Finance Global Economy Business Sustainability China Technology Lifestyle 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.