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Arbitration of Disputes

Mises Daily: Friday, July 01, 2011 by

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[Excerpted from The Market for Liberty (2009). An MP3 audio file of this article, narrated by Holly Hinton and Joel Sams, is available for download.]

Whenever men have dealings with one another, there is always a chance for disagreements and disputes to arise. Even when there has been no initiation of force, two persons can disagree over such matters as the terms and fulfillment of a contract or the true title to a piece of property. Whether one party to the dispute is trying to cheat the other(s) or whether both (or all) are completely honest and sincere in their contentions, the dispute may reach a point where it can't be settled without binding arbitration by a disinterested arbiter.

If no mechanism for such arbitration existed within a society, disputes could only be resolved by violence in every situation in which at least one person abandoned reason — man's only satisfactory means of communication. Then, that society would disintegrate into strife, suspicion, and social and economic breakdown, as human relationships became too dangerous to tolerate on any but the most limited scale.

Advocates of "limited government" contend that government is necessary to maintain social order because disputes could never be satisfactorily settled without a single, final court of appeal for everyone and without the force of legal rules to compel disputants to submit to that court and to abide by its decision(s). They also seem to feel that government officials and judges are somehow more impartial than other men because they are set apart from ordinary market relations and, therefore, have no vested interests to interfere with their judgments.

It is interesting to note that the advocates of government see initiated force (the legal force of government) as the only solution to social disputes. According to them, if everyone in society were not forced to use the same court system, and particularly the same final court of appeal, disputes would be insoluble. Apparently it doesn't occur to them that disputing parties are capable of freely choosing their own arbiters, including the final arbiter, and that this final arbiter wouldn't need to be the same agency for all disputes which occur in the society.

They have not realized that disputants would, in fact, be far better off if they could choose among competing arbitration agencies so that they could reap the benefits of competition and specialization. It should be obvious that a court system which has a monopoly guaranteed by the force of statutory law will not give as good a quality of service as will free-market arbitration agencies, which must compete for their customers. Also, a multiplicity of agencies facilitates specialization, so that people with a dispute in some specialized field can hire arbitration by experts in that field … instead of being compelled to submit to the judgment of men who have little or no background in the matter.

But, the government advocates argue, there must be an agency of legal force to compel disputants (particularly those who are negligent or dishonest) to submit to arbitration and abide by the decision of the arbiter, or the whole arbitration process would be futile. It is true that the whole process would be meaningless if one or both disputants could avoid arbitration or ignore the decision of the arbiter. But it doesn't follow that an institution of initiated force is necessary to compel the disputants to treat the arbitration as binding. The principle of rational self-interest, on which the whole free-market system is built, would accomplish this end quite effectively.

Men who contract to abide by the decision of a neutral arbiter and then break that contract are obviously unreliable and too risky to do business with. Honest men, acting in their rational self-interest, would check the records of those they did business with and would avoid having any dealings with such individuals. This kind of informal business boycott would be extremely effective in a governmentless society where a man could acquire nothing except what he could produce himself or get in trade with others.

Even in cases where the pressure of business ostracism was insufficient to insure compliance with arbiters' decisions, it doesn't follow that government would be necessary to bring the contract breaker to justice. As will be shown in chapters 9 and 10, free men, acting in a free market, are quite capable of dealing justly with those few who harm their fellowmen by any form of coercion, including contract-breaking. It's hardly necessary to institutionalize aggressive violence in order to deal with aggressive violence!

Perhaps the least tenable argument for government arbitration of disputes is the one that holds that governmental judges are more impartial because they operate outside the market and so have no vested interests. In the first place, it's impossible for anyone except a self-sufficient hermit to operate completely outside the market. The market is simply a system of trade, and even federal judges trade with other men in order to improve their standard of living (if they didn't, we would have to pay them in consumable goods instead of money).

In the second place, owing political allegiance to government is certainly no guarantee of impartiality! A governmental judge is always impelled to be partial … in favor of the government, from whom he gets his pay and his power! On the other hand, an arbiter who sells his services in a free market knows that he must be as scrupulously honest, fair, and impartial as possible or no pair of disputants will buy his services to arbitrate their dispute. A free-market arbiter depends for his livelihood on his skill and fairness at settling disputes. A governmental judge depends on political pull.

Excluding cases of initiated force and fraud (which will be dealt with in later chapters), there are two main categories of disputes between men — disputes that arise out of a contractual situation between the disputing parties (as disagreements over the meaning and application of the contract, or allegations of willful or negligent breach of contract) and disputes in which there was no contractual relationship between the disputants. Because of the importance of contractual relationships in a laissez-faire society, this type of dispute will be discussed first.

A free society, and particularly an industrialized one, is a contractual society. Contracts are such a basic part of all business dealings that even the smallest business would soon collapse if the integrity of its contracts were not protected. (Not only million-dollar deals between industrial giants, but your job, the apartment you lease, and the car you buy on time represent contractual situations.) This creates a large market for the service of contract protection, a market that is at present preempted by government. In a laissez-faire society, this market would be best served by professional arbitration agencies in conjunction with insurance companies.

"It's hardly necessary to institutionalize aggressive violence in order to deal with aggressive violence!"

In a free-market society, individuals or firms that had a contractual dispute they found themselves unable to resolve would find it in their interest to take their problem before an arbitration agency for binding arbitration. In order to eliminate possible disputes over which arbitration agency to patronize, the contracting parties would usually designate an agency at the time the contract was written. This agency would judge in any dispute between them, and they would bind themselves contractually to abide by its decisions. If the disputing parties had lacked the foresight to choose an arbitration agency at the time their original contract was made, they would still be able to hire one when the dispute arose, provided they could agree on which agency to patronize. Obviously, any arbitration agency would insist that all parties involved consent to its arbitration so that none of them would have a basis for bringing any action against it later if dissatisfied with its decision(s).

It would be more economical and in most cases quite sufficient to have only one arbitration agency to hear the case. But if the parties felt that a further appeal might be necessary and were willing to risk the extra expense, they could provide for a succession of two or even more arbitration agencies. The names of these agencies would be written into the contract, in order from the "first court of appeal" to the "last court of appeal." It would be neither necessary nor desirable to have one single, final court of appeal for every person in the society, as we have today in the United States Supreme Court. Such forced uniformity always promotes injustice.

Since the arbitration agencies for any particular contract would be designated in that contract, every contracting party would choose his own arbitration agency or agencies (including the one to whom final appeal was to be made if more than one was wanted). Those who needed arbitration would thus be able to reap the benefits of specialization and competition among the various arbitration agencies. And, since companies must compete on the basis of lower prices and/or better service, competition among arbitration agencies would lead to scrupulously honest decisions reached at the greatest speed and lowest cost that were feasible (quite a contrast to the traditional governmental court system, where justice is often a matter of clever lawyers and lucky accident).

Arbitration agencies would employ professional arbiters, instead of using citizen-jurors as governmental courts do. A board of professional arbiters would have great advantages over the present citizen-jury system of "ignorance times twelve." Professional arbiters would be highly trained specialists who made a career of hearing disputes and settling them justly. They would be educated for their profession as rigorously as engineers or doctors, probably taking their basic training in such fields as logic, ethics, and psychology, and further specialization in any field likely to come under dispute.

While professional arbiters would still make errors, they would make far fewer than do the amateur jurors and political judges of today. Not only would professional arbiters be far better qualified to hear, analyze, and evaluate evidence for the purpose of coming to an objective judgment than are our present citizen-jurors, they would also be much more difficult to bribe. A professional arbiter who tried to "throw" a case would be easily detected by his trained and experienced colleagues, and few men would be so foolish as to jeopardize a remunerative and highly respected career, even for a very large sum of money.

Justice, after all, is an economic good, just as are education and medical care. The ability to dispense justice depends on knowledge and on skill in assessing people and situations. This knowledge and skill must be acquired, just as medical knowledge must be acquired before medical advice can be dispensed. Some people are willing to expend the effort to get this knowledge and skill so that they can sell their services as professional arbiters. Other people need their services and are willing to buy them. Justice, like any other good or service, has economic value.

The reason for the superiority of professional arbiters over citizen-juries can be readily seen by an examination of the moral basis for each system. The citizen-juror's "service" is based on the concept of performing a duty to the state or to his fellow citizens — another variation of the irrational and immoral belief that the individual belongs to the collective. The professional arbiter, on the other hand, is a trader, selling his specialized services on the free market and profiting to the degree of his excellence.

Because arbitration agencies would be doing business in a free market, they would have to attract customers in order to make profits. This means that they would find it in their interest to treat all disputants who came to them with every courtesy and consideration possible. Instead of taking the authoritarian stand of a governmental judge and handing down arbitrary rulings with little or no regard for the interests and feelings of the disputants, they would make every effort to find a solution that was, as nearly as possible, satisfactory to both of the conflicting parties.

If a disputant disagreed with the arbiters' proposed solution, they would first attempt to sell him on it by reasoning with him (which means that it would have to be a reasonable solution to begin with). Only as a last resort would they invoke the clause in the contract between disputants and arbitration agency that made the arbitration binding. Arbitration agencies, because they would obtain their customers by excellence of service rather than by coercion, would have to act like arbiters helping to settle a dispute … rather than like judges handing down a sentence.

Insurance companies, looking for new fields of business, would offer contract insurance, and most individuals and firms would probably take advantage of this service. (In fact, insuring the monetary value of contracts is common practice today. Nearly all installment contracts carry insurance against the debtor's failure to pay because of death or some default.) This insurance would be sold to the contracting parties at the time the contract was ratified. Before an insurance company would indemnify its insured for loss in a case of broken contract, the matter would have to be submitted to arbitration as provided in the contract. For this reason there would be a close link between the business of contract insurance and the business of arbitration. Some arbitration agencies would probably develop as auxiliary functions of insurance companies, while others would arise as independent firms.

Suppose the inventor of a Handy-Dandy Kitchen Gadget entered into a contract with a small-time factory owner concerning the manufacture of the Kitchen Gadget, and they had the contract insured. Suppose that the factory owner then changed the design of the Kitchen Gadget and began making and selling it as his own invention, in order to avoid paying royalties to the inventor. After appealing to the manufacturer unsuccessfully, the inventor would take his complaint to the company insuring the contract. The insurance company would then arrange a hearing before the arbitration agency named in the contract as "first court of appeal." Here the dispute would be submitted to one or more professional arbiters for a judgment to resolve it. (The number and general composition of the arbiters, if more than one arbiter were called for, would have been specified in the original contract.)

"Justice, after all, is an economic good, just as are education and medical care."

If the decision reached by the professional arbiters was satisfactory to both the Kitchen Gadget inventor and the manufacturer, their ruling would be observed and the disputed matter would be settled. If the ruling were not satisfactory to either the inventor or the manufacturer and the dissatisfied party felt he had a chance of obtaining a reversal, he could appeal the decision to the next arbitration agency named in the contract. This agency would consent to hear the case if it felt the dissatisfied party had presented enough evidence to warrant a possible reversal. … And so on, up through the arbitration agency named as "final court of appeal."

When a contract is willfully or carelessly broken, the principle of justice involved is that the party who broke the contract owes all other contracted parties reparations in the amount of whatever his breach of contract has cost them (such amount to be determined by the arbitration agency previously specified by the parties to the contract) plus the cost of the arbitration proceedings.

If the arbiters of the final arbitration agency to whom appeal was made decided that the factory owner had, in fact, breached his contract with the inventor, they would set the reparations payment as close as humanly possible to the amount that the facts warranted — i.e., they would attempt to be as objective as possible. If the manufacturer were either unable or unwilling to make the payment, or to make it immediately, the insurance company would indemnify the inventor for the amount in question (within the terms of the policy).

With the inventor paid according to the terms of the insurance policy, the insurance company would then have the right of subrogation — that is, the insurance company would have the right to collect the reparations in the inventor's place and the manufacturer would now owe the insurance company rather than the inventor (except for any valid claim for damages the inventor might have for an amount in excess of what the insurance company had paid him).

If the inventor didn't have insurance on his contract with the manufacturer, he would take much the same steps as those described above, with two exceptions. First, he, himself, would have to make all arrangements for a hearing before the arbitration agency and for the collection of the debt, and he would have to stand the cost of these services until the manufacturer paid him back. Second, he would not be immediately indemnified for his loss but would have to wait until the manufacturer could pay him, which might be a matter of months or even years if, for example, the manufacturer had gone broke because of his shady dealings and had to make payment on an installment basis.

Because those who were guilty of breaches of contract would pay the major costs occasioned by their negligent or improper behavior, the insurance companies would not have to absorb large losses on contract-insurance claims, as they do on fire or accident claims. With only minimal losses to spread among their policyholders, insurance companies could afford to charge very low premiums for contract insurance. Low cost, plus the great convenience afforded by contract insurance, would make such insurance standard for almost all important contracts.

Before examining what steps an insurance company (or the original offended party if the contract were uninsured) could morally and practically take in the collection of a debt, it is necessary to examine the concept of "debt" itself. A debt is a value owed by one individual to another individual, with consequent obligation to make payment. A condition of debt arises when

  1. an individual comes into possession of a value that rightfully belongs to another individual, either by voluntary agreement, as in a purchase made on credit, or by theft or fraud;

  2. an individual destroys a value that rightfully belongs to another individual.

A debt is the result of an action willingly or negligently taken by the debtor. That is, even though he may not have purposed to assume a debt, he has willingly taken some action or failed to take some action that he should have taken (as in the case of what is now termed "criminal negligence") that has directly resulted in the loss of some value belonging to another individual. A debt does not arise from an unforeseeable or unpreventable circumstance, such as an accident or natural disaster. (In such cases, insurance companies would act just as they do now, indemnifying the insured and spreading the loss among all their policyholders.)

When a debt is owed, the debtor is in either actual or potential possession of a value (or of values) that is the rightful property of the creditor. That is, the debtor is in possession of either

  1. the original value-item(s), e.g., a refrigerator that he bought on time and for which he has defaulted on the payments, or

  2. an amount of money equal in value to the original item if he has disposed of or destroyed that item, or

  3. the ability to earn the money with which to make payment (or at least partial payment) for the item.

Since the debtor is in actual or potential possession of a value, or values, which rightfully belongs to the creditor, the creditor has the right to repossess his property … because it is his property. And he has the right to repossess it by any means that will not take or destroy values that are the rightful property of the debtor. If the creditor, in the process of collecting his property, does deprive the debtor of values that rightfully belong to the debtor, the creditor may well find that he has reversed their roles, that he is now the one in debt.

"In a free society, men would soon discover that honesty with others is a selfish, moral necessity!"

To return to the insurance company and its collection of the debt owed by the manufacturer in the Handy-Dandy Kitchen Gadget case, the insurance company would have the right to repossess the amount of the debt, which was now its property due to the right of subrogation. It could do so by making arrangements with the manufacturer for repayment, either immediately or in installments, as he was able to afford. If, however, the manufacturer refused to make payment, the insurance company would have the right to make whatever arrangements it could with other individuals or companies who had financial dealings with him, in order to expedite collection of the debt.

For example, the insurance company might arrange with the manufacturer's bank to attach an appropriate amount of his bank account, provided the bank was willing to make such an arrangement. In the case of a man who was employed, the insurance company might arrange with his employer to deduct payment(s) for the debt from the man's wages, if the employer was willing. Practically speaking, most banks would no doubt have a policy of cooperating with insurance companies in such matters, since a policy of protecting bank accounts from just claims would tend to attract customers who were undependable, thus increasing the cost of banking and forcing the bank to raise its charges. The same would be true of employers, only more so. Most employers would hesitate to attract undependable labor by inserting a clause in their employment contracts guaranteeing protection from just claims against them.

Such drastic means of collection as these would rarely be necessary, however. In the great majority of cases, the debtor would make payment without direct, retaliatory action on the part of the insurance company, because if he failed to do so he would be inviting business ostracism. Obviously, a man who refused to pay his debts is a poor business risk, and insurance companies would undoubtedly cooperate in keeping central files listing all poor risks, just as credit associations do today. So if the manufacturer refused to pay his debts, he would find all insurance companies he wanted to deal with either rating his premiums up or refusing to do business with him altogether.

In a free society, whose members depended on the insurance industry for protection of their values from all types of threat (fire, accident, aggressive violence, etc.) and where, furthermore, insurance companies were the force guaranteeing the integrity of contracts, how well could a man live if he couldn't get insurance (or couldn't get it at a rate he could afford)? If the insurance companies refused to do business with him, he would be unable to buy any protection for his values, nor would he be able to enter into any meaningful contract — he couldn't even buy a car on time.

Furthermore, other businesses would find it in their interest to check the information in the insurance companies' central files, just as they check credit ratings today, and so the manufacturer's bad reputation would spread. If his default were serious enough, no one would want to risk doing business with him. He would be driven out of business, and then he might even find it difficult to get and keep a good job or to rent a decent apartment. Even the poorest and most irresponsible man would think twice before putting himself in such a position. Even the richest and most powerful man would find it destructive of his interests to so cut himself off from all business dealings. In a free society, men would soon discover that honesty with others is a selfish, moral necessity!

Mises Academy: Stephan Kinsella teaches The Social Theory of Hoppe

If, in the face of all this, the manufacturer still remained adamant in his refusal to pay the debt, the insurance company would have the right to treat him in the same manner as a man would be treated who had taken another man's property by aggressive force. That is, the insurance company would have the right to use retaliatory force against the manufacturer, since he would be in wrongful possession of property that actually belonged to the insurance company. But, since this problem falls into the area of aggression and the rectification of injustices, which is covered in subsequent chapters, the manufacturer's case will be dropped at this point.

The moral principle underlying the insurance company's actions to collect from the manufacturer is this: When a man is willfully or negligently responsible for the loss of value(s) belonging to another individual, no one should gain from the default or aggression, but the party responsible for the loss should bear the major burden of the loss, as it was the result of his own dishonest and irrational behavior.

Neither the inventor nor the insurance company should profit from the manufacturer's dishonesty, as this would be to encourage dishonesty. And neither does profit. While the inventor is not forced to bear the financial burden of the manufacturer's default, he does suffer some inconvenience and probably also the frustration of some of his plans. The insurance company loses to some degree because it indemnifies the inventor immediately but must usually wait some time and perhaps even go to the expense of exerting some force to collect from the manufacturer. This principle is the same one that causes present-day insurance companies to write deductible clauses into their coverage of automobiles, in order that none of the parties involved will profit from irrationality and carelessness and so be tempted to make a practice of such actions.

Neither the inventor nor the insurance company was responsible for the manufacturer's default, however, so neither the inventor nor the insurance company should bear the burden of paying for it. Especially the insurance company should not be left holding the bag if it is at all possible to collect from the guilty party, as the insurance company will simply be forced to pass the loss on to its other policyholders who are innocent of the whole affair. The manufacturer is guilty of the default, and the manufacturer should pay for it — in accordance with the moral law that each man should reap the reward or suffer the consequence of his own actions. Actions do have consequences.

It will be argued by statists that the free-market system of contract insurance would leave helpless individuals at the mercy of the predatory greed of huge and unscrupulous insurance companies. Such an argument, however, only demonstrates the statists' ignorance of the functioning of the free market. Insurance companies would be forced to be scrupulously just in all their dealings by the same forces that keep all businesses in a free market honest — competition and the value of a good reputation. Any insurance company that failed to defend the just interests of its policyholders would soon lose those policyholders to other, more reputable firms. And any insurance company which defended the interests of its policyholders at the expense of doing injustice to nonpolicyholders with whom they had dealings would soon lose its policyholders.

No one would want to risk dealing with the policyholders of such a company as long as they held that brand of insurance, thus forcing them to change companies. Business ostracism would work as well against dishonest insurance companies as it would against a dishonest individual, and plentiful competition, plus the alertness of news media looking for a scoop on business news, would keep shady dealers well weeded out.

Disputes that did not involve a contractual situation (but which didn't arise out of the initiation of force or fraud) would be much rarer than contractual disputes in a laissez-faire society. Examples of such disputes would be conflict over a land boundary or the refusal of a patient to pay for emergency medical care administered while he was unconscious — on the grounds that he hadn't ordered that particular kind of care. Noncontractual disputes would usually not involve insurance, but they would be submitted to arbitration in much the same manner as would contractual disputes.

In a noncontractual dispute, as in a contractual one, both parties would have to agree on the arbitration agency they wanted to employ, and they would have to bind themselves, contractually with the agency, to abide by its decision. If the disputants couldn't settle the matter themselves, it is unlikely that either one would refuse to submit to arbitration because of the powerful market forces impelling toward dispute settlement. Disputed goods, such as the land in the boundary conflict, are less useful to their owners because of the lack of clear title (for example, the land couldn't be sold until the dispute was settled). But, more important than the reduced usefulness of disputed goods, the reputation of a man who refused arbitration without good reasons would suffer. People would hesitate to risk doing business with him for fear that they, too, would be involved in a protracted dispute.

As in the case of contractual disputes, the threat of business ostracism would usually be enough pressure to get the dispute submitted to arbitration. But occasionally the accused might want to refuse arbitration; and he could be guilty, or he could be innocent. If an accused man were innocent, he would be very foolish to refuse to submit evidence of his innocence to representatives of the arbitration agency and, if necessary, defend himself at an arbitration hearing. Only by showing that his accuser was wrong could he protect his good reputation and avoid being saddled with a debt he didn't deserve. Also, if he could prove that he had been falsely accused, he would stand a very good chance of collecting damages from his accuser.

If, however, the accused man were guilty, he might refuse arbitration because he feared that the arbiters would rule against him. If the accused did refuse arbitration and the injured party had good grounds for his case, he could treat this recalcitrant disputant just as he would treat a man who had stolen something from him — he could demand repayment (for details of how he would go about this and how repayment would be made, see chapters 9 and 10).

In the matter of arbitration, as in any other salable service, the free-market system of voluntary choice will always be superior to government's enforcement of standardized and arbitrary rules. When consumers are free to choose, they will naturally choose the companies that they believe will give them the best service and the lowest prices. The profit-and-loss signals that consumer buying practices send businesses guide these businesses into providing the goods and services that satisfy customers most. Profit/loss is the "error signal" which guides businessmen in their decisions. It is a continuous signal and, with the accurate and sophisticated methods of modern accounting, a very sensitive one.

But government is an extramarket institution — its purpose is not to make profits but to gain power and exercise it. Government officials have no profit-and-loss data. Even if they wanted to satisfy their forced "customers," they have no reliable "error signal" to guide their decisions. Aside from sporadic mail from the small minority of his constituents who are politically conscious, the only "error signal" a politician gets is the outcome of his re-election bids. One small bit of data every two to six years! And even this tidbit is hardly a clear signal, since individual voters may have voted the way they did because of any one of a number of issues, or even because they liked the candidate's sexy appearance or fatherly image. Appointed bureaucrats and judges, of course, don't even get this one small and usually confusing data signal; they have to operate completely in the dark.

This means that even the best-intentioned government officials can't possibly match the free market in generating consumer satisfaction in any area. Government doesn't have, and by its nature can't have, the only signal system — profit and loss — which can accurately tell an organization whether it is giving consumers what they want. Because he lacks the profit/loss signal, no government official — including a government judge — can tell whether he's pleasing the "customers" by preserving or increasing their values, or whether he's harming them by destroying their values.

The best conceivable government, staffed by the most conscientious politicians, couldn't possibly handle the job of arbitrating disputes (or any other task) as can private enterprise acting in a free market.