Should profane contracts be sanctified?

CAMBRIDGE — Is there such a thing as too much sanctity? After all, even the word sanctimonious indicates an excessive show of devotion. The fervour for sanctification may hide darker motives, and attaining it may be deeply counterproductive. The sanctity of contracts, especially those involving the public sector, is a case in point.

Sanctity of contracts rests on the notion that “once parties duly enter into a contract, they must honour their obligations under that contract”. If you give your word, you should abide by it, because a person is only as good as his or her word. Violating this maxim is a sin before others, if not before God.

Economics provides a strong rationale for this argument. People enter into agreements that involve time: you do something for me now, and I do something for you later. The problem is that such agreements are not self-enforcing: once you have done something for me, I am better off not paying you for your service or not returning the money you lent me. That is why collateral was invented: if I do not repay the money you lent me, you can take possession of something worth more than the loan.

These agreements need third-party enforcement, typically by a court or an arbitration panel. And the more that contract enforcement can be guaranteed, the more agreements people will be willing to enter. Sanctifying contracts by elevating them to a higher moral plane may thus be socially beneficial.

Things get a bit more complicated when the parties to a contract are not individuals, but legal persons such as corporations or institutions. These entities must solve what economists call a principal-agent problem: the person who signs on behalf of a company may have their own interests, not those of the firm, in mind. That person must therefore be authorised to do so on behalf of the organisation, and may require prior authorisation by the board of directors or shareholders. Courts often check whether the signer could “duly enter into a contract”. Matters become even more complicated when the legal person is a government, which is supposed to act on behalf of “the people”. But the people are many, and each person may benefit from public spending that is financed mostly by everybody else’s taxes. This creates a so-called tragedy of the commons that results in overspending.

In addition, although governments are elected for a certain period, typically 4-5 years, they can enter into contracts that extend much further. For example, a government can spend hand over fist before an election by borrowing from a future in which it may not be in power to be held accountable. That is why fiscal discipline is one of civilisation’s hardest and most remarkable accomplishments. 

To achieve it, democracies tend to impose limits on public debt and require legislative consent in order to authorise government debt and other contracts. This raises the question of whether contracts that violate these rules should be treated as sacrosanct or repudiated for their profane origin. 

That issue is now being litigated in the context of Puerto Rico’s recent debt default, because the island’s government borrowed beyond its legal limits. Legislative approval is often cumbersome, which is why many countries exempt state-owned enterprises from this requirement, trusting that these companies’ governance structures — their boards of directors and shareholders’ meetings — will act in the best interest of the organisation and put effective brakes on irresponsible borrowing. But governments, corrupt politicians, and crony capitalists often use these entities as loopholes to circumvent public debt limits. Suppose you are a corrupt individual who wants to make money by helping to sell goods or services to the public sector in exchange for a commission, as, for example, the Gupta brothers are alleged to have done in South Africa. If the goods and services are to be paid for out of current budget resources, they will have to compete with many other claims on the public purse. 

So, it is best if you can sell the stuff on credit, so that you get your commission now and the country makes the payment later. But legislative limits on debt could make this difficult. Better, then, to sign a contract with a state-owned enterprise that is not subject to such restrictions, provided you can convince its bosses to act criminally (or vice versa).

How would you protect yourself? First, you could choose to make the contract secret, with publication of its details considered an act of default. Your co-conspirators in the state enterprise would like that, too. Second, you would secure your loan by having the corrupt officials pledge assets they were not empowered to pledge. Third, you would include a clause that also makes questioning the contract’s legality an act of default, so that if the state entity subsequently calls out your crime, you can just grab the collateral.

Instead of protecting such profane contracts, the courts should treat the contracts themselves as exhibit A of a crime. That would make such arrangements more expensive, because the parties would bear more contract risk. But as Duke University’s Mitu Gulati and Ugo Panizza of the Graduate Institute in Geneva have argued, this would be socially beneficial because it would spur the market to curtail a behaviour that needs curtailing. 

Note that the issue here is the legitimacy of the contract itself, not that of a ruling regime. That distinguishes it from the issue of odious debt, which concerns the legitimacy of the obligations incurred by an odious regime.

Contracts are regarded as “a law between the parties”, and are protected and sanctified by the courts. But they can be written in order to violate the law, and to shield the crime itself from the law. Such profanity does not deserve and should not receive the judicial blessing its authors seek.

Ricardo Hausmann, a former minister of planning of Venezuela and former chief economist at the Inter-American Development Bank, is a professor at the Harvard Kennedy School and Director of the Harvard Growth Lab. Project Syndicate, 2019.  www.project-syndicate.org