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Law and Development

An Institutional Critique

Frank H. Stephen

This book draws on the analytical framework of New Institutional Economics (NIE) to critically examine the role which law and the legal system play in economic development. Analytical concepts from NIE are used to assess policies which have been supported by multilateral development organisations including securing private property rights, reform of the legal system and financial development. The importance of culture in shaping the legal environment, which in turn influences financial sector development, is also assessed using Oliver Williamson’s ‘levels of social analysis’ framework.
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How we got here

An Institutional Critique

Frank H. Stephen

Chapter 1 sets the scene for the book. It discusses the reasons for the interest in the relationship between the law and economic development beginning with an outline of theories of development. The theory of development currently favoured by multilateral development agencies such as the World Bank is one of market-led development which emphasizes the role of the financial sector. Drawing on an analysis of the reasons why the Law and Development Movement of the 1960s and 1970s failed, criteria by which theories of law and the legal system’s role in development should be evaluated are identified. It is argued that a theory based on New Institutional Economics can satisfy these criteria.

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New Institutional Economics

An Institutional Critique

Frank H. Stephen

In Chapter 2 the main concepts and ideas of New Institutional Economics are introduced. These are used with some additional adaptations in Chapter 4 to develop a theory of the role of the law and legal institutions in the process of development. According to a study by Ménard and Shirley in 2014, transaction costs is one of three core concepts in the development of NIE. The others are property rights and contracts. These three have played a crucial role in understanding the role of institutions in society and feature prominently throughout this book.

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Frank H. Stephen

Chapter 3 considers legal reform in developing countries through an examination of Legal Origin Theory which argues that economies based on the Common Law have higher growth levels than those based on Civil Law. This theory is outlined and evaluated. A powerful critique of Legal Origin Theory (as a foundation of policy) is provided by the transplant effect. This considers the factors which influence the effectiveness of transplanting laws or parts of legal systems from one jurisdiction to another. Whether a transplant is successful or not is related to the motives behind the transplant. Is the recipient jurisdiction receptive to the transplant? Is there a demand for the transplant? When neither of these is the case, transplants will increase transaction costs and lower legal effectiveness. This chapter examines the evidence to support this approach and discusses its implications for legal reform as a route to development.

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Frank H. Stephen

Chapter 4 begins with two issues relating to property rights. Hernando de Soto’s ‘collateral effect’ is outlined and evaluated. It is concluded that there is only limited empirical support for the effect’s existence. Second, it is argued that the term called ‘property rights’ as used in cross-country studies of development does not measure property rights per se but the effectiveness of the legal system in defending individual rights more generally. It then develops an NIE approach to analysing the role the law plays in the process of development. The frameworks used by Oliver Williamson and Douglass North to analyse institutions are outlined and compared. An extended version of Williamson’s approach is used to demonstrate the constraints imposed on institutions by culture and on economic organization by institutions. The chapter closes with a demonstration that culture can explain the differential pace of reform in European transition countries.

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Financial markets

An Institutional Critique

Frank H. Stephen

Chapter 5 outlines the role which the financial sector plays in market-based economic development and the role played by the legal system in financial sector development (FSD). After discussing the fundamental functions of any financial system and the different types of markets and institutions which constitute a financial system, the chapter turns to a discussion of how FSD might be measured. The evidence on the relationship between FSD and economic growth is assessed. Building on this empirical evidence, the factors which promote FSD are examined. The chapter draws not only on the finance literature but the institutional literature discussed in Chapters 2, 3 and 4. These tools are then utilized to examine the problems faced and potential opportunities open to FSD in developing countries. In this regard, particular attention is paid to the relative merits of credit markets and capital markets in promoting FSD in developing countries.

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Frank H. Stephen

Chapter 6 develops and estimates an econometric model of the determinants of growth to illustrate the insights gained from using the NIE-based framework developed in Chapter 4. It demonstrates the influence of the legal environment on the size of the financial sector and the influence of culture on the legal environment including the effectiveness of the legal system. The benefits of information enhancing institutions in promoting financial sector development (FSD) are also demonstrated. The model is used to test the competing claims of legal origin and culture in explaining the content and effectiveness of a jurisdiction’s laws. The tests suggest a limited impact of legal origin beyond that of culture in these respects. They also provide support for the transplant effect. These results suggest that legal reform to support a market-based approach to development must take account of the cultural context in which it is taking place.

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Conclusions

An Institutional Critique

Frank H. Stephen

The final chapter of the book reviews conclusions to be drawn from the New Institutional Economics-driven analysis of the role of laws and the legal system in the process of development presented in the preceding chapters. It uses the criteria outlined in Chapter 1 to evaluate the model. It is concluded that the NIE-based model avoids the problems of modernization theory and is free from ethnocentrism. The NIE-based model also is suitable for evaluating the role of law and the legal system in the process of economic development. Finally, it has permitted an examination of law in action and not just the law on the books. The chapter concludes with a summary of the lessons for policymaking which the book provides.

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Frank H. Stephen

This content is available to you

Frank H. Stephen