Lecture 7 Legal Regimes and Economic Growth

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Lecture 7Legal Regimes and Economic Growth

• Se Yan

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Institutional hypothesis
Countries with better institutions, more
secure property rights, and less distortionary
policies will invest more in physical and human
capital, and will use these factors more
efficiently to achieve a greater level of income
(Acemoglu, Johnson, and Robinson, Colonial
Origins, p. 1369).
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Do Institutions matter?

• Yes
• But they are endogenous
• So cant take variation as evidence that they
  affect outcomes.
• Two choices
• Study institutions that are exogenous
• Economists approach
• Implicit if we can show that they matter policy
  makers will chose the right ones
• Explicitly understand the process of
  institutional change
• Economic historians approach
• But then things are often messy

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Law as an Institution

• Its clearly
• an institution
• Endogenous in its detail
• Has lots of variation
• To understand its impact
• Need to focus on specific outcomes
• Need to deal with endogeneity

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Outcomes of interest

• Theory
• Growth
• Property rights
• Impact of law on Business organization
• But you could look at issues of distribution as
  well. And possibly many other channels
• Policy
• Should economic laggards adopt Laws of current
  successes

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An Ounce of Genius

• Legal Regime!
• Its exogenous
• Its easy to measure
• It maps directly into a large body of theory
• Breaking it down
• Creditor rights
• Minority shareholder protection
• Bankruptcy procedures

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But, why? Through what channels?

• Some skeptical of law and finance view
• North Stulz and Williamson (Culture/Religion)
• Berkowitz et al. (transplant process)
• Engerman/Sokoloff Acemoglu, Johnson, Robinson
  (offer alternative, though not mutually exclusive
  explanations)
• But, Beck, Demirguc-Kunt, and Levine while
  supporting AJR, still find that legal origin
  matters.
• But, why?
• Can we identify particular characteristics of the
  legal system?
• Can we identify establish a causal chain running
  from legal origin via legal system traits to
  finance?

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1. Political channel

• State power viv-a-vis individual investors (LLSV,
  1999)
• LO differ in terms of private property rights
  protection
• property rights protection is key for finance
• LO, private property rights, and powerful States
• Common law evolved to protect property rights
  (North/Weingast Mahoney)
• Courts limited kings power
• Civil law (19th century) was constructed to
  solidify State power.
• Justininan places emperor above law, breaking
  with Roman tradition
• French Revolution tried to eliminate
  jurisprudence, judicial discretion
• Place the State above the courts relegate judges
  to minor, bureaucratic role
• Like Napoleon, Bismarck unified and strengthened
  a nation through codification
• Civil law is a proxy for an intent to build
  institutions that further the power of the State,
  relative to the rights of individual investors
  (LLSV 1999) (but RZ)
• Powerful States tend to create policies that
  divert the flow savings toward favored ends,
  which is antithetical to competitive finance.

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2. Adaptability channel

• Premises
• legal systems differ in their abilities to adapt
  to changing financial conditions
• legal systems that embrace jurisprudence and do
  not rely excessively on changes in statutory law
  will tend to evolve more efficiently to changing
  conditions than legal systems that reject
  jurisprudence or require strict adherence to
  statutes.
• Common Law
• An influential, though not unanimous, literature
  holds that the common law tends to evolve
  efficiently (Posner)
• The life of the law has not been logic it has
  been experience.
• Justinian
• tried to eliminate jurisprudence, without success

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Legal origin matters ...

• Legal origin explains investor protection laws,
  property rights, and hence financial development
  (LLSV)
• Through these channels, legal origin helps
  account for
• corporate valuations, dividends, ownership
  concentration (LLSV Himmelberg, Hubbard, Love)
• capital allocation (Wurgler Beck/Levine,
  Claessens/Laeven, etc.)
• informational efficiency of stock prices (Morck,
  Yeung, Yu)
• financial fragility (Johnson, Boone, Breach,
  Friedman)
• Firm, industry, and country growth
  (Demirguc-Kunt/Maksimovic Rajan/Zingales
  Levine)

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Approach of La Porta, et al.

• Bad institutions should affect firms ability to
  secure external investment. So focused on
  explaining variation in size of equity markets
  and amounts of borrowing relative to GNP.
• Hypothesized that extent of protections to
  shareholders and creditors was important.
• Hypothesized that extent of protections vary with
  legal regime.

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Like absolutism, private expropriation is bad for
economic development

• If those in control of firms can expropriate the
  earnings or investment of external investors,
  people with wealth wont invest.
• Commitment of those in control not to expropriate
  is not always credible.
• So investment in wealth-creating activities can
  be inhibited.

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Source LLSV, Legal Determinants of External
Finance, Journal of Finance, 52 (July 1997)
1134-35.
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Extent of External Protections to Shareholders
and Creditors
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External finance f(regulatory protections,
controls)
Where External finance is equity/GNP, debt/GNP,
etc. Regulatory protections are antidirector
rights, creditor rights, or one share one
vote Controls are GDP growth, Log GNP, Rule of
law, legal origin dummies
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Source LLSV, Legal Determinants of External
Finance, Journal of Finance, 52 (July 1997)
1141.
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Source LLSV, Legal Determinants of External
Finance, Journal of Finance, 52 (July 1997)
1145.
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Questions by Economic Historians

• How persistent is the Anglo-American advantage as
  we move back in time?
• How important are different elements of the law
  (Statute, Precedent, Code) in constraining firms?
  Do these roles vary between French Law and
  Anglo-American Law?
• How important are different elements of law
  (Statute, Precedent, Code) in providing
  flexibility? Do these roles vary between French
  Law and Anglo-American Law?
• Where does demand for flexibility come from? Does
  it change over time?

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Why might common law regimes be superior to code
law regimes?

• Common law is more flexibleand hence more
  responsive to business needsthan code law.
• Codes are products of (and thus proxies for)
  interventionist governments, which are bad for
  business.
• Hence we examine two different issues
• To what extent does the legal regime constrain
  entrepreneurs
• To what extent doe the legal regime respond to
  changes in society (is flexible).

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Possible benefits of flexibility

• Better enables business people solve contracting
  problems (static flexibility).
• Rather than forcing them into contractual boxes,
  gives them ability to modify contracts to solve
  problems.
• Law evolves in response to changing business
  needs (dynamic flexibility).
• Legal rules formed in one period may not be
  appropriate to a later era. Need to be able to
  change.

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History Implications
If institutions matter for the wealth and poverty
of nations, then history matters. One of the
problems with the argument is that it is an
historical argument, but the historical part is
never explicitly examined Idea is that once upon
a time, a country got a legal system and that
legal system then affected its development
path Obvious testable prediction is that cross
country patterns in debt or capital markets to
GNP should be stable over time
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Questions of method

• Economic theories are often a-historical.
• Pb here is that they tend to be tested in a
  specific context
• E.g. Common laws advantage is supposed to be
  long running. So that implies can test
• cross sectionally
• Using panels
• With dynamics
• Historical theories are often case specific
• Pb Here is that its not clear how to generalize

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What about concentration of control?

• Control is not the same as ownership they can be
  separated
• Shares with differential voting rights
• Pyramids
• Cross-ownership
• Trust agreements
• In fact, outside US and UK, this separation in
  large companies is very common
• Greater separation (and greater concentration of
  control) seem to be more common in countries with
  weak legal shareholder protection
• Not surprising control is very valuable there,
  more valuable than CFR
• Separating it from CFR gives possibility to
  retain control while selling CFR

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Franks Mayer Rossi

• A simple starting point.
• If legal regime matters. We should see it over
  time
• places with better law should have better
  outcomes
• Formal rules should not have good informal
  substitutes.
• Notice that this is also consistent with an
  argument that runs causality in reverse
• Good law allows dispersed shareholding
• Dispersed shareholders demand good laws
• Need to disentangle the correlation

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Implementation

• Implicit alternative
• If law is bad there has to be a dominant
  shareholder that monitors management (or is
  management)
• Idea is that a large Long Run shareholder reduces
  minority oppression because he/she wants to
  repeat reputational benefits
• A specific metric on outcomes
• Look at the rise of dispersed shareholders
• If law matters, dispersed ownership happens
  faster/slower when law is good/bad

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The sample

• By law starting in 1901 firm must file a bunch of
  stuff with the state
• State keeps all records of extant companies (and
  merges files after mergers)
• State keeps a 1 sample of all dying companies
  (but FMR) ignore this

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Lamoreaux and Rosenthal Key Findings

• Only advantage of US over France is early general
  incorporation? In other respects US adopts a
  narrow menu which only recognizes two types of
  firm organization egalitarian partnerships and
  standard (one share one vote) limited liability
  corporations.
• France allows four types of organization,
  Partnerships, Commandites, Share commandites and
  Corporation. It also allows variety within these
  basic types
• Control need not be aligned with investment.
• the extent of liability is chosen by the firms
  principals
• The most important constraint in both countries
  is the Judiciary. It is very conservative and
  seeks to protect outside creditors minority
  shareholders are rarely protected.
• The main source of innovation is statute law.
  Common Law seems locked in by precedent. The
  commercial code is not constraining as it is
  frequently updated by either judicial decisions
  or stature laws.
• Demand for flexibility seems to grow with wealth
  inequality and with economic heterogeneity. It
  is thus not surprising to see France being more
  flexible that the US in the 1840s.

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Implementation

• Look at France and the US in the mid- Nineteenth
  century, evaluate
• the legal menu.
• Look at take up of different option
• Look at attempts to get around legal constraints
• How to do so?
• In France its easy because of the obligation to
  publish the details of firm organization.
• In the US its comparatively harder

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Availability of Different Forms of Organization
in the United States and France
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Source Timothy W. Guinnane, Ron Harris, Naomi
R. Lamoreaux, and Jean-Laurent Rosenthal,
Putting the Corporation in its Place,
Enterprise and Society, 8 (Sept. 2007).
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If codes are proxies for interventionist
governments, their effects on the business
environment should be stable over time.

• But the evidence is contrary to this supposition.

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Source Aldo Musacchio, Can Civil Law Countries
Get Good Institutions? Creditor Rights and Bond
Markets in Brazil, 1850-2003, p. 26.
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Source Aldo Musacchio, Can Civil Law Countries
Get Good Institutions? Creditor Rights and Bond
Markets in Brazil, 1850-2003, p. 24.