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1 law and economic growth

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Frank B. Cross*

Legal academics study the law extensively, but the great bulk of this research dwells upon the analysis of particular laws or doctrines as judged by standards of justice or individual liberty or simple positive formalism. While such research is unquestionably valuable, law professors have fallen far short when it comes to the study of the effect of law and laws on the economic welfare of nations.1 The now-flourishing law and economics movement has stepped into this void, but even much of that movement’s research has focused on particularized doctrines and micro-level theoretical analyses of efficiency rather than empirical studies of the structural features that conduce to growth.2 There remains a relative paucity of academic legal research on the big picture – what particular laws and legal institutions are conducive to the overall economic welfare of society.3

Herbert D. Kelleher Centennial Professor of Business Law, McCombs School of Business;

Professor of Law, University of Texas School of Law

1 See, e.g., Philip M. Nichols, A Legal Theory of Emerging Economies, 39 VA. J. INT’L L. 229,

236-239 (1999) (discussing how such research has focused on individual countries and failed to develop the
necessary overarching theories). One suspects that law professors think that a focus on economics and
wealth seems a bit tawdry, when compared to the great issues of justice, rights and fairness with which they
commonly grapple. Such a view is quite shortsighted, however. Economic welfare is central to human
wellbeing and relevant to human development and the exercise of freedom.

2 Thus, “[w]ritings in the 'law and economics' genre are especially noteworthy for their insistent

'micro' focus.” Ronald A. Cass, Black Robes and Blacker Boxes: The Changing Focus of Administrative
, 1984 DUKE L.J. 422, 433.

3 I must anticipate the threshold objection that economic growth is not the goal of the law, which
might be characterized as freedom and justice. See, e.g., Ronald Dworkin, Is Wealth a Value?, 9 J. LEGAL
STUD. 191 (1980) (criticizing theory that law should concern itself with increasing wealth); Jules
Coleman, Economics and the Law: A critical Review of the Foundations of the Economic Approach to the
, 94 ETHICS 649 (1980) (challenging philosophical basis of wealth maximization objective). While I
would concede that economic growth is not the sole objective worth considering in the law, it would be odd
to suggest that it should not be one of the central concerns of a legal system. Overall economic growth is
instrumental to the more general well-being of a society, including the welfare of disadvantaged groups.
Thus, “wealth maximization may be the most direct route to a variety of moral ends,” including political
rights, liberty, dignity and contentedness. Richard A. Posner, THE PROBLEMS OF JURISPRUDENCE
382 (1990). Economic growth leads to more collective goods advanced by regulation and redistributive
benefits such as health insurance and unemployment benefits. Carles Boix, Democracy, Development, and
the Public Sector
, 45 AM. J. POL. SCI. 1 (2001) (reporting empirical results to this effect). It is ironic that
liberals may place less value on economics, because growth tends to drive public policies in a liberal
direction, while economic difficulties cause such policies to shift to the right. Randolph T. Stevenson, The
Economy and Policy Mood: A Fundamental Dynamic of Democratic Politics
, 45 AM. J. POL. SCI. 620
(2001) (reporting this empirical result in study of developed nations). While economic growth may be
demeaned on distributive grounds, the empirical evidence shows that such growth directly benefits the
poor, in both developed and developing nations. See David Dollar & Aart Kraay, Growth Is Good for the
, World Bank Research Paper (March 2000) (reporting results from sample of eighty countries over
four decades and finding that income of the poor raises proportionately with overall economic growth);
Cass R. Sunstein, FREE MARKETS AND SOCIAL JUSTICE 210 (1997) (reporting that “[t]ime and again
it has been shown that economic growth can do more than welfare and employment programs to benefit the


Economists have increasingly studied the importance of law to economic growth and made key contributions to our understanding of the issue. Most of these economists, though, are not trained in law and do not test many of the hypotheses that are most important to pragmatic legal and policy determinations.4 Indeed, much of the economic research appears to reflect a fundamental misunderstanding about what is meant by basic terms such as “law” or “rights” or “property rights.” The contribution of economists to this study is invaluable, but the field cannot be left to this discipline; law professors must themselves add their understanding to the conversation.5

This article surveys the field of empirical research on law and economic growth and analyzes its findings. The article begins with a review of the theoretical and historical evidence associating good legal institutions with economic growth rates. The new institutional economics has used history and theory to make the case that legal institutions are crucial to economic development While some may argue that such institutions are unnecessary for growth or ineffective in light of local cultures, these positions contain only a grain of truth. There is ample reason to believe that law and legal institutions are fundamental to a nation’s economic development.

Considerable empirical research now informs the economic and other theories about the relationship of law and economic growth. There is substantial evidence that some major legal rules and institutions (such as democracy, property rights, and certain government regulations) have a distinctly positive effect on growth. The findings, though, are too generalized and for the most part do not focus on the features of democracy, property rights, and regulations that are malleable policy positions. Moreover, much of the research has been conducted by economists who may fail to capture relevant legal variables.

The current issue “before policy makers therefore is no longer ‘do institutions matter?’ but ‘which institutions matter and how does one acquire them?’”6 These are precisely the questions for which input from legal academics is essential. They are trained in the pragmatic

disadvantaged”); The World Bank, BUILDING INSTITUTIONS FOR MARKETS 75 (2001) (reviewing research demonstrating that developed financial system benefits the poorer segments of society and improves income distribution). Choosing to ignore the economic consequences of law is not in the interest of human welfare and presumably antidemocratic, insofar as the people clearly seek economic growth. See, e.g., Douglas A. Hibbs, Jr., Bread and Peace Voting in U.S. Presidential Elections, 104 PUB. CHOICE 149 (2000) (demonstrating significant effect of economic variables on voters’ choices). Even if total national wealth is not a per se good thing, it plainly contributes to very valuable ends.

4 See, e.g., Martin Leschke, Constitutional Choice and Prosperity: A Factor Analysis, 11 CONST.
POL. ECON. 265, 266 (2000) (noting that cross-country studies have found the importance of economic
freedom to prosperity but generally “do not try to examine systematically which of the components that
enhance freedom contribute to a nation’s prosperity”). Leschke emphasized the need for “empirical
measures by which policy decisions and actions can be meaningfully assessed.” Id. at 277.

5 Indeed, the failures of law reform efforts in post-communist nations has been attributed to reliance

on economists at the expense of legal experts. See Rolf Knieper & Mark Boguslavski, Concept for Legal
Counseling in Transformation States
, in MAKING DEVELOPMENT WORK 1115, 116-117 (Ann
Seidman, Robert B. Seidman & Thomas W. Wade eds. (1999) (reporting that the experts who advised on
law reform were “not members of the legal profession, but rather economists” who produced a “flood of
often highly contradictory texts from a wide variety of sources and with greatly differing hierchical

6 Dani Rodrick, Institutions for High-Quality Growth: What They Are and How to Acqurie Them,

NBER Working Paper 7540 (February 2000) at 2.


operation of laws and legal institutions, unlike many economists.7 Legal academics should build upon and enhance the existing economic research and help discern the laws and legal institutions that facilitate the economic wellbeing of nations.

I. The Theoretical Importance of Legal Institutions for Economic


Much research effort has been devoted to ascertaining the determinants of economic growth. Economic wellbeing cannot be ascribed to such fortuities as the natural resource endowments of nations.8 It is clear that factors such as investment and labor productivity are critical to economic growth, and the important research question is how these and other contributors to economic growth may be encouraged. It is now generally recognized that government institutions and the law are relevant to increasing economic growth. This section will review the current understanding of the theory of economic growth.

The review begins with the theoretical contribution of the new institutional economics, which formally recognized the significance of law for economic wellbeing. Under this economic theory, a good institutional structure is necessary to unleash effective capitalist growth. There are some who argue that voluntary arrangements can take the place of a legal structure or that different local cultures are more economically important than particular legal institutions. The remainder of the section examines those claims.

A. The New Institutional Economics

Under the standard neoclassical economic model, legal institutions should not matter. The model explains how, independent of law, levels of economic development should steadily converge among nations, ultimately equalizing wealth, at least roughly.9 Obviously, this has not occurred.10 Great and persistent disparities in wealth remain, and often countries have often

7 See Institutions for High Quality Growth, supra note 000, at 4 (observing that “[I]nstitutions do

not figure prominently in the training of economists”).

8 Ironically, natural resource endowments are generally a negative factor for economic growth. The

immediately available wealth from natural resources was a readily available economic rent to be seized by
the politically powerful. Historically, “the resource-poor countries’ economic performance tended to be
much better, on average, than that of those with abundant natural resources.” Deepak Lal, UNINTENDED

9 See, e.g., Michael Trebilcock, What Makes Poor Countries Poor?, in THE LAW OF

ECONOMICS AND DEVELOPMENT 16 (E. Buscaglia, W. Ratliff & R. Cooter eds. 1997) (reporting that
according to “neoclassical theories of growth, countries that are capital intensive (developed economies)
will have lower marginal products of capital and thus lower investment rates and economic growth, while
countries that are labor intensive (developing countries) will grow faster” implying a “convergence in
growth rates over time”).

10 See, e.g., Mancur Olson, Jr., Big Bills Left on the Sidewalk: Why Some Nations are Rich, and
Others Poor, 10 J. ECON. PERSP. 3, 14 (1996) (noting that “the dramatically uneven distribution of
capital around the world contradicts the familiar assumption that all countries are on the frontiers of
aggregate neoclassical production functions”); Leschke, supra note 000, at 266 (reporting that the
predictions of neoclassical models “do not match reality”).

This finding is not a basis to disregard the theory behind the neoclassical models. In fact, there is empirical evidence that such models do capture some reality. See, e.g., Peter Howitt, Endogenous Growth


shown a divergence, rather than convergence, of economic welfare.11 The neoclassical theory’s predictions of convergence did not take account of the different national legal and institutional framework under which development occurred.12 The new institutional economics developed to address this failed predictions of the neoclassical model, by emphasizing the importance of government institutions and policies to economic growth and explaining divergence by the existence of varying qualities of national institutions across the globe.13 One cannot expect wise or efficient government institutions to evolve naturally.14 When such institutions do not arise, national growth suffers. Capitalism “is not a naturally occurring system” either.15

The new institutional economics is closely associated with the research of Douglass North, who won a Nobel Prize for his efforts and insights in developing the theory. The fundamental theory of institutional economics is straightforward. It begins with the assumption that individuals will invest for economic growth when they can capture the returns from their investments.16 The ability to capture economic returns from one’s work or investment is not naturally automatic. To achieve optimality requires the existence of “[p]erfectly specified and

and Cross-Country Income Differences, AM. ECON. REV. 829 (2000) (discussing evidence of convergence under neoclassical model). However, the neoclassical models are clearly oversimple and require supplementation by consideration of legal institutions.

11 See Philip Keefer & Stephen Knack, Why Don’t Poor Countries Catch Up? A Cross-National

Test of an Institutional Explanation
, 35 ECON. INQUIRY 590, 590 (1997) (reviewing research on
divergence and the institutional explanation); What Makes Poor Countries Poor?, supra note 000,a t 16-17
(citing examples of dramatic divergence during this century). Nor does capital shift to poorer nations, as
the theory projects. See Robert E. Lucas, Jr., Why Doesn’t Capital Flow from Rich to Poor Countries, 80
AM. ECON. REV. (1990). However, once one controls for institutional effects, convergence may occur.
Why Don’t Poor Countries Catch Up?, supra note 000, at 597 (reporting findings that “[n]ot only is growth
faster when institutions are better, so also is convergence”).


GROWTH 9 (1992) (reporting that “[n]othing in the neoclassical theory considers the institutional
framework in which capital (physical and human) is accumulated, invention or innovation is made, or
inputs are converted to output”).

13 For a brief review of the new institutional economics, see Christopher Clague, The New

Institutional Economics and Economic Development, in INSTITUTIONS AND ECONOMIC
DEVELOPMENT 13 (Christopher Clague ed. 1997).


PERFORMANCE 7 (1990) (reporting that “[r]ulers devised property rights in their own interests and
transaction costs resulted in typically inefficient property rights prevailing”). See generally Thrainn
Eggertsson, ECONOMIC BEHAVIOR AND INSTITUTIONS 250-280 (1990) (describing traditional
“naïve theory” that property rights will arise whenever they contribute to efficiency and how it has been
abandoned in favor of an interest group theory describing development of such rights). In fact, most
governments “do not supply structures of property rights that are appropriate for placing the economy close
to the technical production frontier.” Id. at 320.

15 Fareed Zakaria, Lousy Advice Has Its Price, NEWSWEEK, September 27, 1999, at 40.

(reporting that his “model assumes an incentive structure that will allow individuals to capture the returns
to society of investment”).


costlessly enforced property rights.”17 While such an optimal condition is unachievable, societies may be able “to raise the private return close enough to the social return to provide sufficient incentives to achieve economic growth.”18 Absent such property rights, though, incentives may be insufficient to promote growth. In the view of the new institutional economics, “institutional capital may be a more important determinant of economic development than financial capital, physical capital, human capital, or technological capital.”19

North explored the importance of institutions historically. Throughout human history “growth has been more exceptional than stagnation or decline,”20 which demonstrated that the circumstances enabling growth were not inevitable or natural but required thought and effort. It is government that must be relied upon to create the conditions enabling growth.21 However, government does not automatically create these conditions but may in fact produce perverse policies, and the state has also been “the source of man-made economic decline.”22 North’s tour de force through history begins in the ancient world but keys on the Industrial Revolution and associated great expansion of economic growth. This transpired, he finds, only because of the “prior development of a set of property rights, which raised the private rate of return on invention and innovation.”23 England and the Netherlands surpassed France and Spain during the seventeenth century, in large part because of the effective recognition of property rights.24 The “establishment of secure and stable property rights” was a “key element in the rise of the West and the onset of modern economic growth.”25 More recent history shows that strong economies have market-oriented economic systems and that such systems are found in nations “that have recognized the need for and secured widespread property rights protected by just laws.”26 The

17 Id. See also Timothy Besley, Property Rights and Investment Incentives: Theory and Evidence

from Ghana, 103 J. POL. ECON. 903, 903 (1995) (reporting that the “evolution of property rights and their
effect on investment are central issues in the political economy of investment” and that “the role of the state
in codifying and protecting such rights is regarded, in many contemporary and historical discussions as
important to providing the preconditions for economic growth”).

18 Id. See also Eggertson, supra note 000, at 341 (discussing how the failure to provide certainty of

property rights, requires investors to make “various adjustments to minimize the risk of appropriation”
which in turn “tend to lower the level of investment activity and change its nature”).

19 What Makes Poor Nations Poor?, supra note 000, at 19.


21 See id. at 17 (reporting that “[u]ltimately it is the state that is responsible for the efficiency of the

property rights structure, which causes growth or stagnation or economic decline”).

22 Id. at 20.


24 Id. at 148-157.

25 Institutions for High Quality Growth, supra note 000, at 5.

26 Hernando de Soto, Preface, in THE LAW AND ECONOMICS OF DEVELOPMENT, supra note

000, at xiii.


economic difficulties of the privatizing, post-communist states of Eastern Europe are attributed to their poor legal systems.”27

The importance of legal institutions is now widely recognized.28 Another Nobel laureate, Mancur Olson, has identified “the conditions necessary for economic success” as including “secure and well-defined rights for all to private property and impartial enforcement of contracts.”29 Yet identifying the theoretical and historic importance of legal institutions does not answer the truly important practical questions. One cannot say that more or greater legal institutions are necessarily better. The same law and government that can provide the prerequisites for property right enforcement may also take them away. Research must focus upon the nature of institutions and legal rules that promote growth.

Hernando de Soto has recently written on the importance of full property rights to economic growth in poorer nations.30 He argues that squatters with untitled real estate in these countries have assets worth at least $9.3 trillion.31 Yet they cannot access these resources for investment because they lack the full rights of ownership associated with the formal property system.32 The wealth of the Western nations is attributed to the existence of such rights. The “legal property system became the staircase that took these nations from the universe of assets in their natural state to the conceptual universe of capital where assets can be viewed in their full productive potential.”33 Enhancing economic growth and expanding its benefits “is principally a legal challenge,” in which “[a]ll other disciplines play only a supporting role.”34

Simply emphasizing the significance of the existence of property rights is not sufficient. Some poor nations suffer not from the absence of formalized property rights but from legal barriers to the recognition of those rights.35 Property rights must be readily enforceable and credible to have the desired effect. The substantive nature of the property rights is also relevant.

27 See, e.g., Alan B. Krueger, Economic Scene, N.Y. TIMES, March 29, 2001, at C2 (suggesting that

the “overall experience suggests that rapid mass privatization, in the absence of a strong legal system, has
negative effects on performance”).

28 See, e.g., Robert M. Sherwood, The Economic Importance of Judges, 9 FED. CIRCUIT B.J. 619,

620 (2000) (reporting that “North’s views have been warmly received and widely accepted”); Pierre
Englebert, Pre-Colonial Institutions, Post-Colonial States, and Economic Development in Tropical Africa,
53 POL. RES. Q. 7, 8 (2000) (referring to “new consensus” that “it is the lack of state capacity and
institutional quality which is responsible for economic stagnation in Africa”); Rafael La Porta et al., The
Quality of Government
15 J. LAW ECON. & ORG. 222, 223 (1999) (reporting that the “importance of
good government for growth thus appears to be a well-established empirical proposition”).

29 Charles Cadwell, Foreword, in Mancur Olson, POWER AND PROSPERITY viii (2000).

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