Solomon’s Knot and Gray Markets

by on May 17, 2012 at 7:24 am in Books, Economics, Law | Permalink

Solomon’s Knot: How Law Can End the Poverty of Nations has received less attention than some of other recent big books on development but I found it to be rich in institutional detail, wisdom and practical advice. The authors, Robert
Cooter and Hans-Bernd Schafer, are law professors and as befits their expertise they spend less time on why institutions differ and more on the details of how institutions differ–there is more in Solomon’s Knot, for example, on issues like relational finance, venture capital, joint-stock companies, contract law and bankruptcy law than in other books with a similar theme.

Here is one idea that I had not previously considered, should judges enforce contracts in the gray market?

…businessmen and workers must violate many regulations in order to get things done, especially in poor countries. Thus a builder in Cairo violates building restrictions, a worker and employer in Brazil evade employment taxes, and a manufacturer in Russia runs a factory without a permit to do business.

Throughout the world, much of the economy operates in the “grey market”…a survey of 145 countries estimated that gray
markets activities produce between 30% and 40% of GNP (gross domestic
product). The gray market’s share of total employment is even higher than its
share of GNP.

Judges in many countries will not enforce contracts in the gray market considering them null and void due to the extra-legality. Even when the contracts might be enforced, participants fear that they will be otherwise punished if they make use of the legal system. Cooter and and Schafer argue, however, that such contracts should be enforced and a strict separation be kept between law and regulation. They point to Germany as an example:

…Unlike many developing countries, German legal doctrine and practice avoid this
result. German regulatory violations seldom void contracts, and German
prosecutors seldom act on regulatory violations revealed in a civil trial. Thus a
gardener in the German gray market who does not pay taxes can sue an
employer for unpaid wages without fear of triggering regulatory prosecution.
And a customer who buys a restaurant meal at an hour when law requires the
closing of restaurants still has to pay his credit card bill. The same applies for a
construction contract that violates zoning regulations, or a credit contract that
violates banking regulations. Although seldom discussed in constitutional law,
separating the civil courts from the regulators and police is an important part of
the separation of powers, especially in countries with a large gray market.

The case for separation is strongest for gray markets because the underlying acts are not per se illegal but could the argument be extended even to black markets? Jeff Miron and Miron and Zweibel (JSTOR) argue that one reason that drug prohibition increases violence is that when courts are unavailable, violence becomes the least costly method of dispute resolution. What Cooter and Schafer suggest, however, is that it is at least conceivable to have a situation where the act remains illegal but the actors can resolve disputes in court. Imagine, for example, a drug user taking a dealer to court for cutting the product or a prostitute suing a john for not paying.

It seems naive to expect that we would enforce a rule not to use information from civil court to prosecute illegal behavior. Yet there is a precedent; if a police officer obtains evidence illegally, even without intent, then we throw such evidence out of court. A very strange incentive system. Nevertheless, if we can let murderers go free because the evidence against them was obtained illegally then perhaps we could also let drug dealers bring their contract disputes to court without on that basis prosecuting them for drug dealing.

Addendum: Here is a good interview of Cooter by Nick Schulz and an excerpt from the book.

1 Paul Crowley May 17, 2012 at 8:08 am

I’d guess most of us reading are against drug and prostitution laws anyway; for us a more meaningful example to contemplate might be eg a hitman who takes the money but doesn’t perform the hit.

2 Newt May 17, 2012 at 8:46 am

A lot of civil rights issues exist only because of the war on drugs. Ordinarily, the citizenry would not be so terrified of cameras in public places, GPS or telecom records that investigators can get hold of, and traceable payments.

It’s only because of the craziness of felonies that can send you to prison for years that the majority of the population engages in regularly for at least a part of our lives that makes us paranoid and forces us to resist effective law enforcement measures. We’d all be a lot better off with real criminals subject to the sort of swift capture and punishment that modern technology and methods could deliver. Unfortunately, we cannot avail ourselves of that security as long as it will just be used to put millions of innocent citizens in jail.

Of course, the war on drugs shows no sign of ending. Wise citizens will avoid using it as an example to defend other kinds of criminals, though.

3 Adrian Ratnapala May 17, 2012 at 8:21 am

Hmm, quite a lot of this can be summed up as “Enforce bad laws less often. Especially when it gives you an opportunity to enforce good ones.”

4 Dan1111 May 18, 2012 at 10:17 am

This highlights the paradox of the idea. If you have the ability to reform institutions, then why not just change the bad laws, which would be a far superior solution. It is easy to see that legal enforcement of illegal contracts leads to all sorts of messy questions.

The only way this makes sense is if reforming the courts is easier than reforming the regulations. I don’t know why that would be true.

5 doctorpat May 21, 2012 at 2:24 am

if reforming the courts is easier than reforming the regulations

Might be true, might be the reverse. Naively you’ve got a 50/50 chance of that being true so it’s worth a try.

6 Rahul May 17, 2012 at 8:26 am

Sounds tempting but how do we deal with the moral hazard? Couldn’t people file trivial civil suits merely to gain the accompanying (more valuable) immunity?

7 Slocum May 17, 2012 at 9:24 am

But they wouldn’t gain general immunity, they’d only be protected from being prosecuted using information obtained during the civil suit. At least that’s the theory — does anyone believe that typically aggressive police and prosecutors in the U.S. wouldn’t break the rules, monitor civil courts, and then try to develop the same evidence ‘independently’?

8 (Not That) Bill O'Reilly May 17, 2012 at 11:18 am

There are ways around this (or at least to mitigate), such as making all civil proceedings entirely closed – it doesn’t completely preclude law enforcement from finding the information, but given that a lot of the crimes in question are comparatively minor, it alters the cost-benefit analysis considerably.

There is, however, a similar problem with keeping people quiet. If I hire a prostitute who then tries to sue me, there’s a pretty strong incentive for me to at least threaten to turn over evidence to the cops if she goes forward.

9 Vacslav May 17, 2012 at 8:43 am

Re: drug dealers. Remember this, 2008? “Eliot L. Spitzer (D), struggling to close a $4.4 billion budget gap, has proposed making drug dealers pay tax on their stashes of illegal drugs. The new tax would apply to cocaine, heroin and marijuana, and could be paid with pre-bought “tax stamps” affixed to the bags of dope.”

http://www.washingtonpost.com/wp-dyn/content/article/2008/02/16/AR2008021602198.html

10 Benny Lava May 17, 2012 at 8:53 am

This isn’t a bad idea, but I don’t see it happening. Victims and community activists will put too much pressure on District Attorneys. These are usually political jobs, either elected or appointed. Perhaps that is why we don’t see this in America more? Are German prosecutors political?

11 John Thacker May 17, 2012 at 12:22 pm

Well we do see the exclusionary rule in the USA, which you don’t see it Europe. The explanation I have heard there is that in the USA judges don’t run investigations, so that is the only way for them to enforce rules. European countries with investigatory judges wouldn’t rule their own work inadmissible.

12 ohwilleke May 18, 2012 at 8:36 pm

The beauty of the institutional basis of American criminal justice is that it is so decentralized and locally responsible politically.

The vast majority of law enforcement officers, prosecutors, coroners, jails and trial judges in the United States are either elected to local political office or report to someone who is, and are largely funded at the local level as well. This isn’t a terribly effective way to fight large scale criminal organizations, but the big asset that this structure provides is that it is much more difficult to completely corrupt. A drug gang or organized crime cartel may be able to corrupt a few officials in one jurisdiction, but it is virtually impossible for anyone to control all of the necessary law enforcement officials in an entire state or nation, and very difficult to do so on a sustained basis in an entire metropolitan area.

While “transparent” and clean countries (like Germany) can have very good national or state level law enforcement systems, Latin America and Russia have learned the hard way that a centralized law enforcement regime is also much easier to corruptly influence over national or statewide areas. Countries that have very superficially similar criminal justice institutions (e.g. Spain, Italy, France, Germany, Sweden) have vastly different levels of political motivation in prosecutions. Local institutional culture matters far more than formal institutions in that regard.

13 Steve Sailer May 17, 2012 at 10:12 am

I talked to Hernando De Soto about his ideas once. What I finally figured out is that the problem in Latin America is that the rich own so much land, that if they didn’t let the poor squat on some of it, their servants and peons would have such long commutes that it would be inconvenient for the rich. So, the rich let the poor live near them, but don’t let them have title to the land in case they want it back. So, the poor have a hard time borrowing using the land they live on as capital, since it’s really not owned by them.

It seems to me that formal land reform, such as in Taiwan, is the only solution.

14 Rahul May 17, 2012 at 11:56 am

Isn’t that a transfer-payment? Not via incomes but via actually property-transfers.

It might be the liberal solution but is it consistent with the other Steve-Sailer-ian philosophy?

15 MD May 17, 2012 at 2:12 pm

I don’t know from Steve-Sailer-ian philosophy, but I do know a little about land reform in Japan after the war, where large landowners’ property was broken up and transferred to the people living and working on it. Not only did it appear to improve the lives of the now-property owning-former-peasants, but it did a lot to kill radical, often violent, anti-capitalist movements in Japan.

16 Rahul May 17, 2012 at 2:31 pm

What was the opinion of the large landowners? Was the transfer consensual?

17 MD May 17, 2012 at 2:46 pm

Non-consensual, I suppose, but Japan’s surrender was unconditional.

18 TGGP May 18, 2012 at 12:38 am

Sailer sympathizes with the left in latin america (he thinks P.A.N has stolen at least one presidential election in Mexico, for instance). But he doesn’t want them in America.

19 ohwilleke May 18, 2012 at 8:39 pm

One notable data point: In Singapore, something like 95% of the population live in homes rented from and owned by the government, despite a formally strongly capitalist policy in economics that it presents to the outside world.

20 ohwilleke May 18, 2012 at 8:44 pm

Another few data points. In China now, and historically (but increasingly not so much) in post-war Japan and in Soviet Russia, a large portion of all people lived in employer provided housing effectively creating fiefdoms.

In 19th century Japan one of the main way that land reform was accomplished, by consolidating land ownership and creating a landless class that created an urban manufacturing work force rather than by breaking up big landowneship plots, was to end the traditional sharecropping system with shared risk between farmers and land owners, and to replace it with more conventional mortgage lending. A huge proportion of the former landholding population was dispossessed over a decade or so priming the economy for its precocious rise in manufacturing despite having almost no local natural resources.

21 Norman Pfyster May 17, 2012 at 11:33 am

The premise that a violation of one law means that a person loses the benefit of all laws is rather odd. It’s still illegal to murder a drug dealer. On the other hand, the notion that a contract that is itself illegal (i.e., an agreement to trade a class of drugs whose trade is illegal) won’t be enforced is rather straightforward. The post (but not the article, from the excerpts I read) conflates these two distinct notions.

22 Rahul May 17, 2012 at 11:52 am

I think it is an issue at the interface of law and prosecution. Should a case for violation of one law trigger prosecution for others. I don’t think there are easy solutions; proscecutorial discretion is the best way out. And to a large extent it does work that way: If you complain about an carjacking I don’t think the prosecutors dig up whether you had a valid licence.

23 Norman Pfyster May 17, 2012 at 2:12 pm

The “interface” you are describing is the disincentive of someone who would seek the protection of the law seeking such protection if it exposes them to prosecution for another violation of the law. We all take that chance. Just because a person is an aggrieved party in one suit doesn’t wipe away another violation where that same person is the perpetrator. I see no compelling legal or moral reason to take that stance.

24 Cliff May 17, 2012 at 2:26 pm

It doesn’t seem that the post relates to either of the scenarios you suggest.

25 Robert Speirs May 17, 2012 at 11:39 am

What about civil actions for criminality? Wouldn’t it be possible for a “gray market” employer being sued by a putative employee to open a “civil prosecution” alleging that the employee was also breaking the law? Prosecutions of criminal laws at the instance of civilians are not impossible. Criminal violations are used all the time as evidence in civil suits. Even if such evidence were technically unavailable, wouldn’t any jury be influenced by the obvious illegality of, for instance, a prostitute suing a john or a drug addict suing a drug dealer (or vice versa)?
The civil action against OJ would hardly have been possible if the plaintiffs had to ignore the evidence suggesting criminal behavior.

26 mjw149 May 17, 2012 at 12:36 pm

This is already accomplished in the US due to federalism. I’m not positive it’s such a boon to productivity, at least in the method we employ it.

27 TallDave May 17, 2012 at 12:37 pm

Good points.

28 Ray Lopez May 17, 2012 at 2:13 pm

I’d like to see how the authors treat land reform, like in those countries where the rich were granted lots of land (not unlike in the Old West in the US with the railroad barons). Do you allow adverse possession, and shorten the time needed to squat on land that is not yours, to make it yours, from the standard 20 years to say 5 years? Zimbabweans and others want to know.

29 mulp May 17, 2012 at 9:23 pm

Before they were able to grant the land to the railroads and others including lots of immigrants and displaced and pillage and plunder farmers (slash, burn, deplete soil, move on west, repeat), the government had to allow the rich and powerful to violate the Supreme Law of the Land and steal millions of acres of land, killing the landowners in the process (President Jackson – Indian killer, breaker of treaties, robber baron). One of the first Supreme Court decisions was to rule land transfers by bribe and graft of government officials were legal, circa 1800. The crimes leading to the transfers were acknowledged by the court, but rule of law required the illegal transfers must be honored and those defrauded must accept their loss.

30 ohwilleke May 18, 2012 at 8:27 pm

In places which have had chronic problems with owners effectively failing to put their land to any economic use (e.g. Detroit), property tax lien foreclosures and ordinance violation enforcement, have in the long run proven more useful than adverse possession.

A relevant example of land reform for people in Zimabwe in U.S history involved the breakup of plantation holdings after the U.S. Civil War during the Reconstruction era. Essentially, the regional economic downturn caused by losing the war and the particular bite for plantation owners caused by the end of slavery destroyed the profitability of the plantation system. The people who were working the land before the war as slaves were mostly the same as the people who were working the land after the war, but in the absence of slavery and in the absence of their promised 40 acres and mule, the former slaves became a highly migratory workforce promptly moving on from any plantation owner whose treatment they didn’t appreciate or just moving on to see more of the world.

In this economic environment, the vast majority of plantation holders had to mortgage their land, something they’d never done before to any great extent (mostly the money was lent by merchantile class of general store owners and to Northern carpet bagger lenders), and before long, most of them ended up defaulting and losing their properties in foreclosure sales. Often the cycle repeated several times before stablizing. Within twenty or thirty years the bulk of the plantation owning class was dispossessed. Smaller farms that were under economic pressure tended to produce highly fractionated ownership (this was particularly a problem for newly freed black farmers who’d managed to secure small and often marginal farms for themselves) as layer after layer of descendants held ownership in the land and no one had the legal know how or economic means to consolidate ownership and make the arrangement workable – eventually many of those plots ended up in tenures that gave most of the economic value to small landholders who had resisted the temptation to leverage in the reconstruction era, either via lease or sales or foreclosure. These days most mineral estates end up experiencing the same kind of fractionalization after a couple of generations.

Another example that is playing out as we speak in in Northeastern Indian which is home to what are often inaptly named “Maoist rebels” in a long running, sporadically very deadly insurgency with no hope of securing regime change in India as a whole or even their local states. Essentially this insurgency is really a land reform movement pitting landless peasants against hereditary oligarchs who have large land holdings that they don’t manage well.

What Africa has going against it that the other situations do not is that Africa’s most concentrated land holdings are in place where there is no real alternative pool of people with the experience to run large planation style farms or to convert plantations into smaller scale agricultural operations. Without sufficient expertise, the choices are submission to the more knowledgable oligarches, or ruin. Better institutions to build a class with sufficient expertise within the ranks of the landless masses is really a prerequisite to making any other kind of reform stick without ruining the economy such as it is.

31 ohwilleke May 17, 2012 at 3:24 pm

These issues certainly aren’t absent from U.S. law.

As a Colorado attorney, I routinely represent medical marijuana industry clients in litigation in state courts, despite the fact that the transactions, while not in violation of state law (and indeed comprehensively regulated by state law) are illegal under federal law (although the federal government has stated that it will not prosecute these cases, at least absent special circumstances that have changed from time to time and even though approval can be withdrawn at any time). I have yet to see a court invoke the doctrine of illegality to refuse to rule in a case where there is, at least, purported attempt to comply with state medical marijuana laws.

Note also that this is not really a regulatory v. judicial distinction. Criminal charges are prosecuted in the judicial branch, and usually judges handle both civil and criminal casees during the course of their careers. It is more a matter of being proceeding specific than venue specific.

Lack of regulatory compliance is also relatively rarely invoked as a defense to contract claims; the illegality defense is generally limited to contracts that are not merely voidable or in violation of a law, but actually void. U.S. Fair Labor Standards Act cases have specifically held that the fact that someone is an undocumented alien is not a defense to claims that the act has been violated. Putative marriage doctrines provide relief to people who are unwittingly part of void marriages. Indeed, family law courts routinely refuse to consider allegations of violations of the law by would be parents that don’t have a demonstrable relevance to the legal issues presented to it.

Common law property doctrines also generally address claims of one purported owner relative to another, rather than assigning ownership in an absolute sense, which leaves room for adjudicating title even when someone in the chain of title may have violated a law in the course of obtaining it. Person X has the right to property relative to person Y, but it is often possible that someone not involved in that litigation can come forward and stay that they have a superior claim to the property relative to person X. Every adverse possession case requires an act of trespass that was illegal at the time committed. Statutes of limitations also come into play in easing the tensions. For example, in Colorado, an action to tear down a structure built in violation of the applicable zoning regulations generally must be brought in one year.

Model Rule of Professional Conduct 4.5 (“Threatening Prosecution”) (adopted in some form or an equivalent in almost every jurisdiction in the U.S.) specifically prohibits lawyers from threatening “criminal, administrative or disciplinary charges to obtain an advantage in a civil matter” and presenting or participating in presenting “criminal, administrative, or disciplinary charges solely to obtain an advantage in a civil matter”, although simply bringing such charges at the same time that civil matter is pending without a nexus to the civil action is not prohibited, and the reverse (requiring restitution equivalent to a civil money judgment as part of a criminal, administrative or disciplinary charge) is routine.

“prostitute suing a john or a drug addict suing a drug dealer” – Court probably wouldn’t enter a judgment on either claim on a sale of sex contract or sale of drugs contract theory. But, there is more willingness to overlook the illegality of the underlying contractually rooted relationship in the case of tort claims. A prostitute suing a for conversion or battery because john stole her jewelry, or beat her up causing serious bodily injury for which she incurred medical costs, or a drug addict suing a drug dealer for intentionally or negligently giving the addict poison instead of a drug (particularly in wrongful death case by next of kin) would have a decent chance of being heard in a U.S. civil court. Qui tam actions are private civil actions for tax fraud or regulatory violations.

32 Ray Lopez May 17, 2012 at 7:05 pm

“Model Rule of Professional Conduct 4.5 (“Threatening Prosecution”) (adopted in some form or an equivalent in almost every jurisdiction in the U.S.) specifically prohibits lawyers from threatening “criminal, administrative or disciplinary charges to obtain an advantage in a civil matter” ” – toothless. Nobody has ever had their wrist slapped over this, since it’s so broad as to be meaningless. Is a threat the mere mention of the proscribed event? And what are the sanctions? Typical legal style over substance.

33 ohwilleke May 18, 2012 at 8:02 pm

To the contrary, Model Rule 4.5 profoundly influences the daily practice life of attorneys and a lawyer disregards it as his peril because it is one of the few ethical rules that an adversary is frequently in a position to invoke. I am aware of cases of people being sanctioned for violating it. The boundaries of what does and does not constitute a threat are slippery and subtle. There is certainly some degree of implying without making threats, but a violation is not something to be dismissed lightly and typically only rookie attorneys are cavalier about it. I personally probably give serious consideration and analysis to some Rule 4.5 issues at least once a month and have for my entire careers in a wide variety of practice settings.

Sanctions can range from a mere private admonition to suspension or disbarment, although a public admonition or brief suspension would be more typical. A suspension means giving up your livelihood for the duration, and even a public admonition destroys your shot at any top job in the profession afterwards and drives up your malpractice insurance policy rates and reduces your credibility generally, so it is not a sanction without consequences.

Also, judges routinely frown an arguments presented to them that attempt to make such threats.

34 mulp May 17, 2012 at 9:30 pm

Obama said he would prosecute personal medical pot use, which does not give the medical pot industry a pass.

Raich wouldn’t have reached the Supreme Court under Obama, which would have been perhaps good for the pot industry – SCOTUS would have been deciding on the liberty of corporations growing pot to bypass the FDA restrictions on drug regulation, which would have perhaps convinced more conservatives to legalize all drugs, a la Citizens United.

😉

35 ohwilleke May 18, 2012 at 8:05 pm

“Obama . . . does not give the medical pot industry a pass.”

Actions speak louder than words, and until a few months ago, the actions did give the medical pot industry a pass. Even now, federal enforcement in Colorado has been highly targeted, selective, and has not produced any actual court room litigation.

36 ohwilleke May 17, 2012 at 4:14 pm

One more point re: “Jeff Miron and Miron and Zweibel (JSTOR) argue that one reason that drug prohibition increases violence is that when courts are unavailable, violence becomes the least costly method of dispute resolution.”

In practice, in the United States today, there is a threshold somewhere in the low five figures at which the cost of resolving disputes through the courts exceeds the likely return in all but the very most simple contract disputes (e.g. cases other than unpaid vendor-purchaser deals with no dispute as to the quality of the goods or services provided and complicating additional transactions between the parties, promissory note collection, evictions for non-payment of rent), and using courts to resolve smaller disputes really only makes sense when the Plaintiff has a strategic interest in establishing a reputation for contract enforcement in these cases rather than merely an interest in getting that right resolution of that particular case.

In other words, in the vast majority of bona fide contact and non-personal injury tort and personal property disputes, the courts are de facto unavailable because they are impracticable remedies because they are so costly. Even commercial financial creditors actually sue to enforce bad debts in only the minority of cases where they believe that the debtor has a meaningful ability to pay via financial assets, real estate or employment. For example, in all of Arapahoe County, pop. ca. 500,000, there is on average just one instance of judicial enforcement of a general money judgment (as opposed to a security interest) against personal property every year. If the availability of court relief made a difference, it would be due to the “shadow of the law” impact that repeat players who litigate strategically to enforce their negotiating power derive from it, and not due to transaction by transaction litigation logic.

Academics generally are also mostly wrong about the main business of the courts being “dispute resolution”, particularly in the kinds of cases that make up most of the docket in limited jurisdiction courts, but really in most civil actions generally. The main business of the courts is legal right enforcement, not dispute resolution. A huge percentage of all civil cases go straight from complaint to judgment without any adjudication of dispuate concerning the merits in between, and systems of contract enforcement where enforcement is possible without full fledged litigation in a court (e.g. non-judicial foreclosures of mortgages and non-judicial seizures of property under the Uniform Commercial Code) manage to be surprisingly functional despite the absence of a dispute resolution phase of the process (other than after the fact collateral attacks on self-help remedies) entirely. Most defendants in debt collection case (which make up the lion’s share of civil litigation cases) default anyway, and most of those defendants default because they have no bona fide defense (although certainly some default for other reasons).

37 Jason May 17, 2012 at 8:32 pm

Very interesting!

38 mulp May 17, 2012 at 9:46 pm

How does this apply to Greece after it is forced “out of the Euro”?

What does rule of law do with:
1. existing contracts in Euros involving a Greek and a non-Greek
2. existing contracts in Euros between Greeks
3. existing contracts in Euros between a Greek and a non-Greek serviced by a Greek
4. existing contracts in Euros between Greeks serviced by a non-Greek
5. new contracts within Greece with payments in Euros
6. new contracts outside of Greece through an intermediary between two Greeks

Answer the above for a Greek court, then for a German court.

No one is going to do business in drachma except as a last resort because the drachma will constantly be falling in value relative to the Euro, and no one in Greece can survive long without buying things from outside Greece in Euros or dollars.

Or would Greeks switch from Euros to dollars in their efforts to flee drachmas.

FDR/Congress modified contracts in violation of the Constitution, but the dollar by 1932 was as powerful as the Euro is today. Did the Supreme Court ratify the gray laws of Congress for the greater good of rule of law? Did SCOTUS ratify the abrogation on contracts on the basis the dollar was so strong, while imposing conversion of Euro to drachma will never be accepted?

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