Creating the conditions for effective contracting, viable property rights, and functioning financial markets asks much of the government. Laws must be written, but that is the easy part. Building the machinery of adjudication and enforcement, with courts skilled in judging complex commercial disputes, might take a generation or more. And the courts cannot do the job by themselves. Well-functioning markets need, in addition, proactive regulation. The Czech Republic in the 1990s followed the laissez-faire prescription, leaving the resolution of financial disputes to the courts. Poland, by contrast, set up a regulatory agency to supplement the courts by enforcing such investor-protection rules as mandatory disclosure of information by firms. In Poland cases of investor abuse have been relatively few; in the Czech Republic, by contrast, expropriation was rife, as documented by Edward Glaeser, Simon Johnson, and Andrei Shleifer in the 2001 Quarterly Journal of Economics. The Czech Republic’s hands-off approach resulted in a moribund stock market, with few new-share offerings. Poland’s active regulator fostered a viable financial market, giving firms the opportunity to grow and attain economies of scale by acquiring outside investors.

Woodruff and I ran a survey in the late 1990s that asked Vietnamese entrepreneurs whether they had access to banks. Only 10 percent had a bank loan at start-up, and 22 percent currently had one. Almost all said they could not appeal to the courts to enforce contracts with trading partners. India, on the other hand, has a logjam in the courts. Reportedly 25 million contract-dispute cases are pending, and the cases generally take 10 years or more to reach a decision. In many developing countries, the inadequacy of market-supporting institutions means firms have little to gain from becoming registered.

Contracting Without Law

Millions upon millions of transactions occur every day around the world in underground markets. The dynamism of the underground sector illustrates the potency of market forces. Transactions can be successfully concluded under complete laissez-faire, without laws of contract, without assured property rights, without regulatory oversight. The underground economy shows that spontaneous order can develop so as to allow markets to flourish—but only up to a point. Spontaneous order works only when transactions are straightforward. Beyond that, the absence of government results in markets being dysfunctional. It is possible to take nonintervention too far. Every economy works better with some management.

Underground markets are not typical of markets in general because they are relatively uncomplicated. Most of the dealings are pure exchange: food and clothing are sold; immediate services are provided for cash. The goods and services that can be produced and traded underground are inherently limited in nature. They must be simple enough that buyers can easily verify their quality, so there is little scope for a seller to cheat a buyer and little need for a buyer to be wary of being cheated. Underground manufacturing occurs mostly on so small a scale that economies of scale are lost. Transaction costs in the underground economy are high.

The long-term policy prescription to improve the functioning of underground markets is clear-cut: build the range of market-supporting institutions that underpin the successful economies of Western Europe and North America. This includes the legal and regulatory mechanisms that underpin property rights and contracting; the machinery to ensure deals are carried out as promised, even many years into the future; and the rules that assure information disclosure so that consumers know what they are buying and investors know what is being done with their money.

The harder question is how to get there from here. Building the full set of market-supporting institutions is a project of decades. What can be done immediately? The common-sense prescription is to build on what already works. Entrepreneurs survive in the underground economy by ingeniously creating substitutes for the missing market institutions. Unable to rely on laws of contract to support their deal-making, entrepreneurs learn how to use ongoing relationships. They deal with people they know. If a trading partner cheats them, they cease dealing with him, so the sanction against dealing in bad faith is a loss of future business. This sanction is strengthened by the potentially wider loss of business if word about the cheating spreads to other trading partners.

Gossip is, then, crucial to the functioning of the underground economy. People in the same line of business meet each other every day in tea houses and coffee shops to exchange information on who is reliable and who is not. Ongoing relationships, underpinned by gossip, substitute for the missing laws of contract. Unable to get finance from banks or outside investors, underground firms get their finance in the form of trade credit. Sellers offer credit to buyers with whom they have established a relationship, without which the cash-strapped buyer would be unable to do business. The trade credit substitutes for the inaccessible financial markets.

Making the underground economy work more efficiently in the short run entails improving the mechanisms on which it already runs. The reliance on ongoing relationships means that by necessity deals are done only within a relatively small circle. This circle can be widened by formalizing the gossip mechanism. Trade associations often maintain records of their members’ transactions. In Mexico, for example, the shoe manufacturers’ association logs its members’ dealings with retailers. If a retailer fails to pay for shoes delivered, the manufacturer reports the reneging to the association. Any other manufacturer, before selling goods, can look up a retailer’s record. Retailers, knowing the records exist, have an incentive to pay their bills. Credit bureaus work similarly. By keeping track of those who do business dishonestly, they make doing business easier for the honest people. Trade associations and credit bureaus essentially act as information repositories, making deal-making more reliable.

Trade associations are limited in scope to single industries, however, and credit bureaus focus on financial transactions. During the transition to a full-blown legal system, governments or nongovernmental organizations in countries with inadequate market-supporting institutions might consider setting up broader-based information repositories. Such bodies would not have enforcement powers but would create transparency in contracting. A buyer or seller initiating a transaction with an unknown trading partner could go to the information repository to check whether the potential partner’s record is clean. Within any current transaction, the prospect that malfeasance has future consequences could be enough of an incentive to live up to the terms of the contract. Information repositories could be a low-cost and easily implemented mechanism for improving transactions in poor countries.