The rule of law and predictability underpins effective markets

The US invasion of Venezuela and capture of Nicolas Maduro is the signature intervention under the emerging Donroe Doctrine. However, Venezuela’s oil reserves, precisely the reason the US intervened, may end up complicating matters. For a start, despite the President’s exhortation to US oil majors to line up and invest in the country, they appear to bereluctant. 

Ricardo Hausman hits the nail on the head with this brilliant articulation of the paradox - the manner in which the whole thing has been executed undermines the credibility of the objective itself.

Capitalism is not simply private ownership. It is voluntary exchange under predictable rules — rules that bind the powerful as well as the weak, and that survive electoral transitions. Those rules are what make long-horizon investment possible. Predation is what happens when power writes the rules opportunistically, then demands they be treated as law. That distinction matters most when it comes to oil. Reviving Venezuela’s energy sector would require large, frontloaded capital spending to repair and expand infrastructure. Those expenses would have to be followed by many years of positive cash flows to repay sunk costs and earn a return. 

Oil is the opposite of a quick-turn business. Its economics hinge on whether rights will be respected long enough to recover the initial outlays. These rights do not emanate from threats. They come from a legitimate state: a government that can claim consent; a legislature that can authorise commitments; regulators and courts that can enforce them; and a political system that investors believe will honour yesterday’s deal tomorrow. Unpredictability may occasionally be an asset in international affairs, but trust is the real strategic currency. And trust is precisely what a coercive interim arrangement cannot supply. Delcy Rodríguez, Venezuela’s interim president, has no electoral mandate and inherits institutions whose legitimacy is contested. Contracts signed now — especially if shaped under foreign pressure — will be politically and legally fragile. A future democratic government would have reasons to revisit them, if not repudiate them outright. In anticipation, US oil majors will not invest. 

Investors can price commodity risk. They can hedge operational risk. What they cannot hedge is foundational illegitimacy: the risk that the very basis of a contract will later be judged void because it did not emanate from an authorised government. If Washington’s message is that legality follows power rather than constraining it, capital will rationally assume that every deal is hostage to the next shift in power, whether in Caracas or Washington. The political sequencing is also backwards. It is not prosperity that creates legitimate government; it is legitimate government — namely, democracy and the rule of law — that empowers people to create prosperity. With these foundations, markets can do what they do best: decentralise initiative, mobilise investment and reward productive effort rather than proximity to power.

This is brilliant and has resonance elsewhere. Two markets in particular come to mind: infrastructure and technology. 

Predictability arising from the sanctity of the rule of law is the most important requirement for the functioning of private markets. It is this confidence that allows investors to invest their money, and just as importantly, entrepreneurs to put their efforts. Predictability extends not only to business creation and ease of doing business, but also to retaining control of their businesses. The latter is important given trends in industries like emerging technologies and infrastructure, where a dominant industry leader swoops in to forcibly take over a promising emerging firm. 

Ambitious entrepreneurs are driven by their belief in scaling their businesses and leading their industries. And in many sectors, especially but not only infrastructure, these are also long-drawn journeys spanning decades. In other words, building one enduring and dominant business is an endeavour of a lifetime. 

In this backdrop, any threat of being forcibly ousted and taken over can be a serious, if not prohibitive, deterrent to entrepreneurship. Why would an ambitious entrepreneur put in his sweat and toil to build a business if he runs the imminent threat of being forced out by a dominant rival precisely at the time his business starts to show promise and reaches the scaling pathway? Similarly, why should investors put their money in such risky and long-drawn projects when they know that they run the risk of seeing the entrepreneurs they backed being ousted and their upside being capped? 

Thanks to network effects and resultant market structures, the commanding heights of the digital technology industries are oligopolies or monopolies. Therefore, in the technology industry, once a promising startup comes up with a new or disruptive idea in any of the frontier areas like AI, chip design, or robotics, they run the risk of being harried and bullied into being absorbed by the Big Tech firms. Apart from snuffing out any potential competitor, Big Tech firms want to deepen their moats by capturing all innovations in their ecosystem. These pressures and threats are triggered through multiple channels - product development ecosystem, market access, investors, legal notices, and so on. 

Infrastructure sectors, being deeply enmeshed in the political economy and where the dominant incumbents formulate the rules of the game, are rife with crony capitalism and regulatory capture. Therefore, in the infrastructure industry, once a firm builds up a good portfolio of projects after several years of hard work and persistence, they run the risk of the dominant market leader swooping in and taking over by ousting the management. 

The new entrants are vulnerable to being coerced off their assets, even without a fair return or compensation, and often with the active support of the governments. In addition, in the context of Indian states, it is not uncommon to find the ownership of prime infrastructure assets changing hands (or shareholding patterns shifting) from the contractors preferred by the previous government to those favourable to the incoming government. 

All these act as significant deterrents for investors and entrepreneurs. Sectors like infrastructure and information and communications technology (ICT) are critical drivers of economic growth, and incentive distortions that discourage investors and entrepreneurs can be binding constraints on economic growth.