Law and Financial Development

In the paper, Law and Financial Development: What We Are Learning from Time-Series Evidence, which was recently made publicly available on SSRN, my co-authors (Simon Deakin at the University of Cambridge; Viviana Mollica at Queen Mary University of London; and Mathias Siems at the University of East Anglia) and I explore the empirical evidence regarding the legal origins hypothesis. It is widely believed that legal institutions matter for financial development. According to the ‘legal origins’ hypothesis developed by La Porta et al. and their collaborators, legal systems vary considerably in the way they regulate economic activity. A principal cause of this diversity is the role played by the different legal traditions or ‘origins’ of the common and civil law (La Porta et al., 2008). It is argued that countries whose legal systems have a common law origin emphasize freedom of contract and the protection of private property, whereas those with civil law roots favor an activist role for the state. These legal differences seem to have tangible economic effects. Common law systems have been found to have more dispersed share ownership (La Porta et al., 1999), more liquid and extensive capital markets (La Porta et al., 1998), and more highly developed systems of private credit, than civilian ones. In part through the Doing Business reports of the World Bank, these findings have come to influence policy reform in ‘dozens of countries’ over the past decade (La Porta et al., 2008:326). Reforms to corporate and bankruptcy law have seen a strengthening of shareholder and creditor rights, particularly the former.

Influential as it is, the legal origins hypothesis has raised more questions than it has answered. The idea that a country’s approach to the regulation of the economy is fixed at the point when it first adopts or has imposed upon it, through colonization or conquest, a certain type of legal order, implies that national systems are locked into particular developmental paths. This neglects the possibility of feedback effects between legal change and economic development. It is also points to a potential contradiction in the use of the legal origins hypothesis to generate policy reforms: the common law model, while apparently more conducive to financial development might not be appropriate for transplantation into civil law regimes. What is at stake here is the degree of fit between substantive rules and the legal structures which are said to underpin them. Adherents of the legal origins hypothesis suggest that legal changes can be undertaken ‘without disturbing the fundamentals of the legal tradition’ of the countries concerned (La Porta et al., 2008: 325), a view supportive of the move to align civilian systems with the common law approach.

There is now a growing body of data derived from techniques for coding cross-national legal variation over time. This time-series evidence is reviewed here and is shown to cast new light on some of the central claims of legal origins theory. Legal origins are shown to be of little help in explaining trends in the law relating to shareholder protection, although the classification of legal systems into English-, French- and German-origin ‘families’ has greater explanatory force in the context of creditor rights. The widely-held view that increases in shareholder rights foster financial development is not supported by time-series analyses. More generally, the new evidence casts doubt on the suggestion that legal origins operate as an ‘exogenous’ force, independently shaping both the content of laws and economic outcomes. It is more plausible to see legal systems as evolving in parallel with changes in economic conditions and political structures at national level.

The full paper is available for download here.