UNIVERSITY OF VIRGINIA SCHOOL OF LAW Legal Studies Working Papers Series The common law and Economic growth Hayek might be right Paul G. mahoney Working Paper 00-8 January 2000 This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection http://papers.ssrn.com/paper.taf?abstractid=206809
UNIVERSITY OF VIRGINIA SCHOOL OF LAW Legal Studies Working Papers Series The Common Law and Economic Growth: Hayek Might be Right Paul G. Mahoney Working Paper 00-8 January 2000 This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection http://papers.ssrn.com/paper.taf?abstract_id=206809
The common law and economic growth: Hayek Might be right Paul G. Mahoney University of Virginia School of Law 580 Massie road Charlottesville. VA 22903 (804)924-3996;fax(804)924-7536 pgm9h(@virginia. edu I thank Kevin Davis. Ronald Barry Ickes, Ross Levine, Katharina Pistor, and participants at the University of Virginia Studies workshop and the Corporate Governance: Lessons to Ross Levine for access to some of the data used in the pape, Of Michigan. I am also grateful from Transition Economy Reforms conference at the University December 28 1999
The Common Law and Economic Growth: Hayek Might be Right Paul G. Mahoney University of Virginia School of Law 580 Massie Road Charlottesville, VA 22903 (804)924-3996; fax (804)924-7536 pgm9h@virginia.edu I thank Kevin Davis, Ronald Gilson, Barry Ickes, Ross Levine, Katharina Pistor, and participants at the University of Virginia Legal Studies workshop and the Corporate Governance: Lessons from Transition Economy Reforms conference at the University of Michigan. I am also grateful to Ross Levine for access to some of the data used in the paper. December 28, 1999
The Common Law and Economic growth: Hayek might be right ey Abstract Recent finance scholarship finds that countries with legal systems based on the common law provide better investor protections and have more developed financial markets than civil law countries. These findings echo Hayek's claims of the superiority of English to French legal institutions. In this paper, I present evidence that common law countries experienced faster economic growth than civil law countries during the period 1960-1992. I suggest that the difference reflects the common law's greater orientation toward private economic activity and the civil laws greater orientation toward government intervention
1 The Common Law and Economic Growth: Hayek Might be Right Paul G. Mahoney Abstract Recent finance scholarship finds that countries with legal systems based on the common law provide better investor protections and have more developed financial markets than civil law countries. These findings echo Hayek’s claims of the superiority of English to French legal institutions. In this paper, I present evidence that common law countries experienced faster economic growth than civil law countries during the period 1960-1992. I suggest that the difference reflects the common law’s greater orientation toward private economic activity and the civil law’s greater orientation toward government intervention
[T]he ideal of individual liberty seems to have flourished chiefly among people where, at least for long periods, judge-made law predominated"(Hayek, 1973, p. 94) Recently, economists have produced evidence that financial markets contribute to economic growth and legal institutions contribute to the growth of financial markets. King and Levine(1993) demonstrate that the rate of increase in per capita gross domestic product(GDP)is greater in countries with more developed financial markets. La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998; 1997)(hereafter LLSV, 1998 and LLSV, 1997) find evidence that the extent to which a country's corporate laws protect the interests of minority investors is an important determinant of the cost of external capital. They also, interestingly, find that countries whose legal systems are derived from the common law tradition provide superior investor protections on average, particularly in comparison to the French civil law tradition. Levine(1999)and Levine, Loayza and Beck(1999) find that better investor protections are associated both with more developed financial markets and faster economic growth Levine(1999), Levine Loayza and Beck(1999)and LLSV(1998 )treat legal origin as nstrumental variable for financial development. Legal origin is well suited to the purpose. It is largely exogenous, as most countries have had their legal systems imposed by colonization or conquest. Legal origin also correlates strongly with policies(such as creditor and minority shareholder protections) that on the basis of theory and empirical results should lead to greater financial market development. The authors do not, however, provide an explanation for the correlation. Corporate law seems an unlikely place to find a systematic difference between
2 “[T]he ideal of individual liberty seems to have flourished chiefly among people where, at least for long periods, judge-made law predominated” (Hayek, 1973, p. 94). I. Introduction Recently, economists have produced evidence that financial markets contribute to economic growth and legal institutions contribute to the growth of financial markets. King and Levine (1993) demonstrate that the rate of increase in per capita gross domestic product (GDP) is greater in countries with more developed financial markets. La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998; 1997) (hereafter LLSV, 1998 and LLSV, 1997) find evidence that the extent to which a country’s corporate laws protect the interests of minority investors is an important determinant of the cost of external capital. They also, interestingly, find that countries whose legal systems are derived from the common law tradition provide superior investor protections on average, particularly in comparison to the French civil law tradition. Levine (1999) and Levine, Loayza and Beck (1999) find that better investor protections are associated both with more developed financial markets and faster economic growth. Levine (1999), Levine Loayza and Beck (1999) and LLSV (1998) treat legal origin as an instrumental variable for financial development. Legal origin is well suited to the purpose. It is largely exogenous, as most countries have had their legal systems imposed by colonization or conquest. Legal origin also correlates strongly with policies (such as creditor and minority shareholder protections) that on the basis of theory and empirical results should lead to greater financial market development. The authors do not, however, provide an explanation for the correlation. Corporate law seems an unlikely place to find a systematic difference between
common and civil law countries. Compared to other areas of commercial law, such as contract or commercial paper, corporate law has been largely code- like in the common law countries from a very early date. This raises the question whether the tendency toward more efficient rules of corporate law in common law countries is a coincidence that might disappear or reverse in other areas of commercial law This paper explores an alternative possibility-that legal origin is not merely an instrument for financial development, but is causal in its own right. The motivation for the hypothesis is Hayek's(1960)argument for the superiority of English to French legal traditions. Hayek viewed the decentralized, judge-made common law as an example of spontaneous order, and a considerable amount of his later work returned to this idea( hayek 1960, 1967, 1973; see Ogus, 1989 for a critical survey ) Because, in Hayek's view, the spontaneous order represented by the common law is more consistent with individual liberty than the more rationalist and constructivist (and therefore more interventionist)tendencies of the civil law, the common law is associated with fewer government restrictions on economic and other liberties. If common law countries ndeed provide greater freedom to their citizens, they should experience more rapid economic growth Hayek's views are correct as a matter of legal history. Although legal systems are most often acquired involuntarily, they were an object of conscious choice in both England and France English common law developed as it did because landed aristocrats and merchants wanted a system of law that would provide strong protections for property and contract rights and limit the crowns ability to interfere in markets. French civil law, by contrast, developed as it did because the revolutionary generation, and Napoleon after it, wished to disable judges from thwarting
3 common and civil law countries. Compared to other areas of commercial law, such as contracts or commercial paper, corporate law has been largely code-like in the common law countries from a very early date. This raises the question whether the tendency toward more efficient rules of corporate law in common law countries is a coincidence that might disappear or reverse in other areas of commercial law. This paper explores an alternative possibility–that legal origin is not merely an instrument for financial development, but is causal in its own right. The motivation for the hypothesis is Hayek’s (1960) argument for the superiority of English to French legal traditions. Hayek viewed the decentralized, judge-made common law as an example of spontaneous order, and a considerable amount of his later work returned to this idea (Hayek 1960, 1967, 1973; see Ogus, 1989 for a critical survey). Because, in Hayek’s view, the spontaneous order represented by the common law is more consistent with individual liberty than the more rationalist and constructivist (and therefore more interventionist) tendencies of the civil law, the common law is associated with fewer government restrictions on economic and other liberties. If common law countries indeed provide greater freedom to their citizens, they should experience more rapid economic growth. Hayek’s views are correct as a matter of legal history. Although legal systems are most often acquired involuntarily, they were an object of conscious choice in both England and France. English common law developed as it did because landed aristocrats and merchants wanted a system of law that would provide strong protections for property and contract rights and limit the crown’s ability to interfere in markets. French civil law, by contrast, developed as it did because the revolutionary generation, and Napoléon after it, wished to disable judges from thwarting
government economic policies. Thus, quite apart from the substance of legal rules, there is a sharp difference between the ideologies underlying common and civil law, with the latter notably more comfortable with a centralized and activist government(Merryman, 1985) The more complex question is whether the sharp differences in origin and ideology translate into institutional differences that could affect economic outcomes today. I suggest that there are structural differences between common and civil law, most notably the greater degree of dicial independence in the former and the lower level of scrutiny of executive action in the latter that provide governments more scope for alteration of property and contract rights in civil law countries. The law-and-development literature to date, by focusing on differences in the substance of specific legal rules, has missed this larger picture I then report results of cross-country regression analyses showing an association between the common law and higher rates of real per capita growth in gross domestic product(GDP) also provide evidence, derived from Clague, Keefer, Knack and Olson's(1995)concept of contract-intensive money, that citizens in common law countries demonstrate greater confidence in the mechanisms of property and contract enforcement than those in civil law countries Section II provides theoretical background by drawing a link between judicial independence and economic growth. Section Ill draws on the history of the common and civil law traditions to show that the two differ sharply in attitudes toward judicial independence and notes ongoing institutional effects. Section IV reports the results of cross-country growth regressions. Section V provides additional evidence that the association between the common law and growth is a consequence of the greater security of property and contract rights from government interference, and Section VI concludes
4 government economic policies. Thus, quite apart from the substance of legal rules, there is a sharp difference between the ideologies underlying common and civil law, with the latter notably more comfortable with a centralized and activist government (Merryman, 1985). The more complex question is whether the sharp differences in origin and ideology translate into institutional differences that could affect economic outcomes today. I suggest that there are structural differences between common and civil law, most notably the greater degree of judicial independence in the former and the lower level of scrutiny of executive action in the latter, that provide governments more scope for alteration of property and contract rights in civil law countries. The law-and-development literature to date, by focusing on differences in the substance of specific legal rules, has missed this larger picture. I then report results of cross-country regression analyses showing an association between the common law and higher rates of real per capita growth in gross domestic product (GDP). I also provide evidence, derived from Clague, Keefer, Knack and Olson’s (1995) concept of contract-intensive money, that citizens in common law countries demonstrate greater confidence in the mechanisms of property and contract enforcement than those in civil law countries. Section II provides theoretical background by drawing a link between judicial independence and economic growth. Section III draws on the history of the common and civil law traditions to show that the two differ sharply in attitudes toward judicial independence and notes ongoing institutional effects. Section IV reports the results of cross-country growth regressions. Section V provides additional evidence that the association between the common law and growth is a consequence of the greater security of property and contract rights from government interference, and Section VI concludes
II. Theoretical Background Why should legal origin matter? One possibility is that the quality of legal rules varies systematically by origin. LLSV (1997, 1998) provide evidence that common law countries have better systems of corporate law on average. Nevertheless, it is difficult to make out a strong case for the superiority of the rules produced by the common law or the civil law across the board Early scholarship in law and economics contended that the process of litigation should lead to the survival of efficient rules in a common law system(Posner, 1972; Rubin, 1977; Priest, 1977 Priest Klein, 1984). The unspoken implication was that statutory law would be generally less efficient than judge-made law. More recently, however, claims about the comparative efficiency of the common law have nearly ceased. Posner appears to have recanted his belief in the superiority of judge-made to legislative rules( Backhaus 1997). Tullock(1997) provides a heated refutation of the notion of an "efficient"common law and argues for the superiority of civil law codification Another possibility is that the average quality of rules is similar, but the common law provides greater stability and predictability. The common law tradition includes two features-respect for precedent and the power of an appellate court to reverse the legal conclusions of a lower court-that should result in more predictable outcomes(Manne, 1997) These features are nominally lacking in the civil law. Only the code itself-not prior judicial decisions or the pronouncement of a superior tribunal-counts as binding law in the civil law tradition. Legislatures, unlike common law courts, are not bound by precedent. It is debatable, however, whether the difference is a sharp in practice as it is in theory. Civil law courts appear in practice to consult precedents and the decisions of higher courts(Merryman, 1985)
5 II. Theoretical Background Why should legal origin matter? One possibility is that the quality of legal rules varies systematically by origin. LLSV (1997, 1998) provide evidence that common law countries have better systems of corporate law on average. Nevertheless, it is difficult to make out a strong case for the superiority of the rules produced by the common law or the civil law across the board. Early scholarship in law and economics contended that the process of litigation should lead to the survival of efficient rules in a common law system (Posner, 1972; Rubin, 1977; Priest, 1977; Priest & Klein, 1984). The unspoken implication was that statutory law would be generally less efficient than judge-made law. More recently, however, claims about the comparative efficiency of the common law have nearly ceased. Posner appears to have recanted his belief in the superiority of judge-made to legislative rules (Backhaus 1997). Tullock (1997) provides a heated refutation of the notion of an “efficient” common law and argues for the superiority of civil law codification. Another possibility is that the average quality of rules is similar, but the common law provides greater stability and predictability. The common law tradition includes two features–respect for precedent and the power of an appellate court to reverse the legal conclusions of a lower court–that should result in more predictable outcomes (Manne, 1997). These features are nominally lacking in the civil law. Only the code itself–not prior judicial decisions or the pronouncement of a superior tribunal–counts as binding law in the civil law tradition. Legislatures, unlike common law courts, are not bound by precedent. It is debatable, however, whether the difference is a sharp in practice as it is in theory. Civil law courts appear in practice to consult precedents and the decisions of higher courts (Merryman, 1985)
The strongest reason to suspect that legal origin would not be important is that both raditions do well on the most fundamental questions, providing for enforcement of property and contract rights and requiring compensation for certain wrongful(tortious)acts. As North(1981) notes, the creation of a system of enforceable property rights is one of the most important institutional prerequisites to economic growth. The substantive rules of common and civil law provide redress for private actors' interference in property or contracts The story might end here except that would-be appropriators of wealth can also use the machinery of government to obtain their ends. Thus Weingast(1993)poses the "central political dilemma of an economic system: a government strong enough to protect property rights is also strong enough to confiscate the wealth of its citizens. " Combined with the theory of publ choice, this insight shows that governments will often respond to the demands of rent-seekin groups by modifying property or contract rights(Olson, 1982). A growing literature seeks to identify in political and legal institutions forms of credible commitments not to modify property and contract rights and thereby to encourage investment. For example, Weingast (1993)and others identify federalism as a means of decentralizing power and raising the cost of rent-seeking Separation of legislative, executive, and judicial powers is another means to the same end Persson, Roland and Tabellini(1999)model public finance outcomes under two regimes, a parliamentary regime and a presidential/congressional regime, in which the latter has a higher degree of separation of executive and legislative power. The model predicts that the latter regime ill be associated with lower taxation and less redistribution, but at the cost of under provision of public goods. The paper also provides some confirmatory empirical results. The intuition is traightforward; it is more difficult for politicians to coordinate in a system of separated powers 6
6 The strongest reason to suspect that legal origin would not be important is that both traditions do well on the most fundamental questions, providing for enforcement of property and contract rights and requiring compensation for certain wrongful (tortious) acts. As North (1981) notes, the creation of a system of enforceable property rights is one of the most important institutional prerequisites to economic growth. The substantive rules of common and civil law provide redress for private actors’ interference in property or contracts. The story might end here except that would-be appropriators of wealth can also use the machinery of government to obtain their ends. Thus Weingast (1993) poses the “central political dilemma of an economic system: a government strong enough to protect property rights is also strong enough to confiscate the wealth of its citizens.” Combined with the theory of public choice, this insight shows that governments will often respond to the demands of rent-seeking groups by modifying property or contract rights (Olson, 1982). A growing literature seeks to identify in political and legal institutions forms of credible commitments not to modify property and contract rights and thereby to encourage investment. For example, Weingast (1993) and others identify federalism as a means of decentralizing power and raising the cost of rent-seeking. Separation of legislative, executive, and judicial powers is another means to the same end. Persson, Roland and Tabellini (1999) model public finance outcomes under two regimes, a parliamentary regime and a presidential/congressional regime, in which the latter has a higher degree of separation of executive and legislative power. The model predicts that the latter regime will be associated with lower taxation and less redistribution, but at the cost of under provision of public goods. The paper also provides some confirmatory empirical results. The intuition is straightforward; it is more difficult for politicians to coordinate in a system of separated powers
Separation of powers thus produces less redistribution but also fewer public goods. I Judicial independence reinforces the separation of powers between the legislative and executive branches, on the one hand, and the judiciary, on the other, and we would therefore expect it to increase the cost of redistribution. Compared to Persson et al. 's argument for separation between legislative and executive power, the argument for judicial independence is more complicated and controversial. Landes and Posner(1975)argue that an independent judiciary(that is, one that does not make decisions based on the current desires of the legislature makes interest group deals more secure. The reason is that most legislation is not self-enforcing to be effective, it must be enforced by the judiciary. By enforcing the will of the enacting legislature, the judiciary insulates deals from tampering by future legislatures. The future gislature can, of course, enact a new statute, but this is more costly than simply putting pressure on a judge to rule in favor of the legislature's preferred party. Thus, Landes and Posner conclude judicial independence increases the value of legislative deals by making them more durable Anderson, Shughart and Tollison(1989)argue that the Landes/posner analysis does not adequately explain why a judge would be motivated to enforce the will of the initial legislature. A truly independent judiciary would not feel constrained to follow the legislature's intent. Indeed there is some evidence that independent judges behave independently-that is, they consult their own policy preferences when there is no clear answer from the text of a statute or othe I To anticipate a question that might arise in considering this paper's empirical results, there is not an association between the common law and presidential/congressional regimes; indeed, there is a mild negative correlation. The two forms of separation of powers may be substitutes
To anticipate a question that might arise in considering this paper’s empirical results, 1 there is not an association between the common law and presidential/congressional regimes; indeed, there is a mild negative correlation. The two forms of separation of powers may be substitutes. 7 Separation of powers thus produces less redistribution but also fewer public goods.1 Judicial independence reinforces the separation of powers between the legislative and executive branches, on the one hand, and the judiciary, on the other, and we would therefore expect it to increase the cost of redistribution. Compared to Persson et al.’s argument for separation between legislative and executive power, the argument for judicial independence is more complicated and controversial. Landes and Posner (1975) argue that an independent judiciary (that is, one that does not make decisions based on the current desires of the legislature) makes interest group deals more secure. The reason is that most legislation is not self-enforcing; to be effective, it must be enforced by the judiciary. By enforcing the will of the enacting legislature, the judiciary insulates deals from tampering by future legislatures. The future legislature can, of course, enact a new statute, but this is more costly than simply putting pressure on a judge to rule in favor of the legislature’s preferred party. Thus, Landes and Posner conclude, judicial independence increases the value of legislative deals by making them more durable. Anderson, Shughart and Tollison (1989) argue that the Landes/Posner analysis does not adequately explain why a judge would be motivated to enforce the will of the initial legislature. A truly independent judiciary would not feel constrained to follow the legislature’s intent. Indeed, there is some evidence that independent judges behave independently–that is, they consult their own policy preferences when there is no clear answer from the text of a statute or other
authoritative text(Revesz, 1997). In that event, judicial independence should function similarly to the separation of legislative and executive power. Independence introduces another actor with policy preferences that are potentially different from those of the legislature and makes coordination among those actors difficult. Independence thereby increases the risk that an interest group will expend resources attempting to obtain favorable policies but come up empty-handed Indeed, administrative agencies seem much more likely than courts to play the role Landes and Posner describe. Many regulatory statutes entrust an administrative agency with the administration and enforcement of the regulatory program. Civil service laws and statutes creating these agencies may protect their personnel against termination by the executive based on olicy disagreements. Moreover, those personnel may desire jobs with the regulated industr fter their government service, making them a potent force for protecting the rents created by regulatory statutes. Here again an independent judiciary, unless it can be counted on to uphold the agency's decisions, will decrease the predictabil ity of enforcement and the value of favorable The degree of formal separation between the judiciary and the other branch or branches is ordinarily greater in common law than civil law countries. In the common law tradition,the judiciary is a formally separate branch of government and any ordinary judgeship is a prestigious, well-compensated post. A judge is appointed, typically as the culmination of a successful career Ashenfelter, Eisenberg and Schwab(1995), by contrast, find that a judge's ideology (proxied by the party of the President who appointed him or her) do not affect the outcomes of cases at the trial court level in a sample of civil rights cases. They note that in a substantial number of the cases in the sample, the applicable legal rule was reasonably clear. Thus there is no necessary conflict between their findings and those of Revesz, who focused on appellate cases that are more likely to involve the interpretation of facially ambiguous statutes
Ashenfelter, Eisenberg and Schwab (1995), by contrast, find that a judge’s ideology 2 (proxied by the party of the President who appointed him or her) do not affect the outcomes of cases at the trial court level in a sample of civil rights cases. They note that in a substantial number of the cases in the sample, the applicable legal rule was reasonably clear. Thus there is no necessary conflict between their findings and those of Revesz, who focused on appellate cases that are more likely to involve the interpretation of facially ambiguous statutes. 8 authoritative text (Revesz, 1997). In that event, judicial independence should function similarly 2 to the separation of legislative and executive power. Independence introduces another actor with policy preferences that are potentially different from those of the legislature and makes coordination among those actors difficult. Independence thereby increases the risk that an interest group will expend resources attempting to obtain favorable policies but come up empty-handed. Indeed, administrative agencies seem much more likely than courts to play the role Landes and Posner describe. Many regulatory statutes entrust an administrative agency with the administration and enforcement of the regulatory program. Civil service laws and statutes creating these agencies may protect their personnel against termination by the executive based on policy disagreements. Moreover, those personnel may desire jobs with the regulated industry after their government service, making them a potent force for protecting the rents created by regulatory statutes. Here again an independent judiciary, unless it can be counted on to uphold the agency’s decisions, will decrease the predictability of enforcement and the value of favorable legislation. The degree of formal separation between the judiciary and the other branch or branches is ordinarily greater in common law than civil law countries. In the common law tradition, the judiciary is a formally separate branch of government and any ordinary judgeship is a prestigious, well-compensated post. A judge is appointed, typically as the culmination of a successful career
