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We analyze a model of moral hazard in local public services which could be efficiently managed by officials under local democratic accountability, but not by officials who are appointed by the ruler of a centralized autocracy. The ruler might prefer to retain an official who diverted resources from public services but contributed part to benefit the ruler. The autocratic ruler would value better public services only when residents reduce taxable investments which become unprofitable without good public services. For local government to benefit local residents, they must have some decentralized power to punish an official who serves them badly even while serving the ruler well

A review of the history of the United States from its colonial origins shows how Americas successful development has always been guided by two basic principles: representative democracy, and a proper division of power between national and subnational governments. The United States of America was established as an independent nation by a congress of delegates from 13 provincial assemblies, each of which consisted of representatives elected by their communities. Since colonial times, local democratic rights have attracted immigrants to help build new towns in the growing nation. Responsible local governments in America have had the power and the incentive to make local public investments for developing prosperous communities. Democratic competition in America has been strengthened by the ability of successful local leaders to become competitive candidates for higher offices. But in spite of Americas example, many nations since the French Revolution have instead been drawn to centralized democracy, as national elites may prefer to centralize power around themselves. Americas successful growth ultimately depended on its citizens basic understanding that their welfare and security were enhanced by a balanced federal division of power between their elected local governments and the higher sovereign government of their nation.

We present a theory of the state based on political leadership and reputational equilibria. A political leader first needs a reputation for reliably rewarding loyal supporters. Reputational expectations between political leaders and their supporters become the fundamental political laws on which the enforcement of all other constitutional laws may be based. Successful democratic development requires a plentiful supply of leaders who have good reputations for using public funds responsibly to serve the public at large and not just giving jobs to their active supporters. It is argued that decentralized democracy may be the best way to improve the chances for successful democracy.

[This item is a preserved copy. To view the original, visit http://econtheory.org/] We consider a simple political-economic model where capitalist investment is constrained by the government's temptation to expropriate. Political liberalization can relax this constraint, increasing the government's revenue, but also increasing the ruler's political risks. We analyze the ruler's optimal liberalization, where our measure of political liberalization is the probability of the ruler being replaced if he tried to expropriate private investments. Poorer endowments can support reputational equilibria with more investment, even without liberalization. So we find a resources curse, where larger resource endowments can decrease investment and reduce the ruler's revenue. The ruler's incentive to liberalize can be greatest with intermediate resource endowments. Strong liberalization becomes optimal in cases where capital investment yields approximately constant returns to scale. Adding independent revenue decreases optimal liberalization and investment. Mobility of productive factors that complement capital can increase incentives to liberalize, but equilibrium prices may adjust so that liberal and authoritarian regimes co-exist.

We consider a simple political-economic model where capitalist investment is constrained by the government's temptation to expropriate. Political liberalization can relax this constraint, increasing the government's revenue, but also increasing the ruler's political risks. We analyze the ruler's optimal liberalization, where our measure of political liberalization is the probability of the ruler being replaced if he tried to expropriate private investments. Poorer endowments can support reputational equilibria with more investment, even without liberalization. So we find a resources curse, where larger resource endowments can decrease investment and reduce the ruler's revenue. The ruler's incentive to liberalize can be greatest with intermediate resource endowments. Strong liberalization becomes optimal in cases where capital investment yields approximately constant returns to scale. Adding independent revenue decreases optimal liberalization and investment. Mobility of productive factors that complement capital can increase incentives to liberalize, but equilibrium prices may adjust so that liberal and authoritarian regimes co-exist.

The U.S. Army's Counterinsurgency Field Manual, Bremer's My Year in Iraq, and Xenophon's Education of Cyrus all consider problems of establishing a state. Bremer sees constitutions as fundamental, and the Field Manual emphasizes local security operations and effective governance to establish legitimacy. But Xenophon shows how states are founded by leaders with reputations for reliably rewarding supporters. Agency incentive problems in government make patronage an essential aspect of state-building, and political leaders become fundamentally constrained by their reputations. Democratic competition requires many leaders to develop independent reputations for exercising power and patronage responsibly, which can be encouraged by political decentralization.

A political leader's temptation to deny costly debts to past supporters is a central moral-hazard problem in politics. This paper develops a game-theoretic model to probe the consequences of this moral-hazard problem for leaders who compete to establish political regimes. In contests for power, absolute leaders who are not subject to third-party judgments can credibly recruit only limited support. A leader can do better by organizing supporters into a court which could cause his downfall. In global negotiation-proof equilibria, leaders cannot recruit any supporters without such constitutional checks. Egalitarian norms make recruiting costlier in oligarchies, which become weaker than monarchies. The ruler's power and limitations on entry of new leaders are derived from focal-point effects in games with multiple equilibria. The relationships of trust between leaders and their supporters are personal constitutions which underlie all other political constitutions.