The effect of law on the economy

An analysis of the economy of a city governed by two different legal systems

American Nobel Laureate Douglass North famously called institutions the “rules of the game” that govern any society. The legal system, for instance, defines the property rights of individuals and adjudicates disputes that may arise around the violations of these rights. In essence, institutions are what determine what kind of human behaviour would be rewarded or punished by laws, which are either implicit or explicit. A legal system that does not penalise thieves or protect honest people from fraud and other forms of aggression would not offer the right kind of environment for economic growth. Institutions, in other words, shape the incentives that face individuals.

In “Firm Foundations: Legal Systems and Economic Performance in Colonial Shanghai, 1903-1934,” Mingxi Li, a researcher at the University of California, Davis, looks into the effect that two different legal systems had on economic growth in two different areas of the Chinese city of Shanghai. Li compares how, during the colonial period, the areas of Shanghai that were under the control of the French differed economically from the parts controlled by the British. For one, the French settlement in colonial Shanghai was governed by the civil law while the British settlement was governed by the Common law. The civil law is seen as more favourable to state-directed allocation of resources while the Common law is seen as more welcoming towards market-based resource allocation. This interesting setting offers a kind of natural experiment to zero in on the effect that the differing legal systems had on economic growth in two areas within the same city. As a proxy for economic growth, Li uses the value of land in the respective settlements. Land values tend to be higher in richer areas where the land can be sold in exchange for goods of higher value. She finds that initially, at the start of the 20th century, the value of land in the area under French settlement traded at a discount when compared to land under the control of the British. However, the margin between land values in the British and French settlements started to disappear over time for a certain reason.

In the 1900s, land value in areas under British control was 80% higher than in areas under French control. But over the next three decades, the premium started to erode quite significantly. By the 1910s, the land value premium had halved from what it was in the 1900s and by the 1930s the premium was no longer present. In other words, economic growth picked up in areas of Shanghai that were under the rule of the French and this was reflected in higher land prices in these areas. Li says that this happened because the civil law that governed the French settlement suddenly began to operate in a fashion that favoured economic growth. She argues that “the French legal institutions are capable of adapting to become compatible with economic activities.” With a legal system that was more conducive to economic growth, labour and other resources began to move to the land area controlled by the French. It was thus competition between the settlements to attract scarce resources that pushed the French civil law system to reform itself.

Li also observes that it is not the formal legal system per se that determines economic growth in a territory. It is rather the way in which the formal law is interpreted and implemented by the judges that really matters. Thus, the importance of informal institutions cannot be underestimated when it comes to their influence on economic growth. Even when laws are stringent on paper, they can be bent to achieve desired ends.

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