Avner Greif Paul Milgrom Barry Weingast Stanford University The process of European economic growth from the eleventh to the fourteenth centuries is best described using the words of the great economic historian Robert Lopen as "The Commercial Revolution of the Middle Ages." Economic growth was based upon commercial expansion. Many studies have outlined the nature of this commercial expansion and the associated development of trade practices. For this commercial expansion to be possible, however, institutions capable of mitigating contractual problems associated with long- distance trade were required. The operation of these institutions was more important than might be inferred from a simple reading of the historical record. The effectiveness of institutions for deterring breach of contract might best be judged like that of peacetime armies - by how little they are used. In reading the historical record to determine whether institutions like the merchant gild were created largely to ensure contract compliance, the number of instances of enforcement is not a useful measure. Instead, one has to ask: What were the things that threatened, and on occasion thwarted, efficient trading? Can details of these institutions be explained as a response to those threats? What triggered major changes in these institutions? Were changes in structure followed by important changes in trading relations, especially by improved contract compliance? A comprehensive analysis of an enforcement institution must consider why it was needed, what sanctions were to be used to deter undesirable behavior, who was to apply the sanctions, how the sanctioners learned or decided what sanctions to apply, why they did not shirk from their duty, and why the offender did not flee to avoid sanction. Some full game- theoretical analyses according to these criteria have been developed. Greif (1989) has analyzed the institution that governed the relations between merchants and their overseas agents in the eleventh century Mediterranean trade. To reap the benefit of employing overseas agents, a specific group of merchants, known as the Maghribi traders, organized agency relations with a "coalition" whose members ostracized and retaliated against agents who violated their commercial code. Interrelated contractual arrangements assured proper incentives, while close community ties assured that each member had the necessary information to participate in sanctions when necessary. Milgrom, North and Weingast (1990) have argued that the use of merchant courts in the Champagne fairs can be analyzed as an institution with proper incentives for gathering information, honoring agreements, reporting disputes, and adhering to the judgments of the merchant courts. Moreover, by centralizing certain record keeping functions and effectively permitting only merchants in good standing to remain at the fairs, this institution also achieved significant transaction costs economies relative to other feasible enforcement institutions. The papers we have just cited provide consistent analyses of institutions used to overcome contractual problems between individual merchants active in long-distance trade. The merchants, however, were not the only important parties; the trading centers where the merchants met and brought their goods were an important independent force. This paper is concerned with the institutional arrangements that surmounted the commitment problem associated with the relations between a ruler and alien merchants. It develops a theory to explain how the attributes of the institutions that mitigate the ruler's commitment problem affect the possibility of trade expansion. This theory is applied in a preliminary historical study of the medieval Merchant Gild. In his own territory, the Medieval ruler had the ability to abuse the rights of alien merchants using his coercive power. In the age before the emergence of the "state," alien merchants could expect little military or political aid from their countrymen. Without any institutional arrangements enabling a ruler to commit himself ex-ante, not to abuse alien merchants' rights ex-post, after the merchants had come to trade, the merchants were not likely to frequent that ruler's territory. Thus, trade could not expand, leading to the deprivation of rulers and traders alike. Intuitively, one can conjecture that the rulers' commitment problem can be surmounted by bilateral or multilateral reputation mechanisms in which the threat of the merchants to impose an embargo on a trade center that abused their rights in enough to deter abuse. However, when the ruler-merchants commitment problem is modeled, this intuition is found to be inaccurate. Simple bilateral and multilateral reputation mechanisms, without supporting institutions, lack the attributes required to overcome the commitment problem at the efficient level of trade. Accordingly, the model is used to study the attributes required from institutions to support an efficient level of trade by supplementing the operation of multilateral reputation mechanism. The multilateral reputation mechanism in which the merchants are to collectively punish a ruler who abused the rights of some of them to surmount the ruler-merchant commitment problem must be a part of an institution that has the ability to coordinate merchants' responses and to force all (or most of) the merchants to follow its decisions after the rights of some merchants were abused. An institution with these attributes may enable trade to expand to its efficient level by surmounting the commitment problems. Bilateral and multilateral reputation mechanisms fail to surmount the commitment problem without supporting institutions since in the efficient level of trade the "value" to the ruler of the "marginal traders' trade" is "very low." Thus the threat of future boycott by these marginal traders would not prevent the ruler from abusing their rights. In other words, when the ruler-merchants relations are governed by bilateral or multilateral reputation mechanisms there is no sub-game perfect equilibrium in which the ruler's :promise" to respect the rights of the merchants in the efficient level of trade is credible and hence trade can not expand to its efficient level. On the other hand when a multilateral reputation mechanism is supplemented by a "coordinating" mechanism, that is, a mechanism that coordinates the responses of all the merchants to the abuse of the rights of some merchants, the commitment problem can be overcome. There is a sub-game perfect equilibrium in which the ruler's "promise" to respect the rights of the merchants is credible in the efficient level of trade. When a coordinating mechanism exists there is an equilibrium in which the commitment problem is surmounted. It is the efficient equilibrium but not the only equilibrium possible. Accordingly, we use the notion of re-negotiation proof to evaluate the plausibility of this equilibrium and ascertain that it is not a plausible equilibrium. Intuitively, the coordinating institution's threat to punish a ruler by declaring an embargo if he ever abuses rights is not credible since some merchants will find it to their advantage not to respect the coordinating institution's embargo decision. If the number of these merchants is large enough, the embargo threat is not credible and the commitment problem can not be surmounted through a coordinating institution. Thus, to overcome the commitment problem there is a need for an institution that also possesses "internal enforcement" attributes. That is, an institution that has the ability to force its decisions regarding their relations with rulers upon the merchants. The historical analysis of the commitment problem led us to advance the hypothesis that during the late Medieval period a specific institution, the Merchant Gild, functioned as a nexus of contracts that surmounted the ruler-merchants commitment problem by supplanting the operation of multilateral reputation mechanism with its ability to coordinate and enforce merchants' responses. The core of a Merchant Gild was a society of merchants organized on territorial bases with some regulatory power over its members. This regulatory power over its members. This regulatory power could not be subdued by the ruler, usually because the Gild's territorial bases were out of his reach. The Gild governed the relations between an individual merchant and rulers of regions outside the Gild's territorial bases, and the relations between the merchants themselves. The Gild established procedures for information gathering and transmission that coordinated the responses of all the merchants in cases when the rights of some of them were abused abroad. The gild used its power to regulate merchants' activities in its territorial bases to insure its members' obedience to the Gild's decisions. In particular, it insured that all merchants observe trade embargoes declared by the Gild against foreign rulers who had abused members' rights. The Merchant Gild appeared during the late Medieval period in various forms -- the German Hansa, the English Gilds and some Italian and Germanic towns -- were Merchant Gilds. They were merchant gilds because they provided the merchants with the mechanism required for coordination and internal enforcement. By fulfilling these functions of coordination and internal enforcement, the Gild enabled the merchants to collectively commit themselves to retaliate by never trading again in a city whose ruler had abused the rights of any individual member. This collective credible threat increased the long-run cost of abusing traders' rights above the short run gains from abusing. Thus, it became known ex-ante that the best a ruler can do ex-post, after the alien merchants had arrived in his city, was to respect the merchants' rights. Thus, the merchants could "trust" the ruler ex-ante and trade could expand. The Gild was an institution in the sense that its operation constrained the ruler and the merchants by altering the payoffs associated with specific actions. By channeling their choice of behavior, the Gild enabled them to commit themselves. To support the above hypothesis about the role of the Merchant Gilds in overcoming the commitment problem this paper provides historical evidence. Since , in other times and places, the details of Gilds' organizations differed, we distinguish between three groups of historical evidence in our presentation. The first group contains evidence on the importance of the commitment problem, the role of reputation mechanism in overcoming it, and the relations between overcoming the commitment problem and trade expansion. The relation between the credibility of the commitment to respect alien merchants' rights and trade expansion seems to have been clear to Medieval rulers. For example, Edward the Third, King of England, declared in 1283 that because alien merchants did not receive the protection they had expected, "many merchants are put off from coming to this land with their merchandise to the detriment of merchants and of the whole kingdom." Edward's words should be understood against the background of events like the one that occurred in Boston, England. According to an enquiry conducted in 1241, after a Flemish merchant accused an English trader of not repaying a commercial loan " there was an uproar on all sides and the English merchants assembled to attack the Flemings, who retired to their lodging in the churchyard,...The English threw down the pailings, broke the doors and windows and dragged out Peter Balg [the lender] and five others, whom they foully beat and wounded and set in the stocks. All the other Flemings they beat, ill-treated and robbed, and pierced their cloths with swords and knives. Their silver cups were carried off as they sat at table, their purses cut and the money in them stolen, their chests broken open and money and goods, to an unknown extent, taken away, and their cloths pierced with knives." The historical records suggest that the evolution of gilds facilitated the growth of trade. For example, it was noted that the Catalan merchants' trade expanded "within only a few months" after they received, in 1286, privileges and the right to have a consul in Sicily. The trade of the German merchants in Bruges expanded after they had received privileges and the right to have a gild, called a Kontor (establishment or office). The fact that the Italians were able to secure their trade in Flanders only after they established gilds, called 'nations,' indicated the importance of these organizations in increasing the ability of the merchants to retaliate. The importance of reputation in providing protection to alien merchants is reflected, for example, in the agreement made in 1261 between Flemish merchants from different towns who were "associated with the buying of wool from abbeys" in England. The agreement reflects their decision that "if it should happen that any cleric or any other merchant anywhere in England who deals with sales of wool deals falsely with any merchant in the alliance , by giving false weight or false dressing of the wool or false produce,...and if they do not wish to make amends, we have decided that no present or future member of this alliance will be so bold as to trade with them..." Note the implied inability to seek justice in the local court and the use of collective economic sanctions to increase the cost of cheating any individual merchants. The second group of evidence contains information about the internal structure of Gilds, the contractual arrangements between Gilds and their members, between Gilds and the rulers of the Gilds' territorial bases, and between Gilds and rulers who controlled trade centers outside the Gilds' territorial bases. The evidence indicates that the attributes of the Gild and its contractual arrangements were parallel to those found in our theoretical analysis to be required to overcome the commitment problem. For example, the Flemish merchants whose agreement was quoted above recognized that some coordination is required to make the boycott functional and hence they "have decided that there will be in each of these cities one man to view and judge the grievances, and to persuade the wrongdoers to make amends." Simple coordination, however, was not usually sufficient and internal enforcement was required. Historical evidence indicates that ignoring a ban could be very profitable and that gilds faced difficulties in insuring that trade embargoes would be respected by their members. In 1284 a German trading ship was attached and pillaged by the Norwegians. The German towns responded by imposing an embargo on Norway. The export of grain, flour, vegetables and beer was prohibited. According to the chronicler Detmar, "there broke out a famine so great that (the Norwegians) were forced to make atonement." The temptation for an individual merchant to smuggle food to Norway in this situation is clear. To prevent smuggling and sustain the embargo, the German towns had to post ships in the Danish Straits. The fact that the success of a trade embargo depended crucially on obtaining the support of virtually all of the individual merchants involved was also clear to the cities on which embargo was inflicted. When, in 1358, the German towns imposed an embargo on Bruges, the city attempted to defeat the embargo by offering Cologne extensive trade privileges. Similar attention to the need to guarantee solidarity of incentives among merchants is also reflected in Flemish regulations for trade at the English fairs written in 1240. "If any man of Ypres or Daouai shall go against those decisions [made by the gild]....for the common good, regarding fines or anything else, that man shall be excluded from selling, lodging, eating, or depositing his wool or cloth in ships with the rest of the merchants...And if anyone violates this ostracism, he shall be fined 5s..." Placing ships in a strait and imposing fines are specific ways to overcome the distinct incentives problem. The evidence, however, indicates a variety of means through which the credibility of the threat to carry out an embargo was sustained. In England, for example, a gild had exclusive trade privileges in its own town, usually including monopoly rights over retail trade within the town, exclusive exemption from tolls and so forth, as well as the right to exclude under certain circumstances members from the gild. The English gilds were thus able to provide their members with streams of rents in their home towns. Receiving these rents, however, was conditional to following the recommendations of the gild as the Flemish regulations of 1240 illustrate. A merchant who ignored the ban imposed by the gild on another town was expelled, losing his rent stream. Hence, the Gilds' exclusive rights should be understood as an integral part of a system that facilitated trade expansion rather than being simply monopoly rights that hindered trade. Finally, the paper provides a description of the evolution of a specific Gild - the German Hansa - during the thirteenth and fourteenth centuries. This description illustrates that the evolution of this Gild is consistent with our theoretical analysis -- to overcome the commitment problem, for the ruler to commit himself to respect the merchants' rights, there is a need for an institution with coordination and internal enforcement abilities that control a sufficiently large number of merchants. For historical reasons, in the basic organizational unit that coordinated the activities of German merchants abroad -- the Kontor --membership was not conditional upon residency in one particular town. Any German merchant who arrived in a non-German city could join the local Kontor. While the Kontor had the same function as the gild in coordinating the responses of the German merchants in disputes with the town, it lacked the enforcement ability against its own members. This weakness, and the way it was overcome, is the essence of the history of the contractual relations between the German Kontor of Bruges, and the German towns. In 1252, a Kontor of the German merchants obtained extensive trading privileges from Bruges, and a permanent settlement followed. Before long, however, the trading privileges given to the alien merchants in Bruges were continually abused and eventually the German merchants under the leadership of Lubeck retaliated in 1280 by transferring their trade from Bruges to Aardenburg. After two years of negotiation, a new agreement was reached and the alien merchants returned to Bruges. Only seemingly successful, the embargo failed to guarantee the property rights of the German merchants in Bruges, as the city simply ignored its agreement with them. It should be noted, however, that Bruges did respect the rights of other alien merchants who frequented the city. Our analysis points to the reason for that uneven treatment. The embargo was not imposed by the German merchants but by the alien merchants in Bruges in general. In particular, the important and well organized Italian and Spanish "nations" took part in the boycott. While the lesson for Bruges from that episode was to respect the rights of those well organized nations, it soon became clear to the city that the German merchants were the "marginal" traders. The Kontor was not capable of increasing the cost of abusing German merchants since it did not have the ability to enforce its own decision upon its members. A main source of this inability was that the KONTOR embodied only the German merchants actually present in Bruges rather than all the potential German traders. Another embargo, from 1307 to 1309, in which only the Germans participated was required to force Bruges to respect its contractual commitments with them. Between 1280 and 1307 the ability of the German traders to coordinate their responses on the level of towns was enhanced as a consequence of the embargo they imposed in 1284 on Norway. The towns collectively achieved for the first time the coordination needed to expel one of their members. Hence, by 1307, the ability of the German merchants to commit themselves, to coordinate their actions, and thus guarantee Bruges's adherence to its contractual obligations, was rather advanced although it was still the local Kontor that organized the embargo. Bruges respected the charters agreed upon in 1307 and 1309 and, consequently, Flanders' trade flourished and expanded for the next 50 years. It was not until the middle of the century, when the cost of providing security around Bruges rose drastically that a new level of cooperation among the German towns was needed to force Bruges to provide the security required to support trade. The Hansa relations with Bruges deteriorated around 1350, mainly because Bruges was not ready to compensate the Germans for their damages in Flanders from the war between England and France. The Hansa responded by strengthening its internal organization and held, in 1356, its first Diet in which it was agreed that the Kontor of Bruges should be operated according to the decisions of the Diet. The institution of the German Hansa was not crystallized and an Hanseatic trade ban followed in 1358. It was announced that any disobedience, whether by a town or an individual, was to be punished by perpetual exclusion from the Hansa. This time, recognizing the ability of Hanseatic towns to coordinate and internally enforce their decisions, the privileges were written, "in much detail as to prevent any one-sided interpretations." The trade of Northern Europe prospered under the supremacy of the Hansa, and although the trade embargo of 1307 was not the last, later trade disputes seem to have been centered around distributive issues - the provision of trade privileges. Commitment for security was no longer an issue. It is illuminating to compare the development of the Hansa among German towns with the rather different organization among the Italian cities. The solid internal, political and commercial organization of the Italian cities and their prominence in trade enabled them to overcome the coordination and distinct incentive problems. None of the cities were "marginal players" in the ports where they traded. In contrast, the German Kontor was a local organization in a trading center which lacked the ability to enforce its decisions upon its members who came from various German towns. The German towns themselves were small and, before the establishment of the Hansa, each of them was relatively insignificant in its trading relations. For these reasons, overcoming the commitment problem required a trans-town organization. As described above, these towns eventually formed the Hansa in order to present a more unified front against the cities where they traded. The resulting increased security afforded to the merchants and their property contributed to increasing levels of trade in the regions. The historical application of our theoretical model is to the historical issue that led to the construction of this model, namely the study of ruler-merchants relations. We contend, however, that the insights of this model can be used to highlight the essence of other institutions that throughout history advanced efficiency by enabling rulers to commit themselves.