Diamonds are Forever - Private Governance

I'm posting a 14-part series of mini-essays on diamonds (but really about the economic point of view). Here's part 13.

Private Governance 

Yes, diamonds are well-protected, but they also have characteristics which make them easier to steal, characteristics that raise the costs of protecting them. 

Namely, diamonds exhibit some of the highest value-to-weight ratios of any item in the world. 

Items with this characteristic are primary targets of theft—they’re easy to conceal and therefore steal. 

Furthermore, only highly skilled individuals can distinguish fake diamonds from the genuine article. Trade in diamonds seemingly provides ample opportunity for fraud and theft. 

It’d be reasonable to expect that the diamond dealing industry always relies heavily on the state’s laws and courts to enforce contracts, punish theft, and curtail fraud.

It does not. 

In fact, the diamond industry is one of the world’s preeminent examples of private governance—privately devised rules for regulating commercial interaction. The details are documented extensively by Lisa Bernstein in a series of papers, and by Barak Richman in his book, Stateless Commerce: The Diamond Network and the Persistence of Relational Exchange. 

As Richman shows, Manhattan’s 47th Street—the world-renowned Diamond District—was a virtually government-free zone (at least with respect to diamonds) for decades. 

Rather than rely on government, the Orthodox Jews of the diamond business did commerce and adjudicated disputes through their self-created Diamond Dealers Club (DDC). The discipline of continuous dealings undergirded trade and the DDC’s communication of prior arbitration decisions informed diamond dealers about who to avoid. Richman’s book also reveals some the causes behind the unraveling of long-standing private governance in the diamond industry.

So, why, exactly, was a self-created, informal legal arrangement better for so many diamond dealers? Interestingly, Medieval merchants also forsook local government courts in favor of law they themselves created, the world-famous Lex Mercatoria. 

For both Medieval merchants and for diamond dealers, opting out of the formal legal system made sense because the state-sponsored legal system was too costly along a host of margins. Uncertainty about future judicial rulings made contract formation hard. Courts don’t always calculate damages correctly. They’re slow. They’re expensive. 

Instead, as Bernstein puts it: “Jewish diamond dealers in the New York bourse [trading center] in the early 1990s were able to exchange millions of diamonds simply by shaking hands and intoning the [Hebrew] phrase mazal u b’racha.” When disputes arose, they were handled by the Diamond Dealers Club. Yet, true crime was rare. Members of the Jewish diamond community had just about everything to lose upon expulsion from their tight-knit diamond network. 

For details on this sophisticated system of dispute resolution, ostracism, and extralegal governance, see Richman’s book.