Forging credible commitments

Society may have an interest in not polluting the water, and it may even prohibit excess discharges in the water. But if the water is already polluted, aggrieved parties may find it difficult or impossible, for political or other reasons, to punish polluters.³⁰ Such failures to deliver on commitments encourage transgressions by those who are well positioned, and are detrimental to accumulating and protecting assets.

Similarly, a government might want to protect an area from settlement, but it will have difficulty doing so if many settlers can arrive and dig in before the government gets there. A prior action (assigning and paying for suitable guards to protect the area) can serve as a commitment device. For example, the United States posted the U.S. army to protect Yellowstone National Park against incursions before the park service was established.³¹

When assets can be degraded or destroyed without risk of sanction, they are more likely to be depleted, often in a wasteful fashion. But the cultivator settling beyond the agricultural frontier traditionally has not asked for permission. At low levels of human impact on the environment, anyone can use something that nobody else uses, so this regime makes sense. It allows institutions to advance geographically at a pace with (or slightly behind) settlements, which is both economic and realistic.³²

But there may also be times when it is important to get ahead of the advancing frontier of settlement, either because there is scarcely any forest, land, or water left, or because selective preservation has become a priority (chapter 5). In many developing countries the area under agricultural cultivation will stop expanding or may even reverse in the coming 30 to 50 years, so selective preservation now can yield lasting benefits at modest cost. As incomes rise, a time arrives when the forest has value not only to a potential cultivator (or those who depend on it as an ecosystem for their livelihood) but also to citizens far away. If these interests can find a suitable channel for expressing their interests the first-come, first-serve regime can be taken off the table selectively.

It is often difficult, however, to fight the tendency to reward early movers. When fish quota systems are put in place, the race for quotas can become a race to the shipyards, or to government offices-races that can be just as wasteful as the race to fish the declining stock (chapter 7). Preventing waste in environmental matters and natural resources requires confronting those who choose to deplete natural assets with the full social consequences of their actions, whether through informal mechanisms, taxes, or regulations. Similarly, loggers and fishermen must be induced to act as if they faced the consequences of others who might use the forest or the fish.

When commitments to protect are not credible, it is highly profitable to move early to manipulate the (supposedly) protective institutions. Tradable conservation obligations, such as those in Brazil (chapter 8), reduce the costs of compliance, and are thus one way to make conservation commitments more credible. As discussed above, information also helps, as when participatory procedures ensure that consequences are known beforehand. Box 3.7 draws the parallel between commitment by institutions protecting natural assets and by those protecting people's savings in a modern financial market.

Box 3.7 When protective institutions fail: the collapse of Enron and Newfoundland's cod fisheries Like a forest that has been logged behind a nice facade of trees and billboards, the Enron corporation crumbled and filed for bankruptcy in 2001. At $60 billion in market value before it perished, the darling of financial markets became one of the largest bankruptcies in U.S. history. The assets had disappeared over time, shielded by misrepresentation. Even in a private corporation such as Enron, the dispersed interests of thousands of owners are potentially threatened by well-placed individuals. Just as a contracted logger can either log sustainably or wastefully, managers and auditors can-by legal or illegal means-serve their own interests rather than those of dispersed owners. Norms and culture, and of course protective institutions (laws about property, accounting, and auditing) protect dispersed interests, but the protection will never be perfect. The Enron case is still in its fact-finding phase, but the list of techniques used by well-placed officials covers what one would expect in any other public sector or private sector institution that has been corrupted: concealed, misrepresented, and ghost transactions aimed at the enrichment of a few. Why, one might ask, if well-placed individuals can abuse an asset by taking out more than their assigned incomes, would they overdo it, killing the golden goose? They may of course have lost or overtaxed the asset by accident. However, the path of Enron's stock market value looks suspiciously similar to that of another failure of protective institutions, the collapse of Newfoundland's cod fishery, hinting at how failing protective institutions lead to wasteful races. Newfoundland's rich cod catches were growing slowly but steadily for about 100 years, until they increased steeply in the 1960s and 1970s, and then collapsed (chapter 7). In fisheries, as technology and equipment develop, the stock of fish in the sea starts declining. And if protective institutions fail to curtail overfishing, a wasteful race among fishermen follows. Fishermen understand that the fish they do not catch today may be someone else's tomorrow, and a frenzy of harvesting may end in collapse. Collapses are rare, however. It is more common that weak institutions result in steady and sustained losses, for both natural as well as produced assets. For instance, many fisheries steadily yield zero profits, and many managers and workers in overstaffed firms and public agencies add little value for their pay. A system of protective institutions lies behind the success of mobilizing savings through financial institutions and stock markets, undoubtedly one of the great achievements of the United States. Such a system rests on checks and balances and introduces independent veto players, many of whom must look the other way for improprieties to occur. But Enron officials commanded impressive contacts and influence. Though the potential watchdogs were many, Enron went down without a peep from uneasy auditors and with enthusiastic "buy" recommendations from the world's best paid stock analysts. For the United States, the Enron incident is a sobering one but not earth-shattering, and it has not eliminated the credibility of the protective institutions. Valuable assets-be they trees and fish, or people's savings-need protective institutions to thrive. When those protective institutions are successful, trees and fish and air quality and savings will thrive-to the great benefit of widely dispersed interests. But as assets grow, pressures on institutions grow-testing their commitment. Protective institutions are essential for people to make their savings available for banks and business people. The real cost of weak institutions is not that they result in more fraud and theft, but that, as a result, most people are not forthcoming with their savings. Potential is left unrealized. Ownership is concentrated and business is constrained by lack of depth and little competition-serving everybody poorly. Source: CRSP, University of Chicago, original data from New York Stock Exchange; The Economist, February 14, 2002; Hannesson, background paper for the WDR 2003