When Americans think of economic regulation, they think of government as the regulator, both developing and enforcing rules. Regulation is the result of legislation enacted by national, state, and local governments, then fleshed out and implemented by administrative agencies, all for the purpose of “correcting” an observed “market failure.” This focus on government as the solution to market failure problems is misplaced, argues Edward Peter Stringham, the Davis Professor of Economic Organizations and Innovation at Trinity College in Connecticut. Successful private governance solutions presently permeate the marketplace, and more such private arrangements can be used to address problems now considered the responsibility of government.

In his new book, Private Governance, Stringham utilizes analytic approaches drawn from economic history, law and economics, finance, and public choice theory to assist in his building a case for private ordering and self-regulation. He provides the reader with detailed historical examples of the development of national stock markets—including private self-regulation efforts—in Great Britain and the United States, as well as private policing efforts in California and North Carolina. In a more modern vein, he discusses the development of private governance mechanisms to combat online fraud in e‑commerce (PayPal), commercial dispute resolution, and the importance of understanding risk management in relation to financial derivatives that are responsible for expanding the scope of markets.

Stringham proposes the following hypotheses: Fraud is pervasive in commercial transactions, but so are private solutions to mitigate it. Private parties have incentive to create nonviolent, socially constructed solutions for unwanted behavior, though these often are underappreciated by policymakers and the general public. And private governance is a common form of social ordering in society, but is rarely noticed by most consumers. By presenting these hypotheses, he explores the use of many private ordering mechanisms, including sorting, reputation, assurance, bonding, and risk management techniques. All of these are offered in contrast to what is referred to as the “legal centralism” approach to governance in society.

Legal centralism / In contrast to private governance mechanisms, the advocates of legal centralism believe that, regardless of its many forms, government is the primary source of rules and enforcement efforts. All forms of legal centralism assume that markets would not function successfully without the existence of government’s administrative rules. Moreover, legal centralism inherently includes positive assumptions about the efficacy of government. Not surprisingly, legal centralism is widely embraced by lawyers, legislators, and many free-market advocates (including, at least to some extent, Nobel laureate Friedrich Hayek) who believe that the protection and enforcement of contracts through judicial oversight are essential to maintaining a peaceful civil society.

Proponents of the strongest forms of legal centralism consider legal rules and regulations to be costless, and property rights and commercial exchange to be impossible without government enforcement. Weaker forms of legal centralism recognize some costs associated with legal rules or regulations, but still consider them necessary.

Stringham proposes that instead of assuming that government has the ability and interest to solve problems, certain conditions for government intervention should be met. Consequently, he asks that whenever a potential problem exists in society, the following questions should be answered effectively:

  • Do regulators, police, and courts have the knowledge and ability to solve the problem in a low cost way?
  • Do regulators, police, and courts have proper incentive to solve the problem?

Where the legal centralist assumes that the answer is “yes” to both questions, the private governance researcher considers the possibility that regulators, police, and courts may be lacking in important ways. If the answer to one or both of the questions is “no,” then unmet consumer needs exist, and one should ask:

  • Will the private sector have the ability, knowledge, and incentives to solve those unmet needs?

If the answer is “yes,” then private ordering should address the problem. Stringham does acknowledge, however, that in some cases there may be no apparent workable solution to a societal problem. But in other cases, private parties will notice problems both simple and complex, search for solutions, and apply creative private governance mechanisms to solving them.

Clubs and voluntary association / According to Stringham, the amount of governance can be analyzed as a “club” good provided in a variety of forms. A club is an association of persons participating in a common objective who voluntarily agree to make regular payments or purchases in order to secure certain personal advantages. Clubs allow members to voluntarily participate in preferred governance structures to solve problems. They create effective incentives for continued cooperation, while meeting many objectives of creating a civil and free society. Membership in a private club can be formal or informal, long-term or short-term, and can take the forms of belonging to a financial club (Visa and MasterCard), a geographic club (Disney’s Celebration–Florida or Las Vegas’s City Center), an office, apartment complex, or religious organization, among others.

A fundamental difference between governmental clubs and private clubs is that private clubs are voluntary associations that people join contractually and are free to quit, while governmental clubs are involuntary associations where specific behavior is required and ultimately coerced. Private clubs, says Stringham, allow for variation in governance structures, experimentation in leading to what works best, and innovative solutions that meet the challenges presented by emerging problems—all factors missing from most governmental clubs. He further argues that the assumption that only government can create some of the institutions necessary for markets to function is incorrect and believes that government’s structure and enforcement mechanisms are simply a means of extracting revenue for those who control the state.

As mentioned earlier, he offers several case studies of how private governance operates in markets. In his carefully constructed summary of the economic history of how the world’s first stock markets developed in Amsterdam, London, and New York, he found overwhelming evidence of how those exchanges were created and maintained without (and in some cases, in spite of) government regulatory oversight. In the case of the Amsterdam exchange, participants found it more cost effective to rely on reputation mechanisms than on governmental, or even private, courts. The London exchange evolved from coffee house interactions among buyers and sellers. With government enforcement lacking, the exchange clubs developed their own form of assurance against fraud: they only admitted individuals who met their conditions of membership, and removed those who defaulted (“cheated”) on financial arrangements with other members. In New York, the exchange created a transparent operating environment, offering different sets of entry rules (“financial and other governance requirements”) for participants to choose from, with the exchange approving (“accepting as members”) only firms that warrant trading privileges.

In a more modern example of private governance in an anonymous, commercial setting, Stringham evaluates how electronic payment processors such as PayPal have developed ex-ante risk management “fixes” to the problem of online fraud. Traditional methods of ex-post government enforcement against fraud are simply not efficacious. To assuage concerns that its customers might have about using its online service, PayPal has assumed most of the risks associated with fraud by developing and applying risk management technologies that have significantly reduced fraudulent activities, thus ensuring a safer transacting environment for its customers. Stringham concludes that a service like PayPal—if not most electronic commerce—likely would not exist had the market depended on government to enforce contracts transacted over the Internet.

Another example of private governance involves adjudication by contract. He presents a “real world” example of private governance: dispute resolution, which Stringham describes as a system of “market chosen law” that allows parties to evaluate and agree to a set of rules and procedures that they consider best for their transaction. The author discusses mechanisms that are client-centric and make proceeding faster and fairer, with eBay a useful illustration of how this process works to the customer’s advantage. These private arbitration arrangements, which can include arbitration, bracketed-arbitration, final-offer arbitration, private judging, and Med-Arb (“medical arbitration”), allow for a free choice of rules and procedures, and providers of such services have an incentive to offer those that are ex-ante beneficial to all parties. The popularity of private arbitration, both for consumer-to-business and business-to-business transactions, has remained strong, and as noted by Stringham, the more people who can “opt out” of the inefficient government legal system, the less “necessary” that legal system is.

More private governance, less government regulation / Based on the evidence he provides in his book, Stringham concludes that markets preceding government in addressing failures is the correct sequence. Yet, from art certification, to policing, to financial markets, government intervention has often undermined markets for private governance by employing institutional barriers to push out, monopolize, or co-opt private governance efforts. “Private governance always functions to varying degrees, but it functions much less effectively the more it is hobbled by government,” says Stringham. He argues that just as competition generates discovery of new knowledge and innovation in the marketplace, it also is responsible for a similar response in governance systems. He allows for choice to be exercised in the development of mutually beneficial rules and regulations that adapt to problems, contexts, and timeliness, and without the threat of coercion embodied in legal centralism. He acknowledges that while “the assumption that the state creates the framework for markets is an unrealistic view of the state, … one can believe that while still allowing for a very large percentage of governance to be private.”

Stringham makes a powerful case for the existence of successful private governance in the marketplace. He is quite right that private governance mechanisms are invisible until something goes wrong (“a crisis appears”) and the knee-jerk reaction is to reach for a public policy “fix” to resolve the problem. His examples of government regulation implementation and nonmarket failure “put the lie” to this assumption. Unlike the many successes of private governance, which often go unnoticed by the citizenry, the failures of nonmarket intervention are noted but often ignored or explained away under the rubric of “good intentions.” As my experiences in the business school classroom have revealed, students are rarely exposed to examples of successful private governance, such as the private sector–driven development of operating standards in technology-driven U.S. industries. Furthermore, even in the realm of environmental “sustainability” practices that are being voluntarily instituted by companies and industries, the threat of further government regulation is viewed as the motivator, rather than factors such as reputation and consumer demands.

Stringham’s book is a readable treatise, notwithstanding the sometimes tedious but necessary scholarly economic history of financial markets, and his arguments maintain a consistent internal logic. His use of both historical and modern industry case studies effectively complements his philosophical arguments in favor of private governance. He does, however, occasionally include snarky comments that distract from his effective arguments. And more careful proofreading would have eliminated obvious copy errors.

I am pleased that Stringham wrote this book. While I share much of the author’s criticisms on the deleterious effects of nonmarket intervention, I would not go as far as he does in severely circumscribing the authority of public governance. But he recognizes that one need not fully embrace the merits of private governance in order to recognize the merits of the greater use of private governance.