The Economic Role of Political Institutions

Thriving markets require not only an appropriately designed economic system, but a secure political foundation that places strong limits on the ability of the state to confiscate wealth. This requires a form of limited government, i.e., a state whose institutions credibly commit it to honor economic and political rights. To learn something about how this may be accomplished, this paper studies how limited government arose in states of the developed west. Specifically, • it focuses on the critical role of federalism for protecting markets in both England and the United States. Federalism proved fundamental to the impressive economic rise of England in the 18th century and the United States in the 19th and 20th centuries. The main implication for today is that attention must be paid to the political underpinnings of the economic reform. To this end, the paper compares the reform efforts of China and the former Soviet Union, arguing that the former's success lies in part in its having secured an appropriate political basis for economic reform. In short, a successful market system cannot be built without attention to the form of the constitution and limited government.