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Can Financial Innovations Mitigate Civil and Ethnic Conflict? By Saumitra Jha

The failure to align the incentives of to many. In fact, much blame for per- self-interested groups in favor of ben- sistent under-development around the eficial reform is often considered a world has been attributed to a failure to major cause of civil conflict and per- align the incentives of potential losers sistent underdevelopment around the and other disparate interest groups in world. However, much less is known favour of beneficial reforms and peace- about strategies that have been suc- ful cooperation. From Latin America, cessful at overcoming such challenges. where interests forming around wealth This article discusses the role of finan- disparities have been blamed for weak cial instruments as a means for foster- contemporary institutions, to African ing broad political coalitions that favor and other developing countries, where beneficial reform and mitigate social polarisation along ethnic lines appears conflict, drawing on historical cases to lead to lower growth and greater civil in which innovative financial assets, conflict, to reduced public goods provi- often introduced by technocratic sion in ethnically diverse jurisdictions reformers, have succeeded at making in the United States; a common theme politics less conflictual over time. of recent research by economists and political scientists is that within-society t is an all-too familiar story. A differences in endowed characteristics new leader assumes authority in a of wealth, ethnicity or of political rights Icountry that has recently discovered – can lead to conflicting interests that that it has fallen behind its neighbours shape the patterns of economic growth in economic development. He brings in and development we see today. explicitly to align political incentives— foreign expertise, announcing a series of Furthermore, because, inevitably, in doing just that. By allowing individu- modernising reforms that adopt what some groups are strong today, but would als with conflicting interests, whether is perceived as best practice and prom- be weakened by disruptive innovation or stemming from ethnicity, wealth or ises much in the way of social benefits. policies in the future, it is hard to make simply incumbency advantages, to cred- These include the establishment of credible promises to compensate these ibly share in the gains from a common schools and competitive exams based incumbents out of the social gains from future, financial approaches can and upon a modern curriculum, the aboli- policies that weaken their future bargain- have played a crucial role in solving tion of sinecure positions in govern- ing power. Thus a common challenge for credible commitment problems that ment, and the expansion of transporta- innovative firms and policymakers alike might otherwise stifle innovation and tion infrastructure and banks. However is either to fight the often uphill battle create the conditions for conflict. the reforms threaten the interests of towards building broad political support many among the existing elites. Within themselves or to make a deal: figure out Swords into Bank Shares four months of the start of the reforms, how to `credibly commit’ to compen- Take the case of revolutionary Japan these elites stage a coup, imprison the sating incumbents and potential losers in the nineteenth century. Like China executive and rescind the changes. The out of future gains from innovation or twenty years later, Japan faced a crisis country faces years of political unrest, reform, despite the temptation that may when the arrival of the `black ships’ of civil war and revolution, at great human be faced down the line to renege and the US Navy in 1853 made clear that it cost, before reforms occur. exploit their future weakness.1 had fallen behind technologically and Though the failure of the “Hundred These problems are tough, but they militarily. Though often considered Days Reforms,” attempted by the are also old problems and have been highly homogeneous today, Japan in the Guangxu Emperor of China in 1898, solved in the past. The purpose of this 1860s was divided into feudal domains does not occupy a prominent place short piece is to highlight one particular with strong regional differences and in most policy school curricula, the set of approaches—the use of financial varying degrees of political autonomy. outcome would not come as a surprise innovation, often by reformers seeking Japan also possessed a hereditary caste

March - April 2013 www.worldfinancialreview.com 3 system arguably even more entrenched world’s most fractured polities, emerged the government called a halt to future than that of India, as economic distinc- within a generation as one of its most expansion. In 1878, 29,360 samurai and tions were enforced by the State. At the centralised states”.2 Japan’s caste distinc- nobles controlled ¥30, 580, 000 in bank bottom of the hierarchy, ritually unclean tions too rapidly diminished. It is further stock, compared to ¥8, 870, 000 held professions were the exclusive domain of commonly accepted that the reforms by 4,730 commoners. Though com- an untouchable caste, while the samurai of the early Meiji period – including moners would play an increasing role in at the top enjoyed the exclusive right to the abolition of samurai privileges, the banks, in 1882, samurai still owned administrative and military positions in the development of a modern banking three-quarters of the stock of Japan’s exchange for hereditary stipends of rice. system and introduction of private banks. The successor-organizations of a Samurai were legally and custom-bound ownership of land – also laid the basis number of these banks still exist today. not to accept other professions or to inter- for Japan’s remarkable catch up in eco- Put in stark terms, the government marry with commoners, called heimin. nomic growth. How then did the admin- created an innovative, ethnically-delim- Lower-ranking samurai, once more istrators of the Meiji era, like Okuma ited asset – the bonds given to samurai urban bureaucrats than men-at-arms, Shigenobu and Matsukata Masayoshi, — even while eliminating the privileges had begun to remilitarize in response build support for their reforms? and obligations that had made this to the forced opening up by the United States and other countries. A number Japanese government created an innovative, ethnically- had returned from action in the Boshin delimited asset – the bonds given to samurai — while elimi- War, in which they had restored the authority of the Emperor of Japan. nating the privileges that had made this ethnic group distinct. Instead of being rewarded, however, the 1.8 million samurai would be the My co-authors, Kris Mitchener and ethnic group distinct. It then took the likeliest losers of the modernisation of Masanori Takashima and I are recon- ex-samurai, one that was the most likely Japan. General conscription of all male structing the details of how this coali- to engage in violence and enhance polit- Japanese was introduced in 1873, abol- tion was created. However, the broad ical risk, and gave them incentives to ishing the exclusive rights of the samurai patterns are themselves illuminating. In become local bankowners- a group with to the military and to bear arms, leaving 1871, the central government abolished arguably the greatest incentives to avoid large numbers of samurai retainers the domains, pensioning of their feudal engaging in violent actions that would unemployed and naturally weakening lords, and took over responsibility for raise the political risk of their invest- their future bargaining power. paying the salaries of their retainers. ments in local ventures (often rice and With a large incumbent caste group However, these stipends absorbed close silk). By aligning the samurai’s inter- not only with very different political to a third of the government’s budget. ests against political risk, these finan- interests but also the ability to engage in Amidst the period of violent samurai cial innovations aligned their interests violent resistance to protect it, it seemed protest, the government responded by with not only the merchants who were the Japan’s reforms would fall prey to the an innovative package of reforms, using their fellow merchant share-holders but same failure as those that would occur financial innovations to reduce opposi- society at large. Since all could benefit, twenty years later in China, and time and tion. First, the samurai’s rice stipends and in fact the samurai had explicit again in other settings around the world. were compulsorily commuted into stakes, as bankers, in the nation’s future, Indeed, soon afterwards began a series interest-bearing bonds in 1876. 310,971 they also meant that the samurai could of armed rebellions by samurai, the ex-samurai received public bonds worth give up their arms and credibly share the largest of which, the Satsuma Rebellion ¥113 million. At the same time, the gains that modernisation and reduced of 1877-78, often considered a civil war, National Bank Regulations were modi- political risk provided. cost ¥42 million, or 80% of the govern- fied so that samurai bonds could be In essence, financial innovators in the ment’s budget, required the mobilisation exchanged for stock in newly-opening Japanese government took swords and of close to 68,000 troops and led to the branches of the National Bank. Bank made them into bank shares. In fact, loss of life of around 20,000 ex-samurai owners were required to capitalise as one might expect among a class of and 6,000 government soldiers. the bank using 80% government (i.e. newly-minted bankowners, political risk Despite the presence of a class of samurai) bonds. The remaining 20%, in the form of violent samurai rebellions elite and militarised potential losers in currency, could come from the com- appear to have also ceased. Instead the and despite the strong regional cleav- moner class. The change in banking ex-samurai played a central role in peace- ages, however, Japan did not disinte- regulations in 1876 led to a dramatic ful political protests in favour of, at first, grate. Instead, as the historian Marius expansion of bank branches, increasing ex-samurai rights (shizoku minken), Jansen concludes: “Japan, which began from seven to around 150 new banks but later, popular rights (jiyu minken), the Meiji period as one of the modern within two years – so many, in fact, that that helped propel Japan towards the

4 The World Financial Review framing of a constitution and its first national elections in 1890. Social and Like Japan, the United States also had a militarized group of political distinctions based upon caste war veterans that could pose a potential threat of law and or- interests appear to have also rapidly eroded. Finance Minister, and later der who were owed $25 million of backpay by individual states. Prime Minister, Matsukata Matsuyoshi was explicitly concerned with mitigat- and South Carolina, saw an opportunity likely to play an important role in the ing conflict and the threats to law and to share the burdens of this debt with subsequent legislative politics or dis- order the samurai posed. As he noted in taxpayers elsewhere, Virginia, Maryland union of the United States. At the same 1883, “If the government remained an and Georgia had already paid much of time, speculators had bought up the war onlooker to the plight of the samurai, their war obligations. Over a famous bonds from a number of veterans, cre- it would have certainly meant that the dinner at Jefferson’s in 1790, Hamilton ating some concentration of ownership government did not understand the rela- agreed to support the permanent settle- of the new US public debt. While both tionship between peace and rebellion.’’3 ment of the capital in the South on the groups previously would have depended Potomac and compensate for Virginia’s on state legislatures for their payments, Creating a Speculating Phalanx additional tax burden in exchange to a now many, particularly in the erstwhile Financial innovations have played weakening of Madison’s objections over debtor states, had an interest in support similar roles elsewhere and other times the `Assumption’ of state debt. the funding and the policies of a Federal too. Japanese financial innovators, were Whether or not the Compromise of government that backed (and could learning in part on the experiences of 1790 was actually critical to the passage also default) on this debt. In particular, Alexander Hamilton’s financial reforms of both bills is subject to some debate. it is likely that the interests of the war in the United States in the 1790s and Regardless, it appears that Hamilton’s veterans became aligned in reducing from the experience of England in the victory on Assumption in 1790 may have political conflict and in supporting the seventeenth and eighteenth centuries. created a coalition critical for the success integrity of the union. Once again, two The United States in the 1790s, like of his further reforms, including the cre- important but very different constituen- Japan in the 1870s, was recovering from ation of the Bank of the United States. cies thus gained similar interests. The a revolutionary war that also brought The Bank of the United States and its fact that these debts could be traded in into question the territorial integrity of branches stimulated the competitive the emergent market for US securities the state. Levi Allen, one of the two chartering of other banks and joint stock may have expanded these constituencies brothers who helped establish Vermont, companies by the legislatures of individ- beyond veterans and first movers. sought to make a separate commercial ual states. The number of chartered joint To Hamilton’s legislative opponent, treaty with the British in Canada and stock companies experienced a boom, Thomas Jefferson, the causal effect of to assist in Vermont’s secession. There rising from seven in the entire colonial Assumption was clear. Writing three were similarly active discussions by a history of the United States (1607-1776) years after the Compromise, Jefferson number of New Englanders who had to 28 between 1781-91 and 295 between argued that Assumption: was unjust in pre-Revolutionary trading ties with 1791-1800. Between 1800 and 1830, the itself, oppressive to the States, and was Britain to secede. Spanish attempts to ten northeastern US states alone issued acquiesced in merely from a fear of secure the Western hinterland involved more than 3,500 corporate charters. In discussion. While our government was closing the Mississippi at New Orleans New York City, the proportion of house- still in its most infant state, it enabled and offering trade licenses and bribes to holds holding stock may have risen from Hamilton so to strengthen himself by settlers in Kentucky and Tennessee. The 6% in 1790 to 11% by 1826, despite a corrupt services to many that he could commander of the US Army, James period of rapid population growth. afterwards carry his Bank scheme, and Wilkinson, was a Spanish spy. Like While the empirical link between every measure he proposed in defiance Japan, the United States also had a mili- Assumption and the generation of a of all opposition. In fact it was the prin- tarized group of war veterans that could coalition of support for Hamilton’s other cipal ground whereon was reared up pose a potential threat of law and order reforms is a subject of ongoing research, that speculating phalanx, in and out of who were owed $25 million of backpay it is likely that the Assumption of state Congress, which has since been able to by individual states. debts did create a coalition that pro- give laws to change the political com- However, Alexander Hamilton, vided support for Hamilton’s Federalist plexion of the United States”.4 fearing secession and seeking a stronger program. Federal and state war debts Hamilton’s innovative use of finan- centralised state, saw an opportunity totalled $67 million, mostly owed in cial instruments to generate a political where many others saw a liability. While the form of backpay to war veterans, constituency for reform arguably had the representatives of the main debtor an important organized group with the lasting and profound effects on the states such as Massachusetts, Connecticut geographical coverage and resources to unity and the financial development

March - April 2013 www.worldfinancialreview.com 5 of the United States. The Federalists’ have been captured by a relatively small About the Author control over American government segment of the Black population. In Saumitra Jha is Assistant Professor would not last, but Hamilton’s change both cases, it is hard to gauge how much of Political Economy at Stanford’s of the “political complexion” of the social resentment and conflict, if any, Graduate School of Business and United States, particularly in the cre- has been avoided by these policies. Assistant Professor of Economics and ation of a “speculating phalanx” of Regardless, it is important to note of Political Science, by courtesy, at financial institutions and interests one key feature distinguishes these Stanford University. In 2012-2013, he appears to have persisted, surviving policies from the Japanese case: the is a Fellow at the Niehaus Center for Jefferson’s terms as president and even Malay and South African approaches Globalization and Governance and Andrew Jackson’s veto of the charter of are explicitly inter-ethnic transfers, and at the Center for Study of Democratic the Bank of the United States in 1832. recognize and in fact may reinforce Politics in the Woodrow Wilson School Hamilton’s reforms did not result ethnic and social divisions. In Japan, in at Princeton University. He is currently in a dominant central government – in contrast, though the bonds provided in working on a book project entitled fact the competitive chartering of state exchange for samurai stipends were ini- ``Swords into Bank Shares’’, examining banks to compete with the branches tially `ethnic’ in the sense that samurai the role of financial innovations in miti- of the Bank of the United States were owned most of them, they could gating conflict. More details, including may have instead acted ultimately to be sold to non-samurai or used to capi- working papers and published articles also strengthen within-state interests. talize banks. Thus, they ceased to be that this article draws upon, can be Regardless, like in Japan, what the vet- ethnically delineated after their initial found on his website: faculty-gsb.stanford. erans, speculators and local state elites distribution. As joint capitalists in cross- edu/~jha that became the assetholders of both the ethnic banks, however, the distinction Federal and the state banks were likely between samurai and non-samurai may References to share was a natural interest in lower- have thus been undermined over time. 1. This article draws heavily from Saumitra ing the threat of local violent conflict Jha (2011) ``Sharing the Future: Financial and in peaceful, legislative resolution of Conclusion Innovations and Innovators in Solving disagreements between the states. Our two examples of technocratic lead- the Political Economy Challenges of Development” in Institutions and Comparative ership using financial innovations to Economic Development, edited by Masahiko Modern Approaches solve political economy problems – the Aoki, Timur Kuran and Gerard Roland, It is useful to contrast the experi- early US republic and Japan – are inter- Volume I of the Proceedings of the 16th World Congress of the International ence of the US and Japan with that of esting not just because these became Economic Association, IEA Conference other, more contemporary, attempts to among the fastest growing states of their Series 150: Palgrave Macmillan, November mitigate social conflict by using finan- time following their financial develop- 2012, which also contains a complete set of references. An ungated version is available cial equity to share in the future. In ment, but also because they show that at: http://papers.ssrn.com/sol3/papers. Malaysia, where Malaysians of Chinese financial innovations can work in both cfm?abstract_id=2001039. ancestry were disproportionately repre- a democratic environment, where the 2. Jansen, M. B. (2000): The Making of sented in urban and commercial enter- challenges faced by technocratic leaders Modern Japan. The Belknap Press of Harvard University, Cambridge. pg. 335 prises, two months of violent race riots were on building legislative support for 3. Masayoshi, Matsukata (1883) “Memo following the 1969 elections led to a reform, and in an emergent caste-ridden Explaining the Way to Eliminate Bank Notes”, New Economic Policy, with 30 percent dictatorial state, where the threats posed cited in Harootunian, H. D. (1960): “The Economic Rehabilitation of the Samurai Class of shares in non-ethnic Malay firms were mainly of violent resistance. in the early Meiji Period,” The Journal of Asian slated for acquisition by state enterprises Building on these examples suggests Studies, 19(4), [pg.440]. to be held in trust and then redistributed still new approaches. In fact, just as in 4. Thomas Jefferson (1793), in Foley (1900) The Jeffersonian cyclopedia: A comprehensive to the `bumiputra’ population. Japan, it may be the case that there gains collection of the views of Thomas Jefferson. Similarly, in post-apartheid South from constructing novel financial assets Funk and Wagnalls, New York and London, Africa, Black Economic Empowerment that allow the sharing of risks and returns (page 61). Jefferson would remain con- vinced of the importance of Assumption, (BEE) policies have provided similarly from endowments – like ethnicity — that writing near the end of his life: strong incentives for firms to have at least are usually considered uninsurable. By . . . and so the Assumption was passed, and 20 percent equity ownership by Black allowing individuals to hold common twenty millions of stock divided among the South Africans. While in Malaysia, portfolios of new financial assets of this favored States, and thrown in as pabulum to the stock-jobbing herd. This added to the trust seems to have been relatively kind, it may just be possible to align inter- the number of votaries to the Treasury and successful at redistributing assets to ests in new ways in favor of peace and made its Chief the master of every vote in ethnic Malays in a fairly broad manner, cooperation. Financial innovations, if the Legislature which might give to the gov- ernment the directions suited to his political in South Africa, criticisms have been designed well, may hold much promise in views.– Thomas Jefferson (1818) The Anas. leveled that the benefits of BEE policies mitigating social and ethnic conflict. ix, 92, Ford edition, i, 161

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