This is the third of four articles in the series on corporate social responsibility (CSR). In the previous two weeks, I considered the economic and management approaches to CSR. In this week, I use the experience of the Middle East to illuminate the economic and social consequences of a society that failed to develop the corporation.
In the 16th century living standards in the Middle East, loosely defined to include North Africa and the Balkans, were well advanced compared to Europe. Informed reports at that time did not consider Islam inimical to wealth creation or the region’s institutions harmful to economic activity. By the late 18th century the region had become relatively backward. Economic output per person fell behind Western Europe. In the late 20th century it fell behind parts of East Asia as well.
In the late 18th century Western Europe became more hospitable to growth than other regions. The Industrial Revolution marked the period of deploying mass production based on new technologies. Western Europe had the organizational means to exploit the new technologies that emerged. England, the Low Countries, and the rest of the region could finance mass production. The modern corporation could mobilize the savings of large numbers and channel them into large projects. And they could pool the labor and capital of those large numbers into corporations that might continue in business for generations and in perpetuity.
These are capabilities now taken for granted, but they posed immense challenges in the Middle East. The new technologies were easily transferable, but the organizational capabilities to use the technologies were not. Professor Timur Kuran makes a convincing case for why the failure to develop the modern corporation contributed crucially to centuries of economic stagnation in the Middle East. As a consequence, the region not only failed to develop economically over time, but also failed to meet the population’s changing social needs.
Two critical factors prevented institutional innovation: the region’s law of commercial contracts and its distinct form of trust, the waqf (教產). The waqf is an inalienable religious endowment in Islam, typically denoting a building or plot of land for Muslim religious or charitable purposes. Both institutions were elements of Islamic law. Neither had changed significantly over the previous millennium and did not do so until the 19th century when faced with new global realities.
By the start of the second millennium, the Islamic law of contract enabled the pooling of labor and capital through partnerships. Under the system enforced through Islamic courts, investors could finance merchants and producers to undertake profit-oriented ventures. Islamic law did not put any limits on the number of people who could contribute labor or capital to a commercial partnership nor restrict how long that partnership would last. The typical partnership involved two people: a passive investor and an active laborer on a mission lasting a few months. Their profit shares were set in advance and losses were shared up to a point. The active partner carried unlimited personal liability, while the liability of the passive partner was limited. In particular, the latter risked only the capital he had placed at the partnership’s disposal.
Initially, Islamic partnerships did not hinder Middle Eastern capabilities in exchanges with Westerners. Essentially the same partnerships were used throughout the Mediterranean basin. Islamic partnership contracts were enforceable over a vast area stretching from Morocco and Spain to India and Indonesia. In the 12th-century, the institutions governing partnerships in Venice did not differ fundamentally from those of Baghdad.
An Islamic partnership was not what we now call a corporation. Lacking legal standing, it had no independent perpetual existence or life of its own. If a partner died before the contract had been fulfilled, the partnership ended, the assets were divided, and the deceased’s share was distributed among his or her heirs. Whether the interrupted business activity was restarted depended on the prevailing inheritance system.
According to the rules of the Islamic inheritance system, outlined in the Qur’an, two-thirds of any estate is reserved for children, parents, spouse(s), and possibly other relatives. For any category of relatives, the share of a female equals half that of a male. Thus, a daughter gets half as much as a son, and a sister half as much as a brother.
By medieval standards, this system was remarkably egalitarian. It did not allow a parent to favor one child over others. No relative entitled to a share could be disinherited. On the downside, the system made it difficult to keep property intact from one generation to the next. Consequently, successful businesses tended to fragment after their founder’s death.
Successful businessmen were most likely to have many heirs, if only because they tended to have multiple wives. So the death of a partner was especially problematic if he was a successful businessman, in that untimely termination was especially likely to end a business partnership.
To reduce the risks of a premature dissolution of business partnerships, their members limited the size and duration of the partnership’s business agenda. Thus, merchants, producers and investors could all minimize their risks by keeping their partnerships small and short-lived.
In the Middle Ages, premature dissolution also posed problems in Western Europe. However, inheritance practices differed between the Christians and Muslims. The Bible does not explicitly specify an inheritance system. This meant there was much more room for experimentation. In some places in Western Europe, including those that led the Industrial Revolution, a common practice was primogeniture, under which a deceased’s business could fall in its entirety to his oldest son. Primogeniture greatly reduced the risks of premature partnership termination. It allowed a partner to pre-commit credibly to having a son take over in the event that he himself could not continue. It made it profitable, therefore, to form large businesses expected to last for years, as opposed to mere months.
In the West, precisely because businesses expanded and gained longevity, pressures arose to develop more advanced commercial institutions. Thus, standardized accounting methods were developed to facilitate communication among growing numbers of business partners. Stock markets developed to provide liquidity to people who invested in long-lived enterprises.
In the Middle East, such innovations did not occur because the demand for organizational change was absent until the 19th century. Where partnerships are ephemeral and limited to at most a few people, no pressing need arises for double-entry bookkeeping because it is relatively easy for partners to agree to a simple accounting system of their own. Likewise, there is no demand to establish formal equity markets as an instrument of liquidity because shares in ephemeral businesses are already liquid. The persistent smallness of traditional Middle Eastern businesses also limited the division of labor.
In the course of the second millennium, the West developed the capacity to form businesses with hundreds, eventually even thousands, of employees and shareholders. Some of these businesses lasted for many generations and by virtue of their long histories, they came to be very widely known. The Middle East fell behind the West in this crucial respect. Few Middle Eastern businesses could compete with Western enterprises and commerce fell increasingly under the control of Westerners. The Middle East only began to initiate wide-ranging institutional reforms in the mid-19th century, by which time the region was already far behind the West.
There is another channel by which the failure to develop modern corporations has had an enduring effect. At the start of the 20th century, partly because private capital accumulation was limited, civil society – the part of the social system outside direct state control – was weak. The resulting political vacuum allowed, even compelled, states to take the lead in economic development. State-centered development programs have resulted in large bureaucracies and sharp limits on private economic freedoms. Even today, adaptations to global economic realities are slowed and hindered by the political weaknesses of civil society. When public monopolies fell into the politicians’ private hands over time widespread corruption and crony capitalism emerged.
The other Islamic institution that played an enormous role in the Middle East’s economic evolution is the waqf, which is an unincorporated trust established under Islamic law and overseen by Islamic courts. The founder of a waqf is an owner of private immovable property – land or buildings. The purpose is to provide a service allowed under Islamic law. A waqf may be established to support a mosque, a school, an orphanage, a park, a lighthouse, a region’s water supply, or a road, among other possibilities. Whatever the nature of the service, it must be provided in perpetuity.
In the pre-modern Middle East, the waqf permitted individuals to supply, in a decentralized manner, a wide variety of public goods now commonly provided by governments. In some respects it formed an admirable system: precisely because of its lack of centralized control, it was responsive to local needs.
Over many centuries, vast resources flowed into what became the waqf sector. By 1700, depending on the region, waqfs controlled between a quarter and half of all real estate. Their income was used partly to provide social services. In 1700, when Istanbul had a population of around 700,000, 30,000 people were fed each day through waqf financed soup-kitchens. Most of the centuries-old structures that tourists now admire – fountains, inns, mosques, schools, bathhouses, hospitals, even certain markets – are structures built and then operated for centuries through waqfs.
The waqf is not among Islam’s original institutions. A key motivation for it appears to have been the quest for economic security. In the 8th and 9th centuries, when the waqf system took shape, private property was insecure throughout the Middle East, as elsewhere in the Christian world. Arbitrary taxation and outright expropriation threatened high officials, who were major landowners. These officials did what wealthy people still do: they looked creatively for a wealth shelter.
Early Muslims adopted the idea of a charitable trust and developed it into a distinct and ingenious institution under a religion-sanctioned identity. Regardless of the service it provided, a waqf was therefore looked upon as sacred. Establishing a waqf was considered an act of piety. Given this belief rulers were hence reluctant to tamper with waqf assets.
The founder obtained inner satisfaction, social prestige and, in addition, significant material returns. He could appoint himself as the trustee and manager of the waqf for life. He could set his own remuneration, appoint relatives and friends to salaried positions, and designate his successor. The last privilege even allowed him to circumvent Islam’s inheritance rules.
This institution provided identifiable benefits to diverse political players, which is one reason it lasted so long. The wealthy obtained from the state a credible promise of material security. For its part, the state could collect taxes without providing much in return, other than law and order; cities would run on services provided by the wealthy through the waqf. Finally, the average person benefited from various subsidized services. This was a system that encouraged philanthropy and responded to local conditions. The system was bound, therefore, to generate political coalitions with a stake in its continuation. Once in place, it would be preserved. The waqf assumed social responsibility without establishing itself as a corporation and existed outside the direct control of the state.
For all its strengths, this system had economic drawbacks, which became increasingly serious over time. The functions of a waqf had to be fixed in perpetuity. Thus, the waqf was meant to be a rigid organization. In the Middle Ages, when consumption patterns and business opportunities were very slow to alter, the costs of such rigidity were limited.
As technologies and patterns of global comparative advantage started rapidly evolving, the fixed perpetuity rule that locks the use of capital rigidly resulted in huge inefficiencies. Indeed, major waqfs in the Middle East became conspicuously dysfunctional in the 18th and 19th centuries. Their vast resources could not be easily transferred to new waqfs, or moved outside the waqf sector, in order to provide new public goods, or supply old ones more efficiently.
The unintended costs of the waqf system were not limited to rigidities in the supply of social services. It also hindered the development of civil society. The ingredients of a strong civil society are freedom of association and organizational autonomy. The waqf system provided a form of associational freedom, at the expense of organizational autonomy. The discretion of a waqf trustee was substantially more limited than that of a corporate manager.
The waqf was developed in the Middle East as an antidote to predatory states and unreliable property rights. In the West, a weaker central authority allowed corporations to emerge as more powerful self-governing bodies to provide protection for property rights from an arbitrary state. Corporations were free to set their own agenda in a manner that was unavailable to a waqf that was bound by the trust deed set by the founder. These two separate institutional outcomes set the two regions on divergent organizational paths. The divergence continued well into the 19th century.
In the19th and early 20th centuries diverse reformers worked to dismantle the waqf system. They were motivated partly by a quest for resources to finance their modernization projects. Another motivation was to reduce the deadweight of the waqf system because of its rigidities. In the process of this political struggle the power of the state grew enormously at the expense of civil society and private freedoms.
From the very start Islam did not discourage commerce. In the medieval era the Middle East was as friendly to merchants as anywhere. Its businessmen dominated several of the world’s major long-distance trade routes. Islam spread to the Far East and Africa not through the sword but primarily through trade. Vast numbers of conversions to Islam were motivated by the lure of joining Middle Eastern trade networks. Islamic commercial institutions dominated all these areas. But these institutions remained stagnant for centuries and the modern profit-making corporation failed to emerge from within Islam. It had to be belatedly transplanted from the West. The non-corporate, non-profit waqf system provided a rigid perpetual arrangement to meet social needs that became increasingly ossified as those needs began to evolve over time.
Timur Kuran, The Long Divergence – How Islamic Law Held Back the Middle East, Princeton University Press, 2011.