Does Law Matter for Economic Growth? A re-examination of the 'legal origin' hypothesis

This study addresses the role of legal institutions in economic growth. The notion that institutions profoundly influence economic performance is, of course, an old idea, which may be dated to the late eighteenth century when Adam Smith wrote his An Inquiry into the Nature and Causes of the Wealth of Nations. According to Adam Smith, the security of property rights against expropriation by fellow citizens or the state is an important condition for encouraging individuals to invest and accumulate capital, which in turn would boost economic growth. Smith’s wisdom persists and is reflected in contemporary approaches that have used history and theory to make the case that institutions are crucial to economic growth. Broadly, institutions contribute to economic growth by shaping individual incentives and governing markets. Different institutions lead to different economic environments and hence different incentives: while some “good” institutions create the correct incentives that encourage productive activities, including saving, investment, innovation, and entrepreneurial behaviour, other “bad” institutions open the door for unproductive activities, such as opportunism, rent-seeking, and corruption. It is a basic principle of economics that resources tend to gravitate toward their most valuable uses if a market is permitted to function. However, markets are so fragile that they cannot operate in isolation without institutional support designed to reduce transaction costs, eliminate externalities, and promote competition. Briefly, economic growth will be achieved by “getting the incentives right” and “getting the price right” through a set of rules, institutions, and policies. Compared to so-called informal institutions such as social norms, culture, and social capital, legal institutions are recognised to exert a more important influence on economic performance in contemporary economies, which are based on complex and large-scale impersonal exchange and hence render informal institutions ineffective. As North (1990: 58–59) clearly states, the emergence and survival of the state as a credible, low-cost, and formal third party with the responsibility for monitoring property rights and enforcing agreements by the threat of coercion is a necessary condition for realising the gains from trade inherent in the technologies of the modern, interdependent world. North’s theory has been extensively expanded by subsequent studies, among which the most notable may be the works of La Porta et al. (1997, 1998), which resulted in substantial controversy by stressing the superiority of common law over civil law in economic growth. Contributions of La Porta et al. also inspire this research, which attempts to comprehensively understand the relationship between legal systems and economic performance.