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00-1720-2 fm.qxd 10/10/06 11:03 AM Page i The Law-Growth Nexus 00-1720-2 fm.qxd 10/10/06 11:03 AM Page ii 00-1720-2 fm.qxd 10/10/06 11:03 AM Page iii The Law-Growth Nexus The Rule of Law and Economic Development Kenneth W. Dam brookings institution press Washington, D.C. 00-1720-2 fm.qxd 10/10/06 11:03 AM Page iv about brookings The Brookings Institution is a private nonprofit organization devoted to research, education, and publication on important issues of domestic and foreign policy. Its principal purpose is to bring the highest quality independent research and analysis to bear on current and emerging policy problems. Interpretations or conclusions in Brookings publications should be understood to be solely those of the authors. Copyright © 2006 the brookings institution 1775 Massachusetts Avenue, N.W., Washington, D.C. 20036 www.brookings.edu All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without permission in writing from the Brookings Institution Press. Library of Congress Cataloging-in-Publication data Dam, Kenneth W. The law-growth nexus : the rule of law and economic development / Kenneth W. Dam. p. cm. Summary: “Examines the underlying mechanisms through which the law, judiciary, and legal profession influence the economy. Analyzes enforcement, contracts, and property rights—the concepts collectively defining rule of law—and examines their roles in the real estate and financial sectors. Extended China analysis assesses the importance of the rule of law”—Provided by publisher. Includes bibliographical references and index. ISBN-13: 978-0-8157-1720-1 (cloth : alk. paper) ISBN-10: 0-8157-1720-2 (cloth : alk. paper) 1. Economic development. 2. Rule of law. I. Title. HD75.D357 2006 338.9—dc22 2006027764 987654321 The paper used in this publication meets minimum requirements of the American National Standard for Information Sciences—Permanence of Paper for Printed Library Materials: ANSI Z39.48-1992. Typeset in Minion Composition by Cynthia Stock Silver Spring, Maryland Printed by R. R. Donnelley Harrisonburg, Virginia 00-1720-2 fm.qxd 10/10/06 11:03 AM Page v Contents Foreword ix Acknowledgments xi Why This Book? 1 Neo and Other Economics 1 Stages in Economic Development Thinking 3 Legal Institutions: The Law and Finance Literature 5 The Dual Aims of This Book 6 Economic Regulation and Corruption 7 Economic Growth: The Big Picture 9 part i. perspectives on law and economic development 11 1 Where Does the Rule of Law Fit in Economic Development? 13 The Content of the Rule-of-Law Concept 16 What Is the Problem that a Rule-of-Law Approach Addresses? 17 The Role of Foreign Assistance 19 Some Preliminary Questions about Institutions 22 An Advance Look at Some Conclusions 23 2 Legal Institutions, Legal Origins, and Governance 26 Common Law 26 Civil Law 29 v 00-1720-2 fm.qxd 10/10/06 11:03 AM Page vi vi Contents Legal Origins as a Theory of Development 31 Preliminary Questions 35 Some Anomalies 38 Legal Origins and Public Law 45 Governance as an Alternative Theory 49 3 Competing Explanations 56 Geography 57 Culture 60 Values and Cultural Regions 66 Legal Culture 68 4 Institutions and History 70 Early European Substitutes for the Rule of Law: Boycotts and Reputation 72 The Nation-State 76 Predation and the Rule-of-Law Dilemma 77 Legal Evolution in England 78 Assessing the Glorious Revolution 84 Constitutions 86 Nonconstitutional Elements of the Rule of Law 87 part ii. enforcement, contracts, and property 91 5 Judiciary 93 An Effective Judiciary: The Question of “Formalism” 96 Judicial Efficiency 100 Court Decisions as Law 105 Structural Independence 106 Behavioral Independence 111 Administrative Review 118 Legal Origins and Independence of the Judiciary 121 6 Contracts and Property 123 Long-Term Contracts 124 The Relation of Contracts to Property 128 Property 129 00-1720-2 fm.qxd 10/10/06 11:03 AM Page vii Contents vii 7 Land 134 Legal Uncertainty 135 Urban Real Estate 138 Sources of Legal Uncertainty 139 Issues in Titling 141 Transferability: Precedents and Problems 144 Implementation Problems 147 Communal Land 150 Another Look at History 152 From Communal Property to Individual Property 153 part iii: the financial sector 154 8 Equity Markets and the Corporation 163 The Corporation in Historical Perspective 163 Advantages of the Corporation Today 167 Legal Origins Analysis of Equity Markets 169 Corporate Governance 177 Dual Class Shares and Pyramids 182 The Blockholder Phenomenon 184 Legal Protection 185 Securities Laws 187 9 Credit Markets, Banks, and Bankruptcy 190 The Role of Banks 190 Directed Lending, Crony Capitalism, and Related Lending 191 The Relationship of Creditors Rights and Bankruptcy 194 Secured Credit 198 The Relevance of Legal Origin 204 Economic Development, Law and Finance, and Legal Origin 207 Culture and Religion 209 What Is Meant by a Common Law Origin in Creditors Rights? 210 U.S. Corporate Reorganization Practices 212 A Survey of Developing Countries 213 Policy Implications 215 Credit Registries 218 00-1720-2 fm.qxd 10/10/06 11:03 AM Page viii viii Contents part iv: a review of some key themes 221 10 The Implications of a Rule-of-Law Approach to Economic Development 223 Implementing an Institutional Approach 224 Law and Finance: A Reprise 225 The Judiciary 228 Equity Markets 229 Credit Markets 229 A Personal Caveat 230 A Parting Challenge 231 11 China as a Test Case 233 China’s Ranking on a Law and Finance Scale 234 World Bank Rankings 235 The Chinese Economy: Is a Slowdown in Growth Ahead? 237 A Closer Look at the Chinese Growth Record 243 Enforcement and the Chinese Judiciary 247 The Transition in China’s Economic and Legal Structure 255 The Rise of Stock Exchanges and Securities Regulation 260 Corporate Governance 265 Credit Markets 267 Legal and Institutional Reform 268 Guided Evolution? 273 References 279 Index 313 00-1720-2 fm.qxd 10/10/06 11:03 AM Page ix Foreword We often deal with hard data at Brookings. No statistic about today’s world is more important and less acceptable than this one: more than 1 billion people—a sixth of humanity—live on less than $1 per day. The persistence of global poverty is all the more daunting given how much effort has gone into promoting inclusive economic growth. In the years after World War II, policy- makers tried to stimulate development through foreign aid. In the 1980s, they put their faith in liberalization and economic reform. But since the end of the 1990s, the persistence of global poverty has led many experts to conclude that we must look beyond neoclassical economics in order to understand the causes of growth. The “Washington consensus” is looking increasingly wobbly, while a new belief in the power of institutions is on the rise. The idea that institutions matter—and in particular, legal institutions— has attracted a large following among academics and policymakers alike. Among economists, it has also provoked a highly technical and at times acer- bic debate over such questions as the relative value of common and civil law. But to date, the new consensus has not generated much in the way of practi- cal advice. It tells policymakers that law is important, but it is virtually silent on what they should do. With this book, Ken Dam steps confidently and constructively into the breach. It is difficult to imagine anyone better qualified to do so. A lifelong student of comparative law and a pioneer in the field of law and economics, he has served three presidents. He occupied key posts at the Office of Man- agement and Budget and at the White House and served as deputy secretary in both the State and the Treasury Departments, which makes his résumé just about the perfect one for a master of geo-economics. ix 00-1720-2 fm.qxd 10/10/06 11:03 AM Page x x Foreword At the University of Chicago, he initiated generations of students into the subtleties of U.S. and foreign law. And he is no stranger to the world of busi- ness and the global economy, having served for seven years as corporate vice president for law and external relations with IBM. Ken is also a long-time member of the Brookings family. In 1964 we had the honor of publishing his first book, Federal Tax Treatment of Foreign Income, written with Lawrence Krause. He became a Brookings trustee in 1988 and a senior fellow in 2004, after retiring from full-time teaching at Chicago. At Brookings, he has been a key participant in the Economic Stud- ies and Global Economy and Development programs, among other activities. In The Law-Growth Nexus, Ken offers a penetrating analysis of the law and finance literature, based on his expertise as both a scholar and a policymaker. In clear and elegant prose, he explains why legal institutions are important to economic development and which institutions matter most. But that is far from being his main goal. Instead, the great contribution of this book lies in Ken’s determination to help policymakers use this knowledge to foster growth. By spelling out the concepts that underpin the rule of law—property rights, contracts, and enforcement—he brings legal institutions out of the ivory tower and down to earth. By tracing their role in the land and financial sectors, he identifies the challenges and opportunities facing policymakers interested in reform. And as a parting salvo, he takes on the greatest contem- porary challenge to the “law matters” perspective: China’s rapid growth, despite its manifest failings when it comes to the rule of law.