The Answer Is Transaction Costs

When Bribes Become the System: Understanding Lock-In

• Michael Munger • Season 3 • Episode 22

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Corruption persists not because people like it, but because it becomes embedded in the incentive structure of the state, creating feedback loops that reinforce themselves and resist reform. 

• A prebend is a type of benefice historically given to clergymen, now a useful concept for understanding corruption in developing nations
• Douglas North extended Coase's concept of transaction costs to explain why institutions matter in economics and politics
• Bad institutions create feedback loops through rent-seeking, patronage, and corruption that redistribute resources to entrench elites
• Mental models - our imperfect cognitive frameworks - resist change because belief systems are costly to abandon
• Lock-in occurs when early institutional choices create path dependencies that make reform nearly impossible
• Officials in corrupt systems treat public offices as prebends (sources of personal income) rather than public service positions
• In Nigeria, prebendalism meant officials used positions to enrich themselves and distribute benefits to their ethnic communities
• Russian corruption intensified post-Soviet era when state salaries plummeted and bribes became survival mechanisms
• Reform typically requires massive shocks, external enforcement, or exceptional leadership willing to impose significant costs on corrupt officials

The schedule is changing, because summer is over. Going forward, we'll have two episodes each month until January - one on Wealth of Nations and one interview. The next interview will be Tuesday, September 9th, and the next Wealth of Nations episode will be Tuesday, September 23rd.

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If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Speaker 1:

This is Mike Munger, the knower of important things from Duke University. A prebend is a type of benefice, an income or stipend attached to a collegiate or cathedral church. It was historically given to a canon or a member of the clergy. In practice it meant that certain church lands or revenues, like rents, tithes or endowments, were assigned to a clergyman to support him in exchange for his service at the cathedral. The clergyman who held such an income was called a prebendary. Now if that sounds a little bit like feudalism except in the church, that's right. Today we're going to talk about how a prebend is a little bit like feudalism, except in government. The core meaning of a prebend is a provision or allowance given for support which in the medieval church context, became specialized as the income that was attached to ecclesiastical office Turns out, a prebend is a good way to think of corruption in developing nations and Douglas North's theory of lock-in which is caused by transaction costs.

Speaker 1:

There's a new twedge this month's letter plus book it a week and more Straight out of Creedmoor. This is Tidy C. I thought they'd talk about a system where there were no transaction costs. It's an imaginary system. There always are transaction costs. When it is costly to transact. Institutions matter and it is costly to transact.

Speaker 1:

Douglas North extended Ronald Coase's concept of transaction costs the cost of measuring, enforcing and exchanging property rights into history and politics. On the economic side, markets don't work automatically. They depend on institutions, laws, norms, enforcement. To reduce transaction costs Without institutions, exchange is too costly and specialization is limited. On the political side, the state is both the solution and the problem for transaction costs. On the one hand, the state creates and enforces property rights, lowering transaction costs. On the other hand, rulers can exploit their monopoly on violence and in defining property rights to raise transaction costs in ways that benefit elites. Rights to raise transaction costs in ways that benefit elites mostly themselves. Thus politics itself is a transaction cost-laden bargaining process between groups with constitutions and political rules acting like contracts that structure this bargaining.

Speaker 1:

North had a theory of feedback in politics. He emphasized the difficulty of useful and accurate feedback. Now there is positive feedback under some circumstances. Good institutions that is, secure property rights, rule of law, checks and balances on rulers reinforce themselves because they encourage productive investment and cooperation. Those countries get rich fast. But negative feedback also reinforces itself. Bad institutions tend to persist Rent-seeking, patronage and corruption, redistribute resources in ways that entrench elites and make reform harder. The implication is that nations often simply can't correct bad policy with better ideas. Bad institutions create a feedback loop that blocks learning. Elites benefit from existing arrangements and have little incentive to allow change, even if the policies themselves are socially destructive. This explains why nations often remain stuck with bad rules despite clear evidence of failure and the fact that everyone knows that there's a better system.

Speaker 1:

North argued that people interpret the world through what he called mental models, cognitive frameworks that are shaped by culture, ideology and experience. Many of our beliefs are wrong. Mental models are imperfect maps of reality, built from limited information and from biases. People adopt ideologies that make sense within their culture, even if those things are in some sense objectively false. People also resist change, even if they are given correct information. Part of the reason is that belief systems are costly to abandon and restructure. It's a kind of transaction cost. Belief systems are socially embedded. They provide identity. They reduce cognitive complexity. Even when confronted with evidence, people may cling to their ideology because it fits with their group identity. Information is costly to process and it fits with their group identity. Information is costly to process and it's frustrating to have to think about it, and incentives in political systems often reward loyalty over truth-seeking. The implication is that institutional change requires not only new rules, but also shifts in shared mental models what the entire society believes about fairness, legitimacy and authority.

Speaker 1:

North compared nations' institutions to individuals' beliefs. Both can be wrong, but they also both can remain stable. His concept of Lockean captures why. Lockean occurs when early choices—laws, property rights, political bargains—create path dependence. Path dependence means that once you start along a path, it's hard to go back to an intersection and start a new path. Institutions generate vested interests, expectations and complementarities that make reversal very costly. For example, a society that entrenches slavery or monopoly privilege may find it nearly impossible to reform later because too many groups depend on the system. Those groups depend for their legitimacy and for their income on the existing bad, corrupt system. But that means that they will fight, often literally and certainly politically, in order to maintain that system, in spite of the fact that other systems are obviously better. Lockheed explains institutional persistence. Even inefficient rules survive because there's stable equilibria those who benefit can block reform and those who suffer lack power to coordinate change. Especially, they face the collective action problem, where many people each would benefit a little, and the organized elites each of them would be harmed a lot, even if the total benefits to the populace far exceeds the harm to the elites.

Speaker 1:

North's broader claim is that, just as people remain bound by false beliefs, nations remain bound by bad institutions, not because better options are unknown, but because the cost and political resistance to change make bad equilibria self-reinforcing. So, in sum, transaction costs explain why institutions matter, and it's an extension of the Coase theorem. The assignment of rights is irrelevant if transaction costs equal zero. So institutions don't matter if transactions costs are low. But as I have the quote from Douglas North at the beginning of this podcast in the intro music, institutions matter if there are transactions costs, and there are always transaction costs. Feedback explains why bad models persist. Mental models explain why people misperceive reality and cling to ideology even in the face of contrary evidence. And lock-in explains why nation gets stuck with bad institutions even when better ones are known. Lock-in is a classic theme in Douglas North's institutional framework.

Speaker 1:

Corruption persists not because people like it, but because it becomes embedded in the incentive structure of the state. Once officials, bureaucrats or party networks learn that they can reliably extract bribes from licensing or the withholding of public services, that source of income becomes predictable and thus part of their livelihood. The system then resists reform because reform would cut off an established revenue stream and reform must obtain buy-in from those very officials who will lose their income or else that reform might face resistance and quite possibly a coup. So when you think about licensing or permits, if you can't do something unless you have the state's permission, then Having the permission is more valuable to you than it costs the state to provide it. But the state recognizes that and it's a monopoly. You can't get permission anywhere else. So officials in many developing societies have discretionary power over permits. They trade licenses, construction permits, land titles, import clearances for under-the-table payments. That discretion becomes then an opportunity to ask for, and in many cases demand, bribes. As Northwood put it, this creates a kind of path dependency. Once a particular way of doing things is established, organizations have incentives to continue that way, even if it's inefficient.

Speaker 1:

So India famously had the license raj, and in fact we did a Tidy C episode about this earlier and I'll put that up in show notes so you can go back and look at it. But the license raj meant that virtually every industry needed government licenses to do almost anything. So, as one Indian businessman recalled, the license was never denied if you knew whom to pay. Now notice the problem. That's both type 1 and type 2 error. It meant that anyone who applied for a license was always given to it, and they might not be qualified, they might not actually be going to carry out the business in a way that the original legislation that created the licensing process had in mind. But everybody who paid did in fact get a license. No one was denied. Some people should have been denied and some people should have been given the license for free because they qualified Under the license Raj. Everybody was given a license, even those who were not qualified, because the only qualification was that you had to pay the bribe to the bureaucrat.

Speaker 1:

So when officials can delay or deny public services and this can be almost everything think of all the things the government has a hand in Electricity connections, passports, driver's licenses, access to health care, building permits, the right to use a ration card for a bus they can extract payments. Once this becomes normal, both sides actually start to expect it. The political scientist Richard Joseph, in studying Nigeria particularly, but later in looking at a variety of government activities, coined the term Prebendalism, and it comes from, as I discussed at the outset the idea of the prebend, or the set-aside, as a source of rents or income for ecclesiastical officials. Now Richard Joseph was being a little bit puckish about this, because he's treating government and developing corrupt society as a kind of church which you had to worship if you wanted to survive. Prebendalism, then, describes how officials treat public office as a source of rent. As Richard Joseph said, the officeholder regards his position as a prebend that he may exploit it to benefit himself, his kinship and his ethnic group.

Speaker 1:

This system locked in corruption because networks of patronage depended on those illicit flows. So in Kenya, the World Bank noted that anti-corruption campaigns struggled because civil servants in key ministries view bribe income as a substitute for low wages and therefore resist reform that would eliminate it. In fact, in many cases in a lot of developing nations, the effective salary of many offices is negative. You have to pay your boss for the right to have this job, and the reason is that it's as if it's a franchise to collect bribes. I have an office where people have to come in and get building permits, and I will only give them the building permit if they pay me quite a bit. I will pay my boss bureaucrat in order to have this office. So if I say we're going to end corruption, my job doesn't pay anything. This is my only source of income and so you can get very strong resistance. So in many cases the state underpays its employees, effectively relying on bribes as a supplement.

Speaker 1:

Reform then faces a really strong internal veto. So in the 1990s in Russia, one observer put it customs officers earned $10 a month in salary, but their positions are worth $1,000 a month in bribes. Firing or rotating them did little to change the system, because the office itself was valuable, precisely because of its corrupt potential. In fact, the officials carefully calibrated their prices in order to maximize their revenue, and any bureaucrat would do that. If you changed people out, the next bureaucrat would likely reach the same conclusion about what is the profit-maximizing rate of insisting on a bribe? About what is the profit-maximizing rate of insisting on a bribe In Mexico, particularly before the democratization in 2000,.

Speaker 1:

Party loyalty was reinforced by corruption. Bureaucrats got very low formal salaries but were tacitly permitted, even encouraged, to extract informal rents. So this created what the political scientist Guillermo O'Donnell called a brown area, weakly institutionalized and yet self-reinforcing. They evolved rules, even formal prices. So even if reformers want change, ordinary citizens may distrust it. If people expect that nothing gets done without a bribe, they're going to keep paying because they want the system to work and the fact that the system might be otherwise is very hard for them to imagine.

Speaker 1:

The US really ran into this problem in Afghanistan. The US authorities described citizens who routinely paid bribes to police or judges. As one Afghan put it in an interview if you don't pay, you don't get your rights. Everybody knows this. Reform then stalls because both citizens and officials assume corruption is permanent. If an official tries not to take bribes, people will basically insist you're not going to get caught. So bribery and corruption can be locked in. Because officials treat offices as sources of income, citizens expect to pay bribes and plan accordingly. Low state salaries make corruption functional to survival, and reform coalitions are weak compared to beneficiaries of corruption. So that actually is exactly North's point. Bad institutions persist because they create feedback loops that reinforce themselves. Breaking those loops usually requires either massive shocks, an economic crisis or a war, or some kind of external enforcement, maybe conditionality on joining the EU or, in the case of Singapore, a massive government crackdown that involved direct corporal punishment. If bureaucrats were found accepting bribe, they would be whipped in the public square.

Speaker 1:

Let me say a little bit more about Nigeria and Richard Joseph. Nigeria's oil wealth had produced a rentier system where political office itself was the main prize, because that meant you got to give out the benefits that were pouring into government coffers from selling oil. Richard Joseph's term, prebendalism, describes how officials regarded their positions then as prebends, a source of personal rents to be distributed among kin or ethnic supporters. Political positions are then seen not as responsibilities for serving the public good, but as prebends sources of income and benefits for the officeholder and their network. Now, because Nigeria is highly diverse, with deep ethnic and regional cleavages, prebendalism often takes the form of distributing state resources along ethnic or regional lines. Politicians use office to enrich themselves, their family and their ethnic community. That practice became normalized so that citizens expect the officeholders to eat from the state, and since they have so much to eat, they should share with their friends, supporters and family. It's not seen as an aberration, but it's actually part of the logic of politics. So when people from the West object, nigerians thought they were just crazy. The consequence is that prebendalism undermines meritocracy, encourages rent-seeking and locks societies into cycles of corruption and instability. It also helps explain why Nigeria's oil wealth has fueled patronage networks instead of broad-based development.

Speaker 1:

Nigeria has taken in a gigantic amount of money over the decades from selling oil, but there's been relatively little. There's been some Nigeria's done better than many countries, but relatively little broad-based economic development and prosperity. The reason is that oil rents created easy money, making corruption more lucrative than building a tax system as a way of sourcing government revenue. That is, rather than the money going into the private sector and then collecting taxes, the state just took the money itself. Ethnic and regional groups saw office as their turn at the spoils, so anti-corruption efforts appeared like favoritism. You're preventing me from getting what all the previous office holders have got. Why do you hate me? Citizens expecting corruption routinely offered bribes to access electricity, water, even police protection. It was very hard to resist when people are constantly offering you bribes. International oil prices will occasionally crash and then there's some reform talk, but the reforms rarely last. The state lacks any kind of incentive to build transparent taxation system, since oil revenues and bribes around oil licensing were easier to extract and took less work and, frankly, they were safer.

Speaker 1:

After the collapse of the Soviet Union in the 1990s, state salaries plummeted, especially in real terms, controlling for inflation and the way you should think about inflation is a little bit different. There. It isn't so much monetary. Inflation is a dramatic increase from the artificially low prices of rent and food under socialism, where those things were kept at a very low price but then rationed and all that happened was that prices went to their market level, but the salaries of government officials did not go up anywhere close to a commensurate amount. Bribes then became a survival mechanism. Customs officers, police and teachers often went unpaid for months or a year. A Moscow journalist noted Customs officer officially earns $10 a month, but the position is worth thousands in bribes. The office, not the wage, became the commodity, so bribe income far exceeded official salaries, making reform akin to a gigantic pay cut.

Speaker 1:

Political elites relied on bribery networks to fund campaigns and secure loyalty. The money went down, but they expected it to come back, because you were supposed to support your political patrons. Citizens adapted by budgeting bribes into everyday life. It became part of the price they expected to pay for passports, hospital care, university admission, obtaining a driver's license, getting a building permit, almost every aspect of life. Now there were some reforms under Putin. There were wage increases, for officials especially, but they're in a way playing the Nigeria game. So they went from having a distorted system under socialism to depending for their revenue on being able to have money that comes in from oil and gas. So there was some reduction of petty corruption, but high-level state capture became, if anything, more entrenched, and the cycle has continued, now at a different scale and at a different level, as top-level corruption is the most important aspect of corruption in Russia.

Speaker 1:

Well, the takeaway is that bribery and corruption are not just bad habits. They're often locked in equilibria. Officials count on them as income, citizens treat them as routine. Politicians rely on them for survival. Douglas North's insight is that bad institutions persist precisely because they serve the interests of powerful actors and also because the rules of the game have become self-reinforcing. Whoa, that sound means it's time for the twedge.

Speaker 1:

A California legislator was visiting a friend in Chicago. His friend was an Illinois legislator and he took him for a tour. The Illinois Paul stopped the car by a train station and said you see this real line. I got $55 million appropriated, but it only cost $47 million to build. I tell you that's a handy profit for me and my supporters. $8 million skimmed off the top. The Californian pretended to be impressed. Later, the Illinois Paul visited his California friend and the Californian drove him around, stopping the car by an empty concrete slab. The Californian said you see this rail line Illinois guy looked around and said well no, there's no rail line. In fact, nothing is built here at all. The California Paul said exactly we got 1.2 billion to build a railroad line and we stole all of it. You're an amateur Chicago boy.

Speaker 1:

This week's letter is from MF. Dear Dr Mumber, I believe I stumbled across something interesting, but I leave it to the knower of important things to make that final determination. Something almost every transaction cost has is well, a cost, and by cost I mean a net cost on society. In your latest episode you referenced putting credit cards in ice as a way to self-impose a transaction cost to help a spendthrift stay out of debt. Another example could be a dieter locking away snacks or only keeping healthy food in the house. In these instances the transaction cost is likely a benefit to society.

Speaker 1:

Then it dawned on me Puzzles. Puzzle is an instance where the transaction cost is in fact literally the point. Not just a deterrence of some other behavior, but the cost itself is the thing being sought. It's also true of games and exercise. In these instances we might call these transaction costs benefits. Granted, there's the opportunity cost of your time, along with the risk of frustration or injury. That means those aren't literally costless activities, but they seem to be in a category of their own.

Speaker 1:

What I can't seem to think of is an example of this sort of thing in the economy. Seems like every example I can think of where transactions costs have a net benefit to society have one thing in common they're all self-imposed. Am I onto something here? Can you think of any transaction benefits in the economy that are not self-imposed? Thank you, mf. End of letter. Well, that's an interesting question and I'm going to take it up next time. And I'm going to take it up next time we do the interview. I'm going to talk some more about this as an answer to that letter. I thought I would see if anybody has any responses in letters of their own in the meantime.

Speaker 1:

This week there's two Book of the Weeks. One is by Johann Norberg. The title is Peak Human what can we learn from the rise and fall of golden ages? It's a terrific book that looks at the fact that human societies seem to have a cycle. Now they're not actually cyclic because there's no shared periodicity, but there do seem to be a set of conditions which start and represent the ability to grow, and then a set of conditions that seem to happen along the lines of what Mansur Olson talked about in his book the Rise and Decline of Nations.

Speaker 1:

Well, johan Norberg does a great job of talking about peak human, and the second book is suggested by listener S Guy, gavriel Kay, a Brightness Long Ago. So the author's last name is Kay K-A-Y. Title of the book is A Brightness Long Ago, the horse race and Il Palio in Siena, and does a nice job of representing the strategies and the work that people go to in order to try to win that race or, just as importantly, to prevent their worst enemies from winning. Well, this is the last of the weekly Tidy Sea episodes for summer. There'll be two episodes each month at least until January one on Wealth of Nations and one interview. The next interview will go up on Tuesday September 9th. The next episode of Adam Smith's Wealth of Nations will be on Tuesday, september 23rd.