The State as an Organization: Part II

by Michael S. Rozeff
by Michael S. Rozeff

Part I pointed out that shareholders (principals) in a business corporation bear risk and delegate decision-making to managers (agents) via contractual arrangements. This causes a layer of agency costs. Consider the idea of a "contractual" state along the same lines as a shareholder-owned corporation. The idea is that the taxpayers own the state and they hire the government to produce things like defense. The state specializes in law, justice, and military matters, for example, while the taxpayers supply the capital. The taxpayers are principals. Government employees and officials are their agents.

Although this is not how real states come into being, not why they come into being, and not how they operate once they exist, the contractual state is close to John Locke's idea of a social contract. And the contractual state or something like it is one of the foundations of the classic liberal view that such a state is preferable to monarchy or tyranny, the idea being that the principals control their agents in various ways such as by Constitutions and voting. Even if the contractual state is largely inapplicable to actual states, it gives us a way of understanding why states do not work out as well as the classic liberals theorized they would.

Control of agency costs

The fact that citizens and taxpayers bear the agency costs of supplying capital, might be, from their standpoint, a fatal flaw in having a state. They rationally would not agree to such an arrangement, if asked, unless they thought these costs would be low or controllable, or thought that the state would produce offsetting benefits. The state does not ask them these questions. It does not put its existence up for vote. Social contract theory argues that, because we observe states, citizens view the benefits as exceeding the costs; but as just pointed out, they are actually given no way to express their preferences by an up or down vote. Despite this, suppose we stipulate that many citizens do believe the benefits exceed the costs. But immediately we may answer that many also do not, and they have no place to go. And there is no justification for forcing those who do not value the state to remain under its control. Furthermore, even those who support the state are possibly mistaken. People believed once that burning witches would alleviate various diseases and eventually learned that there were better methods.

To help understand why the state is a fatally flawed institution and why it is an error to support it, we can use the agency cost apparatus to clarify this basic issue of citizen control over the state which is used to defend the state's existence. We can pinpoint institutional deficiencies in the taxpayer/state nexus that tell us that the agency costs are neither low nor controllable.

Free markets have encouraged a bevy of institutions that help lower agency costs in firms. Since the state allows no competition for itself, analogous methods to mitigate the state's agency costs are either absent or less effective. I will compare these control devices one by one.

(1) The product market. If a firm's prices are too high or product quality too low, consumers exit their exchanges with the firm. They lower their purchases. No comparable sanction against the state exists. Voters cannot exit the state or its products without incurring high costs. (At best, they can vote in new leaders.) Not exiting, which is called tacit consent, is a false doctrine devised to cover up a big fault in the idea that states actually exist because of a social contract. The doctrine that voters tacitly consent makes it seem that there exists a political product market mechanism to control agency costs. In fact, this sanction is not available to the vast majority.

(2) The takeover market. A badly run company sees its stock value decline. The company becomes vulnerable to takeover, and takeovers often result in new management. The costs of takeover are not excessive. Shareholders have to amass enough stock to gain control, but if there are gains to be made the financing can be found. Markets work to exploit profit opportunities. The takeover market is a sensitive and continuously operating sanction that operates peacefully and effectively. No comparable low-cost sanction against the state exists. Instead, the takeover alternatives are typically costly. Groups sometimes plan and plot for years on end while citizens suffer for decades. They foment rebellions and discontent, and they often fail because the state can mobilize large resources. Sometimes change occurs through violent invasion by a foreign force or revolution at home. Not all states fall violently, however. The Communist states fell with relatively little bloodshed, but only after many decades of Communist rule.

(3) The financial market. Investors raise capital costs for firms with high agency costs. They demand higher returns. Companies that mismanage face capital constraints. States face financial sanctions too, but the stronger ones circumvent it by taxation and inflation. For states with strong tax collectors, financial markets pose little or no problem. The range of misbehavior of states is far less constrained than that of a company in a free market.

(4) Decision control. Bond covenants, bank lending agreements, and corporate charters all impose highly specific conditions on management decisions. This is done to lower agency costs, or prevent the managers from making decisions that are not in the best interests of the principals that are putting up the capital. States, or at least the U.S., face this control in the form of enumerated powers. Custom can serve the same purpose. Limiting state powers is clearly a nice-sounding idea to make a contractual state work. Other attempts are an independent judiciary and separation of powers. These are attempts to have one arm of the state have a veto over what another arm of the state rules. They have failed for a variety of reasons. They fail when states circumvent the limitation on powers by interpreting its powers themselves. They fail because all arms of the state are still part of the state. They fail because the branch with the spending power has an advantage, and/or because the branch that executes policies has an advantage. But the main reason they fail, in my view, is that the power of the state is so great. This power gives rise to tempting opportunities to gain power and wealth. Clever men find ways to offer inducements and deals, to blackmail opponents, to threaten sanctions against others, and to logroll votes, etc. They use their wiles and their power within the state to overcome the checks and balances and consolidate power among a smaller group of men who take over the state.

(5) Bonding. Companies that pay dividends or pay interest on debt lower their agency costs by subjecting themselves to market financial discipline. States do not pay dividends. They do pay interest, but they avoid discipline via taxes and inflation.

(6) Monitoring. Companies can lower agency costs by allowing monitoring of management behavior, by hiring auditors, and by providing accurate information. They have an incentive to provide information so as to lower their costs of capital. As part of this process, security analysts and credit raters monitor companies. States do not have an incentive to monitor because they shift the agency costs to the taxpayers. Much less of what states do is out in the open. Certainly the Freedom of Information Act is a plus for citizens, but the agencies of government have ways to subvert it by delaying tactics, stonewalling, losing information, exemptions, bungling, and charging fees to search files. We do have citizen watchdog groups. The press is our equivalent of security analysts, but its interests in getting stories quite often coincide with the officials who supply the stories. Since the state harms a great many people, its incentive is to hide as much information as it can, misinform, and understate costs and overstate benefits.

(7) The stock market. Shareholders see the stock price, a definite although noisy indicator of value. Shareholders can compare their stock's values to those of other stocks. Taxpayers and citizens have a much harder time discerning the state's effect on their wealth and well-being than stockholders have in discerning the effects of management actions. They face greater noise. They do not see all their taxes, they do not know how their well-being is affected by the state's many complex actions, and they lack standards of comparisons. When they do have standards, as among the 50 states, they do monitor and they migrate to states they prefer.

(8) Shareholder activism. Major shareholders engage in proxy battles, seek seats on boards, place proposals on ballots, and pressure managers. These methods work best when the shareholders own large blocks of stock. We do have taxpayer activists, but they have a hard time fighting better-financed special interests. The big-block holders in the political market are those with lots of influence. They have an incentive to join the state rather than fighting it.

(9) The labor market. The Board of Directors fires many top managers who are performing badly. These face a stringent labor market sanction. They often have trouble getting another comparable job. In the same way, voters can remove politicians from office. This method of control might work if the powers of the state were few in number and strictly limited and if those with a direct interest in the application of those powers had the vote and not others who did not. However, all modern states have expanded the powers of the state to interfere in the economy in multiple ways and they have extended the franchise to almost anyone. Voting's purpose becomes to control the state and shift the costs to others while securing benefits for oneself. The result is that elected officials have discovered ways to keep themselves in office almost indefinitely.

There are many problems with voting as a means of controlling the people's agents, despite the superficial appearance that it should. No voter can keep track of all the issues that an elected official will vote on or believe that his vote matters on any given issue. The result is uninformed voting. Then the opposing political slates are able to provide misinformation without much check on it. In the U.S., the two major parties control campaign spending, debates, and ballot access. They collude to squeeze out competition. Voters do not elect the Supreme Court. The state's powers have grown dramatically, and the Supreme Court approved the increases. No Justice has ever been removed from office by impeachment. The ability of we the principals to control these judicial agents is nil.

In the contractual state, the voters and various institutional measures in the Constitution are supposed to control agency costs. They don't for four basic reasons. (1) Part I pointed out that the state shifts agency costs back to citizens via its power and its ability to extract capital by force. (2) Above, I emphasized the many institutional deficiencies in citizen control over their agents in the state and thus over the state's agency costs. There are two more yet to be discussed. In the rest of this article I discuss (3): The state has an incentive to destroy whatever institutions exist to control its behavior and agency costs. Free market agents have the opposite incentive because they bear the agency costs. In the final installment, I discuss (4): The state levers its position of power by exploiting the natural weaknesses of people at large.

The spectrum of agency costs

Difficult as it may be to define society, a society is not a state. Logically and historically, society precedes the state. All sorts of institutions of governance arise from society, from judges to chieftains to states. No matter what they are, natural laws and customs are the typical foundations of justice. It may be that a subset of society creates the state for its own purposes, in which case the state's aim is to control the rest of society. In this case, the state is not contractual although it may be given that appearance.

Imagine a society that has no single governance organization. Its members might turn in one direction for judgments over marriages, in another for judgments about land disputes, in yet another for mercantile disputes, etc. And there may be several alternatives in each case. Such a society has decentralized governance with private justice and private enforcement of judgments. Since the users of justice services choose their providers, agency costs do not fall upon taxpayers or citizens in general. Instead they fall on demanders of capital, that is, the businesses or the groups that use capital in order to supply these services. Competition and the various monitoring mechanisms of free markets then hold these costs in check. In this example of market anarchism, which is simply free markets extended to all those services currently provided by the state, the incentives encourage lower agency costs. If every good and service is provided in the free market, agency costs are as low as they can possibly be. Any business that tries to coerce buyers loses customers. Its capital suppliers raise its cost of capital because agency costs are higher as the business managers lose market share. The business is caused to cut back because of stringency in both the product and financial markets.

A society with free markets for all goods and no state lies at one end of the political spectrum. At the other are the varieties of totalitarian states in which most free markets are either eliminated or dominated by the state. Without free markets, the totalitarian states extract capital and produce whatever they want. In contractual terms, the principals (the citizens) have no say over what their agents (the rulers) do. Agency costs are maximized. Any real state logically lies along a continuum that is bounded by these two extremes, market anarchism and the totalitarian state. At one end are relatively low agency costs with well-functioning institutions that keep them low. At the other end are very high agency costs with highly inadequate agency cost controls. The citizens are not entirely without resources even in the totalitarian situation. They can bribe officials, resort to black markets, assassinate leaders, etc., but their costs are far higher than if there were free markets. Real-world states lie between these two ends of the political spectrum.

States are organizations whose composition, aims and methods depend on the institutions the society uses to control agency costs. The classical liberal vision was of a contractual state cleverly arranged so as to keep agency costs low. The ideal contractual state is an organization that, like a corporation, is owned by its principals, who are the citizens. Commissioned by them, the state's aims are to dispense law and justice which includes protecting the resources or property of its owners. Such a state defends its owners against predation, internal and external. Imagine a case where the agency costs are low and the control structures work well. Perhaps the state has a monopoly on legal coercion that has a two-year sunset provision or all laws lapse unless 3/4 of voters re-approve them. In this case, the voters are in the state and most of them expect to receive net benefits. This is a watchman state, a minimum contractual state.

With weaker controls over agency costs, we observe instead varieties of the predatory state. Here the state moves toward becoming an autonomous organization, more like a company owned and operated by one person or a small group of persons but without outside stockholders. Its residual claimants are its members. They are the owners. Citizens do not own the predatory state. They are the prey. Such a state is a gang or a mafia that preys on those under its control.

Destruction of checks and balances

The state has the incentive to destroy institutions that exist to control agency costs so that it can have greater freedom of action and shift these costs back to the citizens. If, for example, a Parliament provides a check on a monarch's activities, then the monarch may attempt to undermine the Parliament. At the very least, he will try to control it if he wishes to have it remain as a sop to the people.

Many of the checks and balances of the U.S. Constitution can be analyzed in terms of agency costs. So can the Federalist papers and other documents of the Founding Fathers, who were familiar with agency problems. We can review U.S. history in terms of agency costs and the changes in institutions designed to control them. We can trace how the agents came to overcome the principals and reverse their roles. I will mention a few instances.

For its first 85 years, the U.S. was more of a contractual state and less of a predatory state. The U.S. could not avoid being predatory by construction of the Constitution and by actions of its rulers. Some predation was no doubt the intent of those who promoted the Constitution. Yet the extent of predation was relatively minor compared to later in U.S. history. One reason was that the institutions, agreements and understandings designed to keep agency costs low were still in place at the beginning. Later they were disposed of or perverted.

The War Between the States sealed the fate of one important control device that the principals thought was available to them: secession. The U.S. was set up by the individual states and, in theory, sovereignty rested in the people. Just as a stockholder can exit a corporation by selling his stock, a state could conceivably have exited the union by secession. This could have been a device to control agency costs. If the central state made decisions that imposed excessive costs on its member states or on the public, they might have exited the union. This threat restrained the actions of the central state. The war rendered this method of control null and void. Within a generation or so after the war, the U.S. would accrete power and become more and more a predatory state. Lincoln didn't save the union. He destroyed the contract and the contractual state. He saved and augmented the predatory state.

Another control device was the election of Senators by the state legislatures. This ended in 1913, replaced by direct election by the people. Suppose that stockholders directly elected managers who campaigned on various investment proposals. Companies would be worse off because the stockholders do not have the specialized knowledge to make these decisions. Moreover, they are too diffuse a group to monitor managers efficiently. Instead the shareholders elect a specialized Board that chooses and monitors the top executives as well as approves or disapproves of projects. In a somewhat analogous way, citizens elected state legislatures that selected the Senators. With Senators beholden to their state legislatures, there was a degree of control over their voting. They could protect the interests of the states against the federal state. With Senators beholden to a diffuse electorate, control and monitoring diminished. The path was then open to broader influence by interest groups that could sway the public and simultaneously reach Senators with emoluments. The Senators became part of the central state instead of being spokesmen for their individual states.

Elections are supposed to provide a way to control agency costs. The voters can fire politicians. As the state transformed from a contractual into a predatory state, this device became far weaker. Turnover in Congress is now very low. This is because it pays constituents to have experienced Congressmen who can bring home pork or handle complaints. It is because of the ability to redistrict. It is because with more power over more facets of society, Congressmen can assure their re-election by distributing favors. All of these changes subvert elections as a control device.

One term as president results in sizeable and lifelong retirement benefits, no matter how badly a president performs. This gravy train began with the Former Presidents Act of 1958. Elected or other officials can obtain high-paying jobs from those whom they regulate. They can become lobbyists. They can become commentators or speech-makers. They can write books. All of these income sources insulate the Executive branch. Presidents and their men have far more scope to do as they please while in office. Agency costs rise.

The two major parties control ballot access. Within Congress, party members are sanctioned if they do not vote the party line. Once voters embrace programs like Social Security, no third party can get elected that risks major change.

The civil service system ensures the tenure of important arms of the state, its bureaucracies. The turnover of employees at elections via the spoils system once was an important device to control agency costs. This is gone.

The U.S. Constitution lodged the war-making power in Congress. War is like an important investment project that a firm undertakes. Just as the Board has to approve important projects, Congress was given this job to do. The reason that it has abandoned this is that Congress is now more consolidated with the Executive branch than ever before, both on this matter and on budgeting. The check and balance of divided power is diminishing. This is like having the auditors and accountants in a corporation consolidate with the managers. It is like having a few persons in the company handle all aspects of the cash flows, from billing to collection to spending, which is an invitation to fraud.

The drive of the Executive branch to have plenary powers that are beyond judicial reach is another example of consolidating the separate branches. The goal is removal of a check and balance device in which one internal agent of the state monitors another.

The financial controls over the state consisted of restrictions on taxation and on money. The people's agents were restricted from undertaking all the projects they wanted to by the limitations on the funds available to them. Once the income tax was instituted and once the Federal Reserve System was established, these essential controls vanished. Overnight, the state began its modern expansion which has not yet been brought to a halt. It cannot be halted without restoring the institutions that are no longer in place.

The Constitution attempted to enumerate the powers of the Federal Government, but over time the Supreme Court gave the green light to a broad expansion of Federal powers. In addition, slowly but surely and sometimes not so slowly, the state is whittling away at the liberties mentioned in the Bill of Rights.

In sum, the institutions for controlling agency costs have been systematically ravaged. The movement in the totalitarian direction via explicit removal of institutions and measures that control agency costs is unmistakable. The outcomes are predictable. If we look at all the changes and more, we recognize a common element: destruction of institutions whose aim was to control agency costs. We the People were supposed to control the behavior of our agents in the state via these institutions. Now our so-called agents control us.

Generation after generation of Americans, each more adrift from sound philosophic and religious foundations than the previous one, have blessed these changes and/or have been outflanked and outmaneuvered by the state, a process explained in Part III of this series. This process has gone too far and been institutionalized too deeply to be reversed by anything less than a series of revolutions in thought and deed.

August 2, 2006

Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.

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