, on the other hand, are contracts that fail to account for every possible future contingency. It is largely recognised, and seems uncontroversial to state, that complete contracts are mostly a theoretical fantasy: either the length of time required to create them, or the requisite knowledge imposed on parties needed to consent to the contract, or alternatively the time needed to review them in the bargaining process, are extensive which is why they are seldom if ever seen in reality. In practice, most contracts are what economists would call “incomplete contracts”, and economists in the field have focused on the outcomes that result from the information asymmetries between the parties to the contract.

The history of contract theory is usually said to have begun with the new institutional economist Ronald Coase and his 1937 paper “The Nature of the Firm” (Coase, 1937). In this paper, Coase examined why firms seemed to emerge in specialised economies, and looked at why it seemed to be the case that whilst resources in a market are allocated by the price mechanism, the structure of firms is not determined by a price mechanism but rather by the decision of an entrepreneur, representing a stark contradiction. One of the implications of Coase’s work, sometimes dubbed the “Coase theorem”, is that in a world of zero or minimal transaction costs[6] Most accounts of the history of contract theory then proceed through to the 1970s, with names such as Oliver Williamson.

It would be a mistake to think however that the ability to contract was recognised only by Coase. Among one of the most famous words by Adam Smith in his book The Wealth of Nations is that, “Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal by its gestures and natural cries signify to another, this is mine, that yours; I am willing to give this for that”, highlighting that Smith saw the ability to contract as a uniquely or almost uniquely human activity. Furthermore, and as rightly observed by Brousseau and Glachant (2002), “The notion of the contract is simultaneously broader in scope and more general than the notion of the market”. By this it is meant that contract theory enables us to analyse institutions arguably older than modern-day capitalism, such as marriage, which is viewed as a contract in some communities[7]. Similarly, it has far-reaching implications with regards to the scope of government influence in our lives: whereas economists are typically concerned with the extent to which a government intervention affects a market, contract theory broadens this purview slightly more and enables us to consider issues not usually seen as economic such as home-schooling and no-fault divorce.

Contract theory is mostly concerned with private goods. Private goods typically have the characteristics of being excludable (that is, one can exclude others from consuming it, usually by requesting payment) as well as being rivalrous (that is, the consumption of a good by one person typically prevents someone else from consuming that same good).

Contract theory is important because the ability to formulate contracts is central to a liberal social order (Hayek, 1976). It touches upon various aspects of society. Firstly, it touches upon our human dignity: the ability to say “yes” or “no” is indispensable with our humanity. Secondly, it is important because the formulation of a contract is an expression of our own incentives: as rightly outlined by Ghestin in Brousseau, E. and Glachant, J.-M., (2002), citing Gounot (1912), “No seller would willingly surrender his good, no lender his money, no landlord would allow the use of his property and no individual would perform any service if the judicial principle of obligation did not guarantee them a return of the expected and promised equivalent value”. Thirdly, the formulation of contracts is far superior to a society where resources are taken simply through violence or “might makes right”, a point highlighted by Drobak and North in Backhaus (2002): “Economic growth also depends upon a criminal law that provides for security of both people and property. It is extremely difficult, perhaps impossible, for a sustained economic growth to occur in countries where extortion, theft and other violent crimes undermine market transactions”.

The centrality of contracts to a liberal social order means that a society must be arranged in such a way that contracts are respected and upheld[8]. Contracts can be upheld through a variety of mechanisms, such as within the contractual arrangement itself otherwise known as a “self-enforcing agreement”[9], through the courts, through a mediator or arbitration mechanism, or through some other way. Where contracts are enforced through the courts, typically this is done through force. This force is typically justified on the basis of having been approved by a government, meaning that a government has effectively a monopoly on force. This monopoly on force, however, imposes upon a government the need to act within certain constraints lest it commit the same things it is supposed to prevent. It should be noted that whilst much of the literature in liberalism has been focused on a government going beyond its remit, such as burdening the population with heavy taxes, printing money to such an extent people experience substantial losses due to inflation as well as the government misappropriating funds, a government can also fail by simply failing to act to uphold the law: at the time of writing, this is seen in a number of countries, such as the United Kingdom and the United States, where shoplifting is not tackled or addressed, leaving business owners to have to fend for themselves. Similarly, slow court processes where self-enforcement mechanisms are not possible in a contractual arrangement can also be seen as a situation where a government is not respecting a rule of law.

The importance of spontaneous order in Hayek’s worldview

The concept of “spontaneous order” as elucidated by Friedrich Hayek is, in some respects, similar to the metaphor as it is remembered today of the “invisible hand” by Adam Smith: society is a complex organism that was not deliberately designed by any one mind. Rather, people interact with the limited knowledge that they have, dispersed across all over society, from the highest person to the lowest. The price mechanism is the best way of allocating scarce resources because it is through the price mechanism that people can instantaneously gauge whether a particular resource is in high demand or low demand or in high supply or low supply (Hayek, 1945). This is in contrast to a society that is organised by a central planner, which would quickly become overwhelmed with the different conditions, needs and wants of various people in society.

The role of the judicial system in the market economy and with respect to contracts

The above is the standard interpretation of Hayek’s spontaneous order. However, whilst considerable attention has been paid to the relationship of spontaneous order and the price mechanism, less attention has been paid to spontaneous order and the judicial system. It is precisely here where Hayek fits with regards to contract theory. In Hayek’s view, people are not the automatons as typically depicted in standard economics paradigms. People act according to prevailing norms and custom, with the limited knowledge and information they have, and over time these become more developed and refined. “Complete contracts”, as far as Hayek is concerned, is impossible or impractical. Similar to the assumptions made by theorists in the transactions costs field, Hayek maintains that judges operate on this limited information as well in adjudicating over disputes. However, the role of the judicial system is to ensure that it can be largely (although, for reasons that will shortly be made clear) consistent. This ensures that parties can form expectations about a contract without having to anticipate or worry about arbitrariness with regards to the legal system. At the same time, Hayek perfectly accepts that judges and the judicial system make mistakes, or that they sometimes encounter novel situations. Whereas other schools of economic thought see this as a suboptimality, for Hayek this is one of the features of spontaneous order and it ensures that societies can advance and grow. It is one reason why advanced societies have come to form a separation of powers, such that the judiciary is completely independent from the executive branch (as is the case in the United Kingdom), meaning that people’s rights are more easily respected and contracts can be more easily entered into. The separation of powers is also a protection against corruption, preventing those with high political office from manipulating the judicial process in their favour. For similar reasons, it is also why in advanced economies, there is also the scope to challenge or appeal a judicial decision of a lower court. In the United Kingdom, it is not uncommon for the Supreme Court to directly strike down actions made by a government, which ensures that people’s liberty is protected.

Hayek’s The Rule of Law and its relevance to contracts

Hayek’s The Rule of Law is a meta-legal doctrine that stems largely from his book, The Constitution of Liberty. In this book, Hayek looked at a number of issues relevant to the time period he lived in, such as labour unions, housing and the welfare state. The Rule of Law enables us to judge any particular set of laws without becoming overly-concerned with its precise content. Hayek proposed that the “task of stating the general rules of just conduct, the rules of action that are followed only to preserve the social order and not to achieve specific targets, would be entrusted to a legislative assembly, the composition of which is different from the governmental assembly entrusted with the task of government” (Backhaus, 2002). Further, the “coercive powers of the latter assembly would be limited by the rules of justice laid down by the first” (Backhaus, 2002). This would achieve achieve a separation of powers.

In practice, there is an argument to be made that this is already seen in some situations. For example, in several contractual agreements in the United Kingdom, parties to a contract are typically advised to go before a mediator or to arbitrate before undertaking any kind of legal action in the court. There are several standards by which behaviour is judged, such as the “Pre-Action Conduct for Litigation”, which dissuades parties from using the court system as the first means of resolving disputes, thereby ensuring efficiency and preventing resources that would be better used elsewhere from being spent on litigation. As far as the government is concerned, the “House of Lords” in the United Kingdom acts as a check on the desires of the “House of Commons”, and there have been several instances in recent history whereby people’s rights have been respected simply because of this constraint. Finally, the independence of a central bank can also be seen as falling within this paradigm: in the United Kingdom, the central bank is largely independent from the wishes of the government. This means that it cannot print money at will and debase the currency, which has the impact of affecting contracts as they are ordinarily negotiated in nominal as opposed to real terms. This is further underscored by the central bank conforming to clear inflation targets as well as a need to manage expectations. Whilst those in advanced economies such as the United Kingdom and the United States take the independence of a central bank for granted, there are many places in the world that are not fortunate to have this in their society, such as Latin America.

Conclusion

Friedrich Hayek was immensely influential in economics for explicating the importance of the price mechanism and spontaneous order in allocating scarce resources against competing needs and wants compared to that of a central planner. However, the utility of Hayek’s views rest not just in economics, narrowly defined, but also the legal system as well. Hayek therefore has a firm footing in contract theory, and his concept of Rule of Law is important in understanding why people will feel confident in entering into a contract when the institutional support is there to support them.

Babatunde Valentine Onabajo is a graduate of King’s College, London & Cardiff University. As Director of ChurchMapped Limited, a travel website and social network he is specialising in the heritage of churches around the world.

References

Backhaus, J.G. (2002) The Elgar Companion to Law and Economics. Cheltenham: Edward Elgar.

Brousseau, E. and Glachant, J.-M. (2002) The economics of contracts theory and applications. Cambridge: Cambridge University Press.

Coase, R. H. (1937). “The Nature of the Firm”, Economica NS, 4: 386-405, reprinted in O.E. Williamson and S. Winter (eds.), The Nature of the Firm: Origins, Evolution, Development, New York, Oxford University Press (1991): 18-33

Gounot, E. (1912). Le Principe de l’Autonomie de la Volonté, thesis, University of Paris: 358-9

Secrets and agents (2016) The Economist. Available at: https://www.economist.com/schools-brief/2016/07/22/secrets-and-agents (Accessed: 01 December 2023).

Hayek, F. (1945). “The Use of Knowledge in Society”, American Economic Review, 35: 519-30.

Hayek, F. (1976). Law, Legislation and Liberty, 3, “The Political Order of a Free People”, London, Routledge & Kegan Paul.

Soto, H. de (2006) The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. New York, NY: Basic Books.

[1] Adam Smith is generally regarded as falling within the classical school of economics.

[2] Neoclassical economics is the successor of classical economics and the predominant economic worldview as at the time of writing in many areas in the world. It is typified by the view of consumers and firms acting according to budget constraints in order to maximise utility (or, alternatively, to minimise costs), and this is usually represented in the form of supply and demand. Neoclassical economics generally asserts in complete and perfect information in the marketplace and that the market mechanism operates smoothly in allocating resources to competing needs and wants.

[3] Various thinkers give different justifications for why private property exists. Some thinkers point to it as inalienable right, either due to one’s status as a human being or from God. Others point to scarcity in the world we live in. And still more others point to transaction costs.

[4] Adverse selection describes the situation, underpinned by asymmetric information, in which the party that has more information is able to exploit this to the detriment of the other party. It is usually an ex ante situation, such as in the case of insurance: those who are risk-takers are more likely to buy car insurance, without the insurer knowing about this elevated risk.

[5] Moral hazard describes the situation, again also underpinned by asymmetric information, in which the party that has more information is able to exploit this to the detriment of the other party. It is usually an ex post situation, such as, again, with insurance: the fact that one has insurance can induce a party to take on more risk than otherwise would be the case if they were not insured.

[6] As rightly explained by Parisi in Backhaus (2002), the distinction between minimal and no transaction costs tends to be treated identically as far as the Coase theorem goes.

[7] In Roman Catholicism, marriage is seen as a contract.

[8] Brousseau, E. and Glachant, J.-M. (2002)

[9] This was excellently explained by Klein in Brousseau, E. and Glachant, J.-M. (2002): “Transactors can freely avoid the costs associated with complete contractual specification because they have available a self-enforcement mechanism to assure performance. Rather than court enforcement of written contract terms, a self-enforcement mechanism operates by threatening termination of the business relationship for non-performance of the unwritten contractual understanding”.