Rule of law & economic success

Michael Alan Hamlin

Posted on August 6, 2008

And creative destruction

A country such as the Philippines that comes in dead last in Asia Pacific in attracting foreign direct investment (FDI) and sadly trails its neighbor states in its capacity to foster economic prosperity should think seriously about what it takes to create an environment conducive to rapid and sustainable economic growth. It’s been argued that among the requisites to economic growth is rule of law, meaning that government institutions such as the judiciary should be immune to political pressure, resolute, and honest.

But according to Columbia Law School Professors Curtis J. Milhaupt and Katharina Pistor, that argument is flawed. In a new book, they seek to unsettle the prevailing assumption that a U.S.-style “rule of law” is vital to a successful economy. Milhaupt and Pistor anchor their argument on an analysis of recent high-profile corporate scandals around the world – from Enron in the United States to Yukos in Russia and Livedoor in Japan.

“Does the prevailing view of the relationship between law and capitalism hold up under sustained scrutiny?” Milhaupt and Pistor write in the introduction to Law & Capitalism: What Corporate Crises Reveal About Legal Systems and Economic Development Around the World (The University of Chicago Press, 2008). “Why have some of the most dramatic economic success stories in history – China is only the latest example – occurred in the absence of a ‘rule of law’ as that term is commonly understood in Western economics and legal scholarship?” (Disclosure: This column draws heavily on a statement released by Columbia Law School.)

Using case studies from the United States, China, Germany, Japan, Korea and Russia, Milhaupt and Pistor argue that a wide variety of mechanisms – both legal and nonlegal – have supported economic growth. “The standard approach assumes there is a single optimum model, but there are many systems out there and each has its own strengths and vulnerabilities,” said Pistor. “Our methodology places each corporate governance crisis into the context of a country’s governance regime and thereby helps reveal its systemic weaknesses.”

Milhaupt said that the book’s core argument has potentially far-reaching ramifications for such global economic policy players as The World Bank, which often benchmarks the potential success of other countries’ systems on reforms that bring them closer to the U.S. legal and regulatory system. “We’ve lost the perspective that the U.S. legal system has evolved tremendously over time in response to specific events and crises,” Milhaupt said. “Why should we assume that countries at a different stage of development and with a different institutional starting point should require the same (current) set of laws to support economic growth?”

Recent events – that a scandal such as Enron (and even more recently, the credit crisis) occurred despite the United States’ touted regulatory system, for instance, or the economic success of China despite its authoritarian (but quite flexible and experimental) governance system – argue for a more expansive view of what can boost economies, Milhaupt said.

According to Milhaupt and Pistor, prevailing views assume that law fosters economic activity exclusively by protecting property rights, so a legal system that clearly allocates and protects property rights is a precondition to economic success. “It is,” they write, “clean and straightforward” and “treats law as a kind of technology which can be inserted where necessary.”

This view does not bear up to scrutiny. “Law is not an endowment like a fixed capital investment which, once in place, provides a firm foundation for capitalist activity,” they say. “The vibrancy of a capitalist system hinges on creative destruction in the governance sphere as well as the economic sphere. Governance structures of all types, including law, must adapt and respond to changes in the economy.”

The two authors argue that law and markets evolve together in a “rolling relationship” based on events on the ground that calls for a more dynamic model of creative destruction and institutional development to promote healthy economies. It’s important to understand, of course, that Milhaupt and Pistor also appear to argue that as economies successfully evolve, so does their reliance on rule of law.

A current example is corporate regulatory compliance laws, which China has started to pass in the wake of recent manufacturing and environmental scandals. Indeed, regulatory compliance has become one of the hottest top management topics in the region. China’s leaders appear to realize that to sustain prosperity, government must require business to act responsibly. That requires the dismantling of old, opaque regulatory environments, and the introduction of transparency and accountability.

The bottom line is that successful countries don’t start out with a strong universal rule of law, but they foster the process of creative destruction necessary to achieve it. And that process never ends.

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