The Rise of the Freedom to Arbitrate

Many Liberty Fund conferences chart a sorry decline in the state of some aspect of our liberty. Thus, it was a welcome change that a conference I attended last weekend titled “Arbitration, the State and Liberty” charted a better course. We spent the time discussing an aspect of liberty that has grown in the United States and Britain—the freedom of parties to commit their disputes to binding arbitration rather than be forced to handle them through government courts.

At common law, citizens either did not have this freedom or, at least, if they wanted to retain it, their lawyers had to engage in some clever drafting. Otherwise, an agreement to arbitrate was revocable and thus ineffective in preventing the state from taking over the decision making. But the Supreme Court has interpreted the Federal Arbitration Act to permit parties to enforce arbitration even in the teeth of contrary state legislation as well as the common law. Great Britain has enjoyed somewhat similar developments.

This freedom offers an important protection against exploitation by the state and by lawyers. If the state has the monopoly of determining disputes between consenting parties, it is likely to raise the procedural costs of doing so. Lawyers who dominate the writing of procedural rules have an interest in complex and costly procedures from which they can earn fees.

But arbitration also allows parties to choose better substantive law as well as access to experts who are likely to interpret it in a more predictable way than generalist and politically appointed judges. Parties in competitive markets are under pressure to write optimal contracts that create the greatest possible surplus. That surplus is threatened, however, by decision makers who interpret contracts in wrong or unexpected ways. One way of conceptualizing arbitration is that it provides a mechanism for assuring optimal contracting in a world where some disputes over terms are inevitable.

There are two possible downsides to arbitration, but neither are ultimately substantial. One is that arbitrators do not write opinions and thus unlike judges, they do not provide public guidance for future conduct. But the freedom to arbitrate has not stopped many parties from exercising their continuing right to go to Court rather than commit by contract to arbitration. That resort to the judiciary may stem from an irrational confidence in government or inertia, but the resulting mixed regime of arbitration and judicial decision making assures the publication of thousands of judicial decisions every year that provide guidance on basic law.

The other concern is limited to the class of consumer/merchant arbitration where consumers are said to lack “equal bargaining power.” I am skeptical that the concept of equal bargaining power has moral significance even if this inequality could be somehow calculated. One party is not responsible for the bargaining position of the other.

But, in any event, in competitive markets companies still have reputational incentives to provide reasonable dispute resolution. Just as their brand would lose luster if it fell below the quality that consumers expect, it would also suffer if the terms of the arbitration were outrageous, particularly in our world where outrages are easily publicized. And most consumers would like lower priced products rather than face the higher prices that companies would have to charge if they were more worried about unpredictably adverse litigation outcomes.

If consumers want to buy the lottery ticket that litigation in court often provides, they can do so at their local convenience store.