Economics and the rule of law
Order in the jungle
Mar 13th 2008
>From The Economist print edition
The rule of law has become a big idea in economics. But it has had its
difficulties
“AM I the only economist guilty of using the term [rule of law] without having
a good fix on what it really means?” asks Dani Rodrik of Harvard University.
“Well, maybe the first one to confess to it.”
The rule of law is usually thought of as a political or legal matter. The
world's newest country, Kosovo, says its priority is to improve the rule of law
in order to reduce corruption and build up the state. But in the past ten years
the rule of law has become important in economics too. Indeed, it has become
the motherhood and apple pie of development economics—which makes Mr Rodrik's
confession the more striking. The rule of law is held to be not only good in
itself, because it embodies and encourages a just society, but also a cause of
other good things, notably growth. “No other single political ideal has ever
achieved global endorsement,” says Brian Tamanaha, a legal scholar at St John's
University, New York.
But as an economic concept the rule of law has had a turbulent history. It
emerged almost abruptly during the 1990s from the dual collapses of Asian
currencies and former Soviet economies. For a short time, it seemed to provide
the answer to problems of development from Azerbaijan to Zimbabwe, until some
well-directed criticism dimmed its star. Since then it has re-established
itself as a central concept in understanding how countries grow rich—but not as
the panacea it once looked like.
Economists became fascinated by the rule of law after the crumbling of the
“Washington consensus”. This consensus, which was economic orthodoxy in the
1980s, held that the best way for countries to grow was to “get the policies
right”—on, for example, budgets and exchange rates. But the Asian crisis of
1997-98 shook economists' confidence that they knew which policies were, in
fact, right. This drove them to re-examine what had gone wrong. The answer,
they concluded, was the institutional setting of policymaking, especially the
rule of law. If the rules of the game were a mess, they reasoned, no amount of
tinkering with macroeconomic policy would produce the desired results.
This conclusion was strengthened by events in the former Soviet empire. Many
post-communist countries got their policies roughly right fairly quickly. But
it soon became clear this was not enough. “I was a traditional trade and labour
economist until 1992,” says Daniel Kaufmann, now head of the World Bank
Institute's Global Governance group. “When I went to Ukraine, my outlook
changed. Problems with governance and the rule of law were undermining all our
efforts.”
Pretty quickly, “governance”—political accountability and the quality of
bureaucracy as well as the rule of law—became all the rage. Economists got busy
calculating what it was, how well countries were doing it and what a difference
it made. Mr Kaufmann and his colleague Aart Kraay worked out the “300%
dividend”: in the long run, a country's income per head rises by roughly 300%
if it improves its governance by one standard deviation. One standard deviation
is roughly the gap between India's and Chile's rule-of-law scores, measured by
the bank. As it happens, Chile is about 300% richer than India in
purchasing-power terms. The same holds for South Africa and Spain, Morocco and
Portugal, Botswana and Ireland. Economists have repeatedly found that the
better the rule of law, the richer the nation. (The chart below shows the
results of three studies, put on a comparable basis by Mr Kaufmann.) Every rich
country with the arguable exceptions of
Italy and Greece scores well on rule-of-law measures; most poor countries do
not.
Mr Rodrik reviewed the contributions to growth of governance (“institutions”,
he called it), geography and openness to trade. He concluded, to use the title
of an article he published in 2002, that “Institutions Rule”. Writing from the
perspective of a political scientist, Francis Fukuyama of Johns Hopkins
University concurred: “I believe that the institutionalists have won this
argument hands down.”
Partly because of this, and also because the rule of law is desirable for its
own sake, governments and aid agencies began splurging money on rule-of-law
reforms, such as training judges, reforming prisons and setting up prosecutors'
offices. Such reforms had begun in Latin America in the mid-1980s. Now they
became universal.
The European Union insists that all its members satisfy standards for the rule
of law. It requires applicants to commit themselves to legal reforms to meet
those standards and dispatches armies of lawyers to advise them how to bring
their legal systems up to scratch. America's Millennium Challenge Corporation,
set up in 2004 to improve the effectiveness of American official aid, confines
its largesse to countries that have committed themselves to minimum rule-of-law
standards (one of three basic requirements). Western donors have poured
billions into rule-of-law projects over the past 20 years. The World Bank is
now running such projects (narrowly defined) worth almost $450m; on a wider
definition, almost half the bank's total lending of $24 billion in 2006 had
some rule-of-law component (for example, advice on conflict resolution in
village-development projects, or on bankruptcy law in privatisation
programmes). In roughly a decade the rule of law has
gone from a specialist political and legal topic into a staple of economic
thinking and the subject of a vast aid-giving effort.
So it came as an unwelcome surprise when, in 2003, one of the world's
acknowledged experts on governance wondered aloud whether the emperor had any
clothes. Thomas Carothers of the Carnegie Endowment for International Peace, a
think-tank in Washington, DC, wrote a paper politely entitled “Promoting the
Rule of Law Abroad: The Problem of Knowledge”. According to Mr Carothers, the
problem was, as William Goldman said of Hollywood, that nobody knows anything.
Mr Carothers argued that the intrinsic difficulty of defining the rule of law,
combined with the problems of knowing how specific laws work in practice, meant
that “the rapidly growing field of rule-of-law assistance is operating from a
disturbingly thin base of knowledge at every level.” Many of the difficulties
are inherent, he said. But not all: aid organisations always look forward to
the next project, rather than back to the lessons of experience; lawyers who
carry out the work are not much interested in development; university
professors are not gripped by applied policy research. As a result, according
to one rule-of-law promoter, “deep down, we don't really know what we are
doing.”
The shock of Mr Carothers's argument was salutary. In response, there has been
a flurry of rule-of-law studies. A new body of work has appeared, which could
be called the economics of the rule of law. It shows the rule of law can indeed
be improved. It has made clearer what economists and others mean when they talk
about the rule of law. It has laid down some guidelines about reforms, helping
show what works when, say, training judges or policemen. What it has not yet
shown beyond doubt is that the rule of law is a precondition for economic
growth everywhere. In the process, the subject of law as an economic matter has
begun to grow up. It has passed from vigorous childhood into more troubled
adolescence.
Unruly law
In “The Rule of Law and Development” (to be published next month by Edward
Elgar), Michael Trebilcock of the University of Toronto and Ron Daniels of the
University of Pennsylvania tackle the question of what economists mean by the
rule of law. A report by a new research group, the Hague Institute for the
Internationalisation of Law, does the same thing. Both publications argue that
people routinely use two quite different definitions, which they call “thick”
and “thin”.
Thick definitions treat the rule of law as the core of a just society. In this
version, the concept is inextricably linked to liberty and democracy. Its
adherents say a country can be spoken of as being ruled by law only if the
state's power is constrained and if basic freedoms, such as those of speech and
association, are guaranteed. The “declaration of Delhi” drawn up by the
International Commission of Jurists in that city in 1959 followed this line in
saying that the rule of law “should be employed to safeguard and advance the
civil and political rights of the individual” and create “conditions under
which his legitimate aspirations and dignity may be realised.” Among other
proponents of a thick definition are Friedrich Hayek, an Austrian economist,
and Cass Sunstein of the University of Chicago. In their view, the rule of law
includes elements of political morality.
Thin definitions are more formal. The important things, on this account, are
not democracy and morality but property rights and the efficient administration
of justice. Laws must provide stability. They do not necessarily have to be
moral or promote human rights. America's southern states in the Jim Crow era
were governed by the rule of law on thin definitions, but not on thick.
The existence of competing definitions of something may seem fatally to
undermine its usefulness. If you argue that the rule of law is vital to growth,
which version do you mean—the one that defends human rights or the one that
guarantees property rights? But economists love competition. Their differing
definitions of the rule of law reflect competing explanations of what drives
economic growth.
One account of growth—associated with Douglass North of Washington University
in St Louis, Missouri—is “institutional”. It focuses on the importance of
property rights, transaction costs and economic organisation. On this view,
stable, predictable laws encourage investment and growth. Thin definitions of
the rule of law fit this well. The other—associated with Amartya Sen of
Harvard—says that if you expand people's “capabilities” (Mr Sen's term), they
will do things that help countries grow rich. Freeing people to take advantage
of their capabilities usually means lifting the oppressive burden of the state
and guaranteeing certain basic rights—a much thicker concept.
The distinction between thick and thin versions of the rule of law overlaps
another distinction between legal traditions. Starting in 1997, a group of
economists led by Andrei Shleifer of Harvard and Robert Vishny of Chicago
started to compare the economic performance of common-law countries (such as
America and Britain) with that of civil-law ones (France, Germany and
Scandinavia). They argued that common-law countries have more secure property
rights, better protection of shareholders and creditors, more diversified share
ownership, and tougher disclosure and liability laws—to the benefit, they
claimed, of stockmarket performance.
Like the initial claims for the rule of law, those on behalf of the common law
were subject to harsh criticism at about the same time, mostly from continental
economists. Some claimed the differences between common and civil law were not
as sharp as they seemed, and were proxies for differences of politics, history
and culture. Others pointed out that a country's legal origins do not seem to
explain much about how it is faring economically or in terms of the rule of
law. North and South Korea have the same legal origins.
But just as rule-of-law scholars have responded to criticism with more
research, so have the legal-origins crowd. In a stream of papers they have
found strong evidence that civil-law countries encourage government ownership
of the media and banks, a higher burden of entry into business, more
labour-market regulation and greater formalism of court procedures—to their
detriment, they claim.
Perhaps such arguments can never be resolved. As Rainer Grote of the Max Planck
Institute for Comparative Public Law and International Law in Heidelberg says,
the rule of law “belongs to the category of open-ended concepts which are
subject to permanent debate.” This part of the new economics of the rule of law
clarifies its role, but no more. Other findings, though, are more constructive.
Scales of justice
There have been huge improvements in monitoring and measuring the rule of law,
even though people cannot agree exactly what it is. “Fifteen years ago, we
didn't talk about this stuff,” says Steve Radelet of the Centre for Global
Development, a Washington think-tank. “Ten years ago, there was no data.” Now,
the Worldwide Governance Indicators project—“one of the best kept secrets at
the World Bank”, believes Gordon Johnson, a grand old man of aid-giving—is the
state of the art. It gathers data on more than 60 indicators (the extent of
crime, the quality of police, judicial independence and so on) to create
rule-of-law and governance measures for virtually every country in the world.
Aggregating like this (and being honest about the margin of error), says Mr
Kaufmann, is far from perfect, but is a decent approximation.
These measures confirm what is clear anyway: some countries have been able to
improve their legal framework even in a short time. In 2000 Mikhail
Saakashvili, then Georgia's minister of justice, sacked two-thirds of his
country's judges for failing to pass an exam. Four years later as president, he
fired all the country's traffic police. Georgia's World Bank rule-of-law score
rose from nine out of 100 in 2002 (in the bottom 10%) to 33 at the end of
2006—low, but better. Central European and Baltic countries are doing better
still: the radical legal changes required by membership of the EU improved
their economies as well as their judicial systems.
In general, the measures suggest, bold reforms work better than gradual ones.
Latin America modernised its penal codes and made trials more transparent.
Chile, for instance, established a new public-prosecution system beginning in
2003. But many of its officials lack experience and have met resistance from
the police. Russia implemented some judicial reforms in the 1990s and raised
spending on the courts in 2000—to no avail: its rule-of-law scores have fallen
in five of the past seven years.
The difference between central Europe and Latin America may be one of political
backing. Messrs Trebilcock and Daniels divide countries into three: those where
politicians, legal professionals and the public all support reform (central
Europe after the fall of communism, South Africa after apartheid); those where
politicians support reform, but lawyers and police do not (Chile and
Guatemala); and those where lawyers want change, but not politicians
(Pakistan). Only in the first group, the professors say, does rule-of-law
reform get far.
Consistent with that rather gloomy finding, some new research finds only a weak
link between the rule of law and economic growth. The connection with wealth is
well established (see chart again) but that is different: it has been forged
over decades, even centuries. The link with shorter-term growth is harder to
see. China appears to be a standing contradiction to the argument that the rule
of law is needed for growth. It is growing fast and is the world's largest
recipient of foreign investment, yet has lots of corruption and nothing that
most Westerners would recognise as a rule-of-law tradition. (It does, though,
guarantee some property rights and its government is good at formulating and
implementing policies.)
On the other hand, there is surely a connection between the legal reforms
carried out in central Europe and the Baltics and their fast growth rates, or
between Spain's post-Franco legal opening and its long boom. And there are
proxy indicators connecting legal reform with growth in other areas. The value
of rural land in Brazil, Indonesia, the Philippines and Thailand increased
sharply when people were given title deeds, because owners were more willing to
invest. One independent study for the World Bank a decade ago found a
surprising link between projects the bank financed and civil liberties:
projects in countries with strong civil liberties had far higher rates of
return than those in countries with weak traditions of liberty.
But such links do not tell you anything about causation. Perhaps growth helps
the rule of law, not vice versa. Perhaps countries can afford the luxury of the
rule of law only after they have grown rich. The persistence of “frontier
justice” into the 1930s in America gives a colour of plausibility to that idea.
Yet it is not Mr Kaufmann's view. He argues that rule-of-law improvements tend
to help growth; that few countries have sustained gains in growth without
improving their rule of law; and that places that have grown without such
improvement have subsequently lurched backwards (Argentina used to be one of
the ten richest countries in the world). The real puzzle is to explain the
exceptions: why crony capitalism has flourished in parts of fast-growing Asia
or Kremlin banditry in Russia. The answer, he says, is that, without a rule of
law, well-connected crooks can grab an unfair share of the spoils of growth,
especially if these include windfall gains from oil and raw materials.
The existence of crony capitalism and “state capture” by robber barons is, of
course, an argument for trying to strengthen the rule of law where you can,
since it suggests growth will not necessarily create law automatically. There
are other arguments, too: the rule of law is desirable for its own sake—to
improve human rights or to increase citizens' chances of justice against
predatory governments. As John Locke wrote in 1690, “wherever law ends, tyranny
begins.” Plainly, in some countries, such as Myanmar and Zimbabwe, legal abuses
and over-mighty regimes are direct obstacles to growth. Reforms would help—if
they could be implemented.
But as a generalisation, the efforts of the past few years have thrown up mixed
messages. They suggest the rule of law can be improved sharply; that
rule-of-law reform is at root a political not a technical undertaking; and that
it is linked to growth, if weakly in the short term. But they do not really
bear out the assertion that the rule of law is an underlying prerequisite for
growth. Rather, the more economists find out about the rule of law, the more
desirable it seems—and the more problematic as a universal economic guide.
Sources
“Growth without Governance”, by Daniel Kaufmann and Aart Kray
“Governance Matters IV”, by Daniel Kaufmann, Aart Kray and Massimo Mastruzzi
“Civil Liberties, Democracy, and the Performance of Government Projects”, by
Daniel Kaufmann, J. Isham and L.H. Pritchett
“Institutions Rule”, by Dani Rodrik, Arvind Subramanian and Francesco Trebbi
“Promoting the Rule of Law Abroad: The Problem of Knowledge”, by Thomas
Carothers
“Rule of Law Reform and Development”, by Michael Trebilcock and Ron Daniels
(forthcoming, published by Edward Elgar)
“Institutions, Institutional Change and Economic Performance”, by Douglass North
“Development as Freedom”, by Amartya Sen
“Law and Finance”, by Andrei Shleifer, Robert Vishny et al.
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