Pillars of prosperity

Notes - Chapter 3: Legal Capacity

The public good is in nothing more essentially interested, than in the protection of every individual's private rights.

- William Blackstone

Our models of legal capacity in this chapter focus mostly on enforcement of private contracts by a public body. In the terminology of Dixit (2009), we are considering enforcement-based rather than information-based institutions. In particular, we do not deal with self-enforcing agreements between private parties. In the terminology of Greif (2005), we are primarily considering (public-order and designed) contract-enforcement institutions, i.e., government enforcement of agreements between private parties, rather than coercion-constraining institutions, i.e., obstacles to government expropriation of private parties. But the governance institutions we introduced in the predatory state would be of the latter type.

A long-standing tradition in development economics sees reallocation of resources to higher return activities as the main mechanism for raising incomes. Perhaps the most famous statement of this view is Lewis (1954), who highlighted the movements of labor from traditional to advanced production as the key mechanism of development. More recent work in this vein has paid increasing recognition to misallocation in capital markets, as in Banerjee and Duflo (2008).

Hseih and Klenow (2009) stress the aggregate productivity consequences of factormarket misallocation using micro-data from India and China. Restuccia and Rogerson (2008) also looks at aggregate implications of policy induced resource misallocation. More general implications of these views are developed in Hseih and Klenow (2010), who conclude that 50-70% of income per capita differences across countries can be accounted for by differences in TFP rather than in physical or human capital. Related work on China by Song, Storesletten and Zillibotti (2011) considers the process of capital accumulation through the entry of new firms as the main source of Chinese growth, and argues that this pattern is due to capital market imperfections.

Acemoglu (2006) underlines the political origins of resource misallocation with a particularly focus on adverse factor price effects which lead to inefficiencies in production. This work also highlights the importance of fiscal capacity, although it takes such capacity as given.

Many researchers have emphasized the links between financial development and growth. See Beck (2010) for a useful general overview of the literature on legal institutions and their impact on economic development. Early discussions include Schumpeter (1934) and Gershenkron (1962). King and Levine (1993) and Aghion, Howitt and Meyer (2005) offer modern day tests of these ideas. Levine (2005) gives an overview of the large literature on finance and economic growth.

The factors - economic and political - which shape capital market development have been an active area of research. The legal-origins tradition pioneered by La Porta, Lopez de Silanes, Shleifer and Vishny (1998) has emphasized how some legal traditions - particularly those rooted in common law - are more conducive to development of some kinds of capital markets. The body of research on this is summarized in La Porta, Lopez de Silanes and Shleifer (2008).

La Porta et al (1999) discuss the quality of government more generally and a variety of factors - including legal origins - that determine it. They find that larger governments are associated with more effective governments in many dimensions. Gradstein (2008) and Chong and Gradstein (2007) also consider the link between inequality and property rights protection both theoretically and empirically. Hodgson (2006) finds that fractionalization, measured using Fearon's (2003) measure, is one of the most important and statistically significant variables in explaining differences in post-1989 real GDP growth per capita among ex-Soviet countries.

The importance of the business climate for economic development has been an important theme in much recent research, a great deal of which emphasizes the important of legal origins. For example Djankov, McLiesh and Shleifer (2007), find that legal origins are an important determinant of both creditor rights and information sharing institutions which, in turn, affect the supply of credit. Djankov, La Porta, Lopez-de-Silanes and Shleifer (2002) find a relationship between the regulation of business entry and legal origins. Cantoni and Yuchtman (2009) study how historical market development patterns within Germany is affected by the availability of legal institutions, trying to circumvent the simultaneity problem by using the locations of medieval universities following the Papal Schism in the late 1300s as an instrument for legal institutions.

Svensson (1998) and Rajan and Zingales (2003) emphasize the role of politics in affecting financial market development, as do Pagano and Volpin (2005) alongside legal origins. Further work in this tradition includes Perotti and van Thadden (2006), Pagano and Volpin (2001) and Pagano and Volpin (2006). Caselli and Gennaioli (2008) develop an interesting political-economics model of institutional reform in financial markets.

A variety of political-economics oriented macroeconomic models have explored the links between government policy and economic growth. These include Alesina and Rodrik (1994), Persson and Tabellini (1994), Krusell and Rios-Rull (1996), and Parente and Prescott (2000). Acemoglu (2003) builds the link between these ideas around a Political Coase Theorem. Besley and Coate (1998) develop a theory of political failure based on governments not implementing Pareto improving policies.

There is a now a large micro-economic literature on the role of private property rights in improving resource allocation in developing countries, which is surveyed in Besley and Ghatak (2009). There is also an emerging empirical literature using micro-data, which entails work by Besley (1995), Banerjee, Gertler and Ghatak (2002), Johnson, MacMillan and Woodruff (2002), and Field (2007).

Barro and Sala-i-Martin (1992) look at conventional links between taxes and growth where taxation is spent on productive investments. There are a number of contributions that have tried to link taxation and growth surveyed in Benabou (1997). More in the spirit of the arguments in this chapter Dincecco and Prado (2010) argue there is positive link between fiscal capacity and development - they use casualties sustained in pre-modern wars to instrument for current fiscal institutions.

The predatory state as a constraint on development is an old idea. The ideas is reviewed in historical perspective by De Long (2000). Pioneering work by North and Thomas (1973) and North (1990) highlights the central role played by property-rights protection in fostering historical developments in Western Europe. De Long and Shleifer (1993) uses city growth in medieval Europe as a testing ground for these ideas. North and Weingast (1989) regard the Glorious Revolution in 1688 leading to the establishment of secure property rights as a pivotal moment in UK history. In addition, this set in train important fiscal and financial changes. Stasavage (2003) discusses their arguments looking at both France and Great Britain.

Acemoglu, Johnson and Robinson (2001) stress the empirical importance of settler mortality in explaining modern-day income levels by predicting the creation of productive or predatory state institutions. Similar ideas lie behind the empirical work of Hall and Jones (1999). Seminal work by Bates (1981, 2009) has explored the importance of state institutions in an African context.

Theoretical models of predatory states have been proposed by many, including Azam, Bates, and Biais (2009), Grossman and Noh (1994), Grossman and Kim (1995), McGuire and Olson (1996) and Olson (1993), Moselle and Polak (2001) and Weingast (1997). Within the institutions literature, there is considerable debate about which aspects of institutions are most important. Acemoglu and Johnson (2005) argue that the most robust finding is that protecting private property rights rather than promoting contracting institutions is most important. This would put more weight on the dangers of a predatory state.

Related to studies of the predatory state, there is now a large literature on corruption - its causes and consequences. See Treisman (2000) and Svensson (2005) for overviews of this literature. An early contribution by Mauro (1995) emphasized the negative correlation in the cross-country data between corruption and growth although the direction of causality is notoriously hard to determine. Hodgson and Jiang (2007) argue that corruption should not be confined just to the public sector, in part because public/private boundaries are often unclear. This provides a link to the literature on rent seeking since such activity can either be public or private. The original rent-seeking models were due to Tullock (1967) and Krueger (1974). Hillman (2011) offers a recent overview of the main ideas and existing literature on such behavior. For all the importance attached to institutions, some scholars remain doubtful about how much institutions can help explain economic growth. Bloom and Sachs (1998) and Gallup, Sachs, and Mellinger (1999) stress geography rather than institutions, whereas Glaeser, La Porta, Lopez de Silanes and Shleifer (2004) stress human capital rather than institutions.