The Concept of a World Economic

Order
by Horst Siebert

No. 1392 | January 2008

 Kiel Institute for the World Economy, Düsternbrooker Weg 120, 24105 Kiel, Germany

Kiel Working Paper No. 1392 | January 2008

The Concept of a World Economic Order*

Horst Siebert

Abstract: This paper studies the concept of an international economic order, i.e. an
institutional arrangement of international rules. Such rules emerge from negative experiences
– historical disasters – that inflict severe hardship on people. A taxonomy for rules reducing
transaction costs is developed, for instance through decentralization of decisions, property
rights, territoriality and the internalization of border-crossing negative externalities and
mechanisms for global public goods. Some aspects of the rule system are studied including
the process of ceding sovereignty and philosophical thoughts on international rules.

Keywords: International rules, transaction costs, welfare gains of rules, property rights,
hierarchy of rules, concept of order, Freiburg school, philosophical ideas.

JEL classification: A 12, F02, F15, K00, N00, P00

Horst Siebert
Kiel Institute for the World Economy
24100 Kiel, Germany
Telephone: +49/431/8814-567
E-mail: hsiebert@jhubc.it
E-mail: hsiebert@ifw-kiel.de
*This paper is part of my research and of a planned book on “Rules for the global economy” (see also
my Kiel Working Papers No. 1381 and No 1388). I would like to thank the Heinz Nixdorf Foundation
for financial support.

____________________________________
The responsibility for the contents of the working papers rests with the author, not the Institute. Since working papers are of
a preliminary nature, it may be useful to contact the author of a particular working paper about results or caveats before re-
ferring to, or quoting, a paper. Any comments on working papers should be sent directly to the author.
Coverphoto: uni_com on photocase.com
The Concept of a World Economic Order

Horst Siebert

Institutional arrangements, including informal norms of behavior, the law, property rights for
using land and resources as well as nature and the environment, can be interpreted as a set of
rules and procedures which humankind has introduced for the governance of society and the
economy on the basis of historical experience. The origin of these rules is: learning from ex-
perience, mostly learning from mistakes. In a broad sense, institutions - not to be confused
with organizations - are the way things are done in a society.

In the domain of economics, institutional arrangements assign the benefits and opportunity
costs of an economic decision to individuals or other subunits of society, for instance to indi-
vidual households which consume goods and supply labor and savings, to firms which pro-
duce and invest, to the private sector or to governments and its different layers (Siebert 1996).
In assigning benefits and opportunity costs, institutional arrangements define the incentives
for the economic agents, and these incentives in turn determine the performance of the econ-
omy, for instance its growth and employment. Rules take the place of ad hoc solutions and
discretion (Kydland and Prescott 1977).

Global rules refer to the institutional arrangements among states. In specific areas and to a
certain extent, sovereign states cede sovereignty. The multilateral rule system that is estab-
lished in this way binds sovereign states and their citizens in their behavior. In the economic
sphere, the institutional set-up relates to all aspects of international interaction and interde-
pendence, including the allocation of goods and resources, the flow of capital, the diffusion of
technology, the movement of labor and human capital as well as global environmental scar-
city. In addition, a rule system does not only refer to the international interaction and interde-
pendence on the real side of the economy but also to international relations on the monetary
side. Using the word “order” in the tradition of the Germany Freiburg School (see Eucken
1940; p. 238), we can speak of a world economic order.

As with norms in a nation state, rules for a world order can be based on ethical grounds, and a
theologian or a philosopher may attempt to construct a rule system in a constructionist “top-
down” process, starting from one or some basic axiomatic ethical norms given by religious
values, natural law or philosophical principles, such as the Kantian Imperative. He may then
derive specific and concrete implications for the behavior of economic agents from these

3
principles. Such a constructionist approach, however, is not likely to succeed in deriving pre-
cise rules for economic decisions, since ethical principles allow a wide range of human be-
havior in specific situations.

Reduced transaction costs as a measure of welfare gains

I here use a different approach (which is in line with economics). The emergence of rules is
the result of learning from experience. Most importantly, negative experiences that inflict se-
vere hardship on people, - historical disasters - become the underlying origin of a new rule.
Rules arise from the attempt to prevent human tragedies in the future. For the economist,
hardship can be interpreted in terms of transaction costs. These are defined as resources used
in human exchange in a broad sense and are here understood in the interpretation of Coase
(1937; 1960). Costs mean opportunity costs, i.e. the costs of an opportunity forgone. When a
resource is used for one purpose this means renouncing on its use for another purpose.
Opportunity costs are thus defined by the welfare lost by not being able to use a resource for a
forgone alternative. If fewer resources are needed for transaction they can be used for other
purposes, for instance in production. Hardship or human tragedy goes together with high
transaction costs. Examples are wars between nations, internal civil wars in countries, border-
crossing negative externalities, for instance acid rain, but also opportunistic behavior of one
nation to the detriment of another in the international division of labor. Many rules, especially
in institutional arrangements relating to the economic sphere, can be explained as serving to
reduce transaction costs. We therefore speak of a transaction costs approach or an experience
approach to rules.

Transaction cost reduction is visible in a whole set of phenomena: lowering transportation

costs, reducing market segmentations, decreasing uncertainty from all sorts of distortions and
disruptions, for instance those arising from internal or cross-border political turmoil, and in-
ternalizing the negative effects of one nation’s action on others, i.e. internalizing negative ex-
ternalities. According to this approach, the rule system for the world economy can be inter-
preted to have evolved in a bottom-up process of learning from experience, starting from sub-
sidiary national rules. Whenever severe international transaction costs of national arrange-
ments became apparent because new interdependencies arose or because unexpected opportu-
nity costs of existing rule systems reveal themselves, new institutions evolved.

Ethical norms and ethical values can be viewed as a restraint to such rules. They limit the rule
space that can be established nationally and globally. If ethical values differ markedly be-

4
tween nations, the potential global rule space becomes limited. For instance, if the values and
goals of a specific group consider the destruction of other groups as their core aim, global
rules cannot be established. Examples for this are the credo of Islamic terrorists or the ideol-
ogy of the Nazis. An international rule system may fall apart, when values in different nations
and cultures start to diverge significantly. If, however, ethical values are universal, there is
more scope for an international institutional arrangement.

Ethical principles may be interpreted as being completely independent from economic institu-
tional arrangements. However, institutional set-ups influence human interaction and are vital
in the creation or prevention of new economic options. In turn, economic activities and inter-
dependencies may then affect ethical values, for instance by showing the implications of be-
havior and the opportunity costs of norms. In this view, ethical principles are not completely
autonomous from institutional arrangements. With the long-run impact of ethical norms being
revealed by reality, the institutional arrangement reflects, at least to some extent, the experi-
ence made with ethical norms.

The transaction cost approach has the advantage that it does not motivate rules by a rosy con-
cept of the welfare of the world that might be easily determined by a politburo, by a dictator
or some other organization but is impossible to be defined in free societies with different pref-
erences of individuals. The approach also does not start from the preferences of a subgroup of
society, for instance the ideas of some NGOs that are shared by their supporters but are not
accepted outside the group by other members of society. In contrast, under the transaction
cost approach, the benefit of rules is assessed according to the concept of reduced costs, and
these costs can be defined in a decentralized way by individuals according to their preferences
and by nation states according to their goals.

Apparently, we need an agreement or understanding on the procedure how transaction costs

are determined since this is vital for the emergence of rules in a society. In the transaction cost
approach, the reduction of transaction costs can be revealed either through a market process
that brings to light lower costs or through explicit political mechanisms through which prefer-
ences of society are aggregated. This means that the transaction cost approach assumes a
competitive process, an open society and democratic structures. Under these conditions, if a
country accepts a rule, it is likely to find it advantageous, unless it is coerced to obey the rule.
By agreeing on rules voluntarily, the cost reductions are revealed implicitly. If, however, eco-
nomic transactions are locked in by market monopolies or by political power of specific
groups, there is no or only a limited scope for reducing transaction costs through new rules.

5
An example is existing distortions between countries, for instance when free market access to
foreign countries is not agreed upon and when market access is prevented through regulations
or subsidies protecting domestic producers.

The concept of opportunity cost clearly varies with preference shifts in time. A case in point is
that opportunity costs for future generations may become more relevant in the utility functions
of individuals or in the goal functions of governments, as for instance with respect to envi-
ronmental degradation in Europe since the 1970s. In such preference shifts, NGOs and new
political parties as the Greens in Europe can be a forerunner or a prime mover of future values
which eventually make their way into society. This is especially relevant since preferences
shift occur with intergenerational change, i.e. with new young cohorts entering the population.
In this interpretation, subgroups of society can indeed play a role in determining the political
preferences of society. Another example is that the utility function of individuals begins to in-
clude argument variables that extend to a wider space than the nation state, including phe-
nomena in other countries. Thus, the Tsunami that hit Thailand and other parts of Asia and
India in 2005 was of concern to individuals in Europe and North America.

The gains for individual countries from accepting a rule need not be identical. Some countries
may derive a larger gain from the rule system than others. Take the case of preventing a war
through a rule system. In that case, it is difficult to determine whether the benefits of such a
rule system are identical to all countries. It is then more important to have an effective rule
preventing wars than to discuss who gains most. However, if the benefits of a rule system are
visibly one-sided or if they diverge very much, the stability of a rule system will most likely
be put into question.

Admittedly, the approach described here is rather functional and rationalist, being founded on
historical experience. It corresponds to approaches discussed in the age of enlightenment, for
instance by Kant. For many people and for many NGOs, the transaction costs approach may
appear to be not compassionate enough, not showing sufficient empathy and not having a
heart and a soul. But it is dependable. It is more important to have a reliable rule system than
to be at the mercy of bloomy feelings and the intentions of do-gooders. Good intentions are
not sufficient for an international order.

6
Lowering Transaction Costs through International Institutional
Rules
International rules, representing norms of behavior for governments, firms and citizens, re-
duce transactions costs.

First, the practice of decentralizing economic decisions, made possible by a framework of

rules, represents a method of lowering transaction costs. This practice can be interpreted as an
informal agreement corresponding to the subsidiarity principle which is mostly applied to the
different layers of national governments in federal states, but is also relevant for the institu-
tional set-up of regional integrations such as the European Union and also of multilateral ar-
rangements. This principle is based on the experience that the decentralization of decisions is,
in many areas, more efficient than the centralization of decision-making, one reason being
that on lower levels of organizations information is more readily available and preferences
can be expressed more easily. As a matter of fact, explaining rules through the lowering of
transaction costs is implicitly based on the concept of decentralized decisions.

Second, relying on markets is a specific form and an essential way of decentralizing decisions
and implementing the subsidiarity principle. Markets represent an institutional mechanism
that aligns the production of private goods with the willingness to pay, determines consump-
tion, saving and investment from individual choices and allocates scarce resources towards
competing uses. The core function of markets is to convey the benefits and opportunity costs
of economic decisions to individual agents. This means that markets express economic con-
straints and signal scarcity in the form of prices to economic agents – a role most relevant
globally. Thus, global resource constraints are indicated by scarcity prices. New demand (of
emerging countries) can drive out old demand (of developed economies) in a peaceful way. 1

How efficient markets are in allocating resources could be observed after the transition of
property rights from the large oil companies to the resource countries prior to the first oil cri-
sis in 1973. The allocation in the hierarchical vertically integrated main oil companies in-
cluding upstream and downstream activities – the Seven Sisters – was replaced by spot and
future markets. Prior to this change, the Seven Sisters controlled oil exploration and oil pro-
duction in the upstream activities as well as refining, transportation and distribution in the

1
For instance, Chinas share of world imports is 46 percent for iron ore, 36 percent for cotton, 23
percent for copper ore, 21 percent for pulp and paper, 20 percent for rubber and 6,2 percent for crude
oil. For comparison: China’s share of world output was 5 percent (data for 2005). In 1993 China did
not need oil imports.

7
downstream activities. Concession contracts, often valid for a period of 50 to 70 years, guar-
anteed their access to the natural resources, also to the undiscovered resources of the resource
countries. When extraction rights shifted to the resource countries, the vertical integration of
the enterprises was broken up; spot markets (for example, in Rotterdam) and forward markets
replaced vertical integration. Moreover, long-term resource contracts between governments -
the result of political negotiations – became unattractive, as soon as spot and future markets
for crude oil had developed. Note that a firm can be interpreted as a network of explicit and
implicit contracts that combines different production factors. Following institutional eco-
nomics, a firm can also be defined as an organizational unit with lower transaction costs than
on markets: a transaction will be carried out within a firm if the transaction costs within the
firm are lower than on the markets. The dividing line between firms and the market therefore
is determined by the level of the transaction costs.

The reduction of market segmentations is an important vehicle to reduce transaction costs.

Over time, new options of reducing market segmentations arise, for instance technological
progress in transportation, new property rights in network industries and institutional har-
monization, as in regional integrations.

Third, property rights represent a crucial condition for decentralization. A property right can
be defined as a set of rules specifying the use of scarce resources and goods (Furubotn and
Pejovich 1972). The set of rules includes obligations and rights; the rules may be codified by
law, or they may be institutionalized by other mechanisms such as social norms together with
a pattern of sanctions.

Property rights may be defined over a wide range of specific uses. Dales (1968) distinguishes
four types of property rights: A first category are exclusive property rights, covering the right
of use, notably the right of sale and the right of disposal, even the right to destroy the good or
the resource. However, an exclusive form of ownership is controlled by a set of restraints
which protect other individuals or maintain economic values. For instance, according to na-
tional regulations, a homeowner may not destroy his house. Zoning rules and criminal law are
examples of restrictions on exclusive property rights. A second type is status or functional
ownership, referring to a set of rights accorded to some individuals, but not to others. In this
case the right to use an object or to receive a service is very often not transferable. Examples
of this type of right include the access to services of party officials in communist systems, li-
censes to notarize documents, and, during the Medieval Times, the right of admission into a
guild. A third class are rights to use a collective good such as a highway or have access to a

8
school or to a public good (health protection against contagion) for a specific purpose. A
fourth kind are common-property resources such as the commons represent de facto a non-
property because nearly no exclusion is defined.

Property rights represent a mechanism that reduces conflict. Accepting property rights means
that people renounce on brute force. Without accepted property rights people would turn to
violence and dash out each other’s brain. This holds for individuals within a society and it
also applies to nations. This latter application is the more relevant issue in out context.

In the past, common properties or free access goods and free access resources have been
turned into private properties or, in an international context, into national properties. Thus, the
high sea was interpreted as “res nullius” in the times of Hugo Grotius in the 16th century, not
belonging to anyone. Meanwhile, we have established rules for using the seas. Since the 18th
century up to the mid 20th century, the territorial waters where a sovereign state had complete
jurisdiction were three nautical miles. At the end of the 20th century, this zone was extended
to twelve nautical miles (1982 UN Convention of the Law of the Sea). In a contiguous zone,
up to 24 nautical miles beyond the territorial sea of 12 miles, a coastal nation can prevent
infringement of its customs, fiscal, immigration or sanitary laws and regulations. In addition,
an exclusive economic zone extends for 200 nautical miles, with control of all economic
resources, including fishing, mining, oil exploration, and any pollution of those resources.
Thus, a coastal country has a differentiated control on its coastal waters.

In terms of the property-rights approach, the basic question of economics can be posed: How
are property rights to be defined so that the economic system generates “optimal” results? The
meaning of “optimal” may be manifold, encompassing quite a few criteria, such as freedom of
the individual and correct incentives to produce and to invest, to find new technologies,
search for new resources, and to supply the resources he owns (for example, capital, labor and
minerals). Also we can ask whether property rights can be defined in such a way that exter-
nalities are internalized.

A most important issue in property rights is who can use land. Property rights assign the use
of land to those who have a title to it. This question is also relevant for the use of the land of a
country. Historically, respecting the integrity of other countries, i.e. following the principle of
territoriality, can be interpreted as a national property right that prevents war as a means to
conquer space. Territoriality is an international principle by which nation states agree on re-
specting the other nation's autonomy, in my interpretation their property rights. This gives le-
gal authority for a state to exercise jurisdiction within its borders, not beyond. Most impor-

9
tantly, it relates to the nation's right to decide on using its resources and organizing its econ-
omy and its affairs as well as its political system.2 In that sense, a nation can be understood as
a resource machine that allocates resources and the power to decide on the use of resources.

Territoriality finds its limits in international public law, especially in the violation of its prin-
ciples. Figures like Milosevic’s, Pinochet and Hitler cannot be allowed to motivate their deci-
sions with the principle of territoriality. Thus, the violation of "natural" law and human rights
is not covered by the principle of territoriality.

Territoriality is overcome by international agreements, for instance in ceding sovereignty to a

supra-regional level in regional integrations (like the EU) or in international treatises like the
Kyoto Protocol. The principle of territoriality also loses importance if the utility functions of
individuals include more and more argument variables from other countries. International
courts such as the Court of Justice serve to implement these agreements and to solve disputes.

Fourth, international rules reduce uncertainty in transactions. Such uncertainty arises many
courses, for instance from opportunistic behavior of national governments and of market par-
ticipants in the fulfillment of contracts by private market participants, e.g. in the interpretation
of contracts. Rules take the place of ad hoc negotiations between governments in the case of
disputes. If rules do not exist, ad hoc negotiations are needed to solve disputes over the be-
havior of governments or in the fulfillment of contracts by private market participants, for in-
stance to prevent cheating, finagling and double-dealing. Uncertainty is likely to arise when
states of nature change so that contingent contracts are imperfect. The reliability and certainty
of an international institutional framework can be considered to be a public good, enhancing
the welfare of nations.

Fifth, international rules set limits on strategic behavior of national governments. This refers
to governments with political power or market power who might use policy instruments to in-
crease their national gains from the international division of labor to the disadvantage of other
countries. Potential conflicts between different national interests are thus eased. Countries
who find their own advantage negatively affected by such strategic behavior are bound to ob-
ject to such rules. In this role, international institutional arrangements can be interpreted as
public goods.

2
See Langewiesche (2007) who explicitly mentions power resources, “the access to culture” and the distribution
of “what has been commonly produced” (Translation of author).

10
Sixth, by joining an international rule system, states self-commit themselves, limiting national
governments’ choice of actions in the future. We can speak of a ‘negative catalogue’, a re-
straint on government behavior. It protects the international division of labor against the inter-
est of national governments. The self-commitment of states is also a shelter against the power
of protectionist groups in national economies. It helps against political cycles, for instance
against a protectionist leaning of a government in order to win votes in a national election. It
also shields against the shift of political preferences in a country, for instance when a gov-
ernment comes into power with completely different preferences.

Seventh, a rule system can lead to cooperative behavior among states, which makes it possible
to increase the total benefits from the international division of labor to all countries (the dis-
tribution of the increased benefits is another story). Without cooperative behavior, countries
find themselves in a prisoners’ dilemma, unable to reduce their protectionist measures or
capitalize on potential gains. Cooperative behavior is more likely in repeated games in which
economic agents have to deal with each other over time. Rules then are embedded into a rela-
tional contract (MacNeil 1978). Transaction costs would be higher with non-cooperative be-
havior.

Eighthly, rules can internalize negative externalities between states (negative spillovers) and
thus reduce transaction costs. Negative externalities are interdependencies between economic
activities that exist not through market mechanisms but that follow non-market systems or
technological systems. For instance, national economic activities are interdependent through
border-crossing groundwater or river systems, through atmospheric systems or the bio-chain.
Contagion in a currency crisis through communication systems, social or “psychological”
systems is such another example of economic interdependency. In a broader interpretation, a
war started by one country can be considered as an extreme form of negative externality.
Rules may hopefully be able to prevent this super externality. Contrary to negative external-
ities, also positive externalities, for instance the supply of biodiversity by a country, can be
internalized among states.

Ninthly, global public goods require specific rules in order to reduce transaction costs. Public
goods are goods that are consumed in equal amounts by all (Samuelson 1954). There is no ri-
valry in consumption and, technically, users cannot be excluded. In our context, public goods
have a global dimension, for instance, the earth’s atmosphere in the case of global warming or
the depletion of the ozone layer. Such public goods can be interpreted as a special case of
negative externalities, but public goods are an important case of its own right in the taxonomy

11
of interdependencies. How much of a public good we want to have cannot be determined by
decentralized market decisions; this would lead to an under-provision of the public good and
transaction costs would be too high. Instead, the optimal provision of a public good must be
determined by the aggregation of countries’ preferences in a bargaining solution between
states. Institutional arrangements are needed for the process of establishing the desired quan-
tity of the public good, i.e. for aggregating national preferences. Putting it differently, an in-
ternational agreement is needed on how much deterioration in the quality of the public good is
acceptable, for instance how much global warming is tolerated. Agreement is also needed on
how the costs of the desired quality of the public good are allocated to individual countries
and how free rider behavior can be prevented.

This taxonomy represents nine categories in which transaction costs can be reduced. One may
look at these cases as international market failures that lead to too high transaction costs. The
international rule system can then be interpreted as a correction of subsidiary national rules
and of international market failure. Multilateral rules can thus be interpreted as an expression
of the subsidiarity principle. Only when national rules lead to undesirable results with high
transaction costs, do multilateral rules come in. However, it is well known that the correction
of market failure by bargaining and cooperation is not free from policy failure. Only if the
costs of policy failure are lower than the benefits of correcting market failure will transaction
costs be reduced.

Note that the taxonomy presented here differs from the theory of fiscal federalism which
applies when communality applies as a common interest, for instance in the form of a national
identity in culture and language and where usually at least a weak institutional arrangement
exists. The conditions given for fiscal federalism, as presented by Ahearne and Eichengreen
(2007), namely similarity of tastes and economies of scale do not apply to multilateral
arrangements. Similarity of tastes should not be confounded with the utility function
including phenomena in other nation states. Economies of scale seem to be a narrow concept
applying to existing organization units.

A Hierarchy of Rules
The rule system consists of a complex net. Most rules have a spatial dimension: some are lo-
cal, others are regional, a good number of rules are national; some apply to regional integra-
tions or pertain to border-crossing interdependencies, and finally various rules relate to global

12
phenomena. In this interpretation, rules follow the subsidiarity principle: rules are relevant for
the organizational layer, for instance households, firms and organizational strata of govern-
ments, where they fulfill their function in the best way. Thus, local rules make sure that in-
formation on problems is easily available and that preferences of local people can be straight-
forwardly expressed. Therefore, quite a few rules can be decentralized. When spillovers oc-
cur, the dimension of rules needs a larger scope. In this interpretation, rule systems have a
vertical structure. With globalization and increasing independencies, institutional arrange-
ments become more global.

In contrast to this vertical structure of rules according to the subsidiarity principle, some rules
are universal. This characteristic applies to ethical norms, religious values and principles of
natural law. Such universal rules cut through the network of hierarchical rules. Thus, the rule
system is a complex matrix containing many dimensions: it is defined over space; with space
it has a vertical structure; it applies to different walks of live, also having a spatial dimension;
and it contains universal rules.

The Process of Ceding Sovereignty

Historically, it has been a long process in which nation states ceded sovereignty to multilateral
arrangements, with many accomplishments and also many setbacks. Abandoning national de-
cision power went along with poor historical experiences made and the arrival of new inter-
dependencies becoming apparent. An example is the increased awareness of environmental
degradation, going hand in hand with industrialization and affecting not only national envi-
ronmental systems but also global media such as the atmosphere. Another example is the ex-
perience with the disintegration of the world economy in the 1930s and of World War II
which then lead to the founding of GATT, the IMF and the World Bank.

The transaction costs approach to rule setting relies on rules being found by voluntary deci-
sions because rules are expected to bring advantages. This is the approach that fits a multipo-
lar world. Historically, rule systems have been strongly influenced by a hegemon as were the
Bretton Woods institutions after World War II by the US. In other times, the rule system was
imposed by the dominant power; witness the Pax Britannica or the Pax Romana. Such rule
systems collapsed when the dominant power went under. Then rule systems had to be in-
vented anew. This is the moment when the transaction cost approach is in demand again.
Consequently, in a long-run historical analysis, the transaction cost approach holds.

13
A rich practice in ceding rules exists in the European Union where the process of giving up
sovereignty is now going on for nearly sixty years, having started with the European Coal and
Steel Community in 1951. The original group of Six now has grown to 27 members, through
four consecutive steps: northern enlargement, southern enlargement, enlargement by the neu-
tral states and eastern enlargement. The ceding of sovereignty also included policy instru-
ments in substance, such as the single market, the control of national borders and monetary
union. The process of ceding sovereignty embraces many other mechanisms, for instance an
informal meeting of constitutional court judges of the EU countries to discuss inconsistencies
between national constitutions and the European basic treaty.

As concerns the extent to which rules are ceded, unconditional delegation to a supranational
agent, supervised delegation and coordination can be distinguished (Coeuré and Pisani-Ferry
2007, p. 29). Unconditional delegation is unusual. As examples, monetary policy in the euro
area and EU competition policy are used where the agents have full authority to take decisions
(although the EU member states remain the master of the EU treaty). The term unconditional
delegation is more fitting inside nation states. Supervised delegation also is unusual interna-
tionally. Again in the EU, trade policy may be considered as illustration where a committee
made up of trade officials nominated by the member states monitors the negotiation process
(ibid, p. 30). Coordination means that states cooperate, in taking into account the conditions
existing and the instruments chosen elsewhere as well as the interest of other countries.

As concerns the rules ceded, they apply to different areas (see the following Chapter) and rep-
resent different intensities in which rules are relinquished. For instance, Stiglitz and Charlton
(2005, p.133) distinguish a descending order of transparency-enhancing obligations on firms
and countries, co-operation between jurisdictions and putting in place enforceable interna-
tional rules.

A Political Order as Precondition

A necessary frame of reference for the transaction cost approach is some international politi-
cal stability, i.e. a political order in which rules are respected. At the same time, the rule sys-
tem may contribute to political stability. Such a rule system may be provided by a hegemon,
assuming that the hegemony is not selfish. It may also be developed by a group or all nations
in a pluralistic approach in a multi-polar world. This is our frame of reference.

14
However, the political order often does not represent a stable equilibrium. Imperiousness,
ideological dominance, political supremacy and strategic behavior have the potential to harm
existing international rules.

As a warning, the Communist systems and the National Socialism experience remind us, that
rules, even agreed upon within a country and between countries, may be fragile. Dictators
may appear, governments or political systems may turn authoritarian, populists may seduce
people, institutions may fall into the hands of lunatics and political preferences may vary over
time. Our experience tells us that the transaction cost approach is not immune against ideolo-
gies and religions that want to destroy other ethnic groups or the people of other religious be-
liefs. It is also not resistant against terrorism. We, especially the generation that has not seen a
war in Europe in the last sixty years, cannot be sure that rules will not be reneged, forgotten or
thrown into the waste basket of history. Unfortunately, man has only a short memory. Some-
times, man is only one generation away from the Stone Age. As a consolation, the possibility
of overthrowing the rule system becomes smaller the more integrated the countries are in the
world order; then the international community has a strong interest to prevent a country from
deviating.

Historically, shifts in the balance of power have been periods of disruptions in international
rules. Witness the rise of Germany after its unification in 1871 and the two world wars that
ensued, to a large extent as a consequence of the shift in the balance of power between Euro-
pean nations. A case for the future will be the shift of power in the coming decades from the
US to China. For such shifts, it is essential to have a rule system that accommodates the rising
powers and to have effective forms of mediation that can be used.

Philosophical Thoughts on International Rules

International rules have been studied by philosophers since a long time. Especially the age of
enlightenment has seen many proposals looking into the issue how rules can be found. A
common feature is the principle of rationality and the analysis how such a rule system may
function.

Adam Smith (1757), the founder of economics, in his work “The Theory of Moral Senti-
ments” explained rules by a combination of sentiments and experience. As stated in the
opening sentence of his book, moral sentiments, called sympathy by Smith, are feelings or
emotions of approval, disapproval, gratitude, resentment: “How selfish so ever man may be
supposed, there are evidently some principles in his nature, which interest him in the fortune

15
of others, and render their happiness necessary to him, though he derives nothing from it
except the pleasure of seeing it.” (p. 1). Sympathy means feeling with another person,
imagining oneself in another’s place. By observing the behavior of others and feeling or
expressing approval or disapproval, the rules are revealed. “Our continual observations upon
the conduct of others, insensibly lead us to form to ourselves certain general rules concerning
what is fit and proper either to be done or to be avoided. Some of their actions shock all our
natural sentiments. (p. 265). “We thus naturally lay down to ourselves a general rule, that all
such actions are to be avoided, as tending to render us odious, contemptible, or punishable,
the objects of all those sentiments for which we have the greatest dread and aversion.” (p.
265) In this way, a general rule is established upon experience of which actions are approved
or disapproved. These general rules are universally acknowledged and appealed to as stan-
dards of judgment.

In contrast to Adam Smith, Immanuel Kant provides a rationalistic foundation of international

rules, reason being the basis of rules, for instance of an institutional arrangement to prevent
war: "Nonetheless, from the throne of its moral legislative power, reason absolutely condemns
war as a means of determining the right and makes seeking the state of peace a matter of un-
mitigated duty. But without a contract among nations peace can be neither inaugurated nor
guaranteed. A league of a special sort must therefore be established, one that we can call a
league of peace (foedus pacificum), which will be distinguished from a treaty of peace (pac-
tum pacis) because the latter seeks merely to stop one war, while the former seeks to end all
wars forever." (Kant 1795, p.117)

Karl Marx (1867) proposed a system of rules for organizing society with public ownership of
the means of production. Meanwhile, we have gained experience with Marxist societies and
economies, especially in Europe. Communist economies were centrally planned; nearly all
sectors of the economy were nationalized. Private ownership was reduced to a minimum. In-
dividuals were deprived of economic and political freedom, access to information was lim-
ited, freedom of expression prohibited. One political party controlled all political processes
and all educational and cultural activities. Society was organized according to the principles
of constructive rationalism with the communist ideology as the underlying approach. Self-cor-
recting mechanisms were lacking. Gulag Archipelago was an inherent result of this approach
and cost many millions of lives. Residents were walled in. Although the system clearly failed
and citizens walked away from it when the iron curtain fell, the disaster of its historical per-

16
formance is fading in the perceptions of young generations and Marxist principles are receiv-
ing attention again in the intellectual circles of Europe.

Another immoral orientation with a devastating impact for the world and for the international
institutional arrangement was National Socialism or Nazism in Germany; this also holds for
Fascism in Italy. Again, power was centralized, political freedom and democracy were abol-
ished, one party had all the power, decisions were taken by the “Führer” and its immediate
environment and nationalistic emotions were appealed to. The laws of the state and social be-
havior were brought in line – all ending in a terrible World War II.

The historical experience of Communism and National Socialism was the origin of social
philosophers whose intention was to understand why such aberrations were the inherent nec-
essary consequence of poor institutional arrangements. They also searched for conditions that
would prevent the recurrence of such anomaly and to look for principles on which superior
rules could be based.

Germany’s Freiburg School, most prominently Walter Eucken (1952), developed the concept
of the competitive order and its constituting principles: Open markets, nowadays the most im-
portant ingredient of the concept of contestable markets, are a prerequisite for competition.
Private ownership is both a guarantee of individual liberty and an incentive to minimize costs
and reveal truly economic information. Freedom of contract is conducive to competition. Li-
ability ensures that social costs are internalized. The constancy of economic policy helps to
prevent a misallocation of resources over time, and price level stability is a sine qua non for
the price mechanism to operate. All this feeds into the competitive order which Eucken con-
sidered as the very basic principle. The ordoliberals took the view that the competitive order
is instrumental in allowing individual liberties. Decentralization permits personal choice and
provides options. How the institutional set-up affects the behavior of the individuals and firms
was a central issue for the ordoliberal thinkers of the Freiburg School – to think in terms of an
order, i.e. in terms of incentives, was a central demand of the ordoliberals. Their thinking be-
came the foundation of German’s concept of social market economy.

Karl Popper (1945) developed his concept of the open society as a counter position to a closed
society in which inheritance, tradition, party membership and status decide on an individual’s
options and in which measures and hierarchies cement social structures, limit entry and hold
down vertical income and social mobility. According to Popper society should not be
“closed”, but it should be an open society, “in which individuals are confronted with personal
decisions” (2003:186), “in which institutions leave …room for personal responsibility”

17
(2003:185) and “which sets free the critical powers of man.“ (2003: xvii). This concept of the
free society implies "competition for status among its members" (2003: 186).

Hayek (1944, 1971, and 1973) developed the concept of a “spontaneous order” which evolves
from the interaction of the multitude of decentralized agents. Many rules and institutions have
evolved in a historical process and were refined by selection. The institutional arrangements
for the different spheres of human life - economic, political, educational, cultural, and
religious - are partially separate. They are so complex that it is impossible that any individual
could know all the facts which are relevant to the functioning of the rules. The rules are not
"designed" nor can they be "designed" by a social planner, they "emerge" spontaneously from
a seemingly complex network of interaction among agents with limited knowledge. Instead of
constructive rationalism “from above”, rules and institutional arrangements are the outcome
of evolutionary rationalism. The subsidiarity principle is part of the institutional arrangement.
Self-correcting mechanisms for amending errors and improving malfunctioning are essential.
Market prices are important information signals to bring about adjustment to changed
conditions. Governments must create a legal framework - including laws of property, contract
and tort - which allow the market order to function.

18
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