Volume 42 | Number 3 Summer 2007
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II. Governance, Economic, and Legal Systems
State governance and the appropriateness of political and economic structure have been of interest for over ten thousand years, prompted by specialized human activity encouraging the first agricultural settlements. This in turn allowed the development of writing systems appropriate and necessary to sustain the administrative structures of such settlements. Building the “perfect society” and creating governance systems to encourage its development has been a focus of many thinkers, including Confucius, Plato, Aquinas, Locke, and Marx. All political and economic systems function in close parallel, even though the interplay may not always be acknowledged by political theorists. Certainly, the relationship between politics (or governance) and economics has been a central interest of Smith, Marx, and more recently Keynes, Hayek, and Friedman. Although politics and economics became increasingly distinct disciplines in the twentieth century, the end of the millennium saw a reviving interaction between governance and economics, partly encouraged by the experience of market orientation undertaken by many centrally planned economies, and from the conspicuous failure of earlier economic development models in neglecting institutional issues of governance.
The role and development of financial intermediaries have become a focus of attention only recently in law, financial policy, and economics, although each discipline is directly concerned with both the problem and its several explanations. Similarly, conditions influencing how financial structure develops have begun to interest scholars in the developed and developing world, and those helping to create supportive policy. Until the 1970s few economic or finance theorists gave attention to the nature of financial systems or how they may affect economic development. Similarly, the importance and influence of the characteristics of financial markets and intermediaries has been accepted only since the late-1980s, with the inception and success of the law and finance and institutional economics schools. Financial intermediation is now recognized as vital to many aspects of economic development, and what determines the nature of financial intermediaries and financial system infrastructure is susceptible to both quantitative analysis and the tools of legal and economic theory.
By the beginning of the 1990s, two traditionally polar alternatives—central planning under state ownership and laissez-faire—had been subsumed into an apparent consensus as to the general superiority of a market economy, but one functioning under the framework of an appropriate and transparent regulatory system, with the state taking a benign but active role in addressing the interests of any society through the provision of largely agreed public goods, systems to limit or ameliorate market failure, and sanctions to penalize market abuse, whether arising from monopoly or the occurrence of asymmetric information available to privileged participants. Nonetheless, as Shleifer and others have recognized, many differences remain among today’s economic and governance models.5 The question then arises as to what may represent the best choices among available options, and to what extent those choices lead to the disadvantage of certain interests.
For institutional economists such as North, and writers in the law and economics school, governance systems must provide for two fundamental features to support a market economy, regardless of its ideological identity and consequent form. First, the system must provide for clear and usable property rights. Second, it must facilitate practical and fair contract enforcement. Both literatures agree that these conditions are essential in the context of imperfect markets where there exist discernable transaction costs. While there appears to be agreement as to the need to satisfy these basic points, the governance structure that best supports a market economy is less apparent, and may change in relation to the relative development of the host economy.
Many scholars have argued further that democratic models of governance are optimal in protecting property rights and enforcing contracts, albeit this was the result they sought most often to prove. However, Olson has presented a convincing argument that a variety of governance structures can provide each of these necessary features.6 Specifically, he suggested that an autocrat with a long-term time horizon will have a strong incentive to support both property rights and contract enforcement in order chiefly to maximize revenue from taxation.7 Conversely, Olson argues that any democracy, while potentially providing for property rights and the enforcement of contracts, may nevertheless become subject to inefficient outcomes due to its responsiveness to representative but factional interests.8 Thus neither autocracy nor democracy is necessarily a superior political system in providing the most beneficial support for a market economy. Instead, what is necessary is a “market-augmenting government.”9 There is contemporary anecdotal evidence that certainly supports Olson’s theory,10 and recent empirical research has begun to test these ideas and appears to be supportive.11
North sums up the interaction between the political system and property rights thus:
Broadly speaking, political rules in place lead to economic rules, though the causality runs both ways. That is, property rights and hence individual contracts are specified and enforced by political decision-making, but the structure of economic interests will also influence the political structure. In equilibrium, a given structure of property rights (and their enforcement) will be consistent with a particular set of political rules (and their enforcement). Changes in one will induce changes in the other.12
The result is that a national governance structure is important and must provide for property rights and the enforcement of contracts, as well as human capital development. However, while some governance structures are clearly not conducive to liberty (any state run by the myopic autocrat-bandit), there is at present no clearly preferable model. Both autocratic and democratic governance systems can support a market economy. Similarly, each can provide for institutional choices that fail to result in efficient, wealth-maximizing outcomes in a given economy.
Two further underlying issues are present throughout this study: those relating to the mechanisms that transmit influences on economic growth, and those involving the means by which finance affects economic development, including the relationship between legal systems and financial structure. Neoclassical economic theory, post-1940s growth theories and traditional finance theory all ignore or assume away the nature of financial systems.13 While finance and corporate finance theory examine commercial organizations in terms of contract or cost, a similar approach has been applied only recently to financial intermediaries, and rarely to examine financial systems. Thus, early modern studies of the determinants of economic growth identified a strong correlation between the “rule of law” and per capita growth.14 These analyses were weak in terms of identifying with any practical precision the ways in which legal reform might be invoked to promote growth, given that the measures used to specify rule of law explanatory variables were primitive and included subjective components such as commercial indexes of sovereign risk.
The law and finance school asserts that there exist significant causal links between the origins of law or the means by which a national system of law is acquired, and the nature of financial system development.15 Certain scholars further suggest a causal relationship that flows from financial development to economic performance, although most accept that such links are unlikely to be unicausal.16 Questions investigated or prompted by the law and finance school include: first, the relationship of institutional development to general economic welfare; second, the relationship between legal origin and the effectiveness and even-handedness of legal systems; third, whether the effectiveness of a national legal system is significantly determined by its origin or the form of its acquisition; and finally, whether common law is inherently more effective than other systems in encouraging financial development, stimulating credit growth or protecting property rights.17
While the general premise of law and finance protagonists has become accepted, especially in suggesting more specific legal research agendas, the school has been criticized for two main methodological reasons. The first is its choice and specification of explanatory variables:18 which may either be incomplete or endogenously related to the objective questions that the analysis seeks to answer;19 which may not signify close substitutes or take account of compensatory mechanisms in different legal systems;20 or may reflect customary choice appropriate mainly to developed, homogenous markets.21 The second attack concerns the usefulness of the school’s conclusions in indicating legal or regulatory reform, given that legal related explanatory variables have of necessity been general and unspecific.22
As examples, the scale of finance evident in an economy has often been used as an explanatory variable, but it may not measure financial sophistication, contrary to the intentions of La Porta, López-de-Silanes, Shleifer & Vishny (LLSV) or Rousseau & Sylla;23 no distinction is made between types of claims against a debtor or firm. Rather, all debt is generally taken as secured. The chain of causation identified by the law and finance school (especially LLSV) runs from legal origin to enforcement, to financial development and finally to growth. This is unreliable for policy development if legality impacts growth but legal origin does not impact legality. A more fully informed identification of explanatory variables will assist with these problems. It may also overcome problems caused by the static nature of the law and finance school’s analysis, for example, ignoring the convergence of civil and common commercial law with political regionalization and financial harmonization, more extensive financial and trade treaty networks, and the activity of international self-regulatory bodies.
Theoretical interest in the structure and operation of financial systems was largely absent from legal and financial studies before the 1970s, and in schools of economics was confined to political economy.24 That such indifference has vanished results largely from the influence of two trains of scholars. First, Goldsmith sought ways to test whether financial structure could be related to levels of economic development.25 This work was to become a foundation of the law and finance school. Second, North and others synthesized hitherto separate concepts from law, finance and economics in what has become modern institutional economics, which stresses the nature and effect of core rights, duties and incentives. While the first is primarily concerned with whole markets or national economies and the latter is initially microeconomic in its emphasis, the two disciplines share certain interests, and meet in the analysis of the effects of legal systems and property rights, for example, on economic conditions and development.
The approach of the traditional financial development school was to examine the role of banking and bank credit creation. More recent law and finance analysis has taken account of environmental and cultural factors, and indeed all measurable financial variables. None has yet examined in detail the quality of law enforcement in a commercial context, for example, in the willingness of national courts to enforce foreign judgments and accept non-exclusive jurisdiction transaction provisions. Instead, where quality of law and regulation is included in analysis, its tendency to date has been on subjective index measures of the “rule of law.” In addition, while law and finance scholars have sought to quantify the effects on financial development of national legal systems or their origins,26 no systematic attempt has yet appeared in this context that together considers legal origins, their form of acquisition and the distinct nature of jurisdictions, especially when their roots are mixed.27 Nor has analysis yet recognized that the nature of commercial legal disputes may itself be endogenous to the legal system.
Related work includes a considerable body of empirical studies in the style pioneered by Goldsmith and following the methods adopted by King & Levine and LLSV in seeking evidence of causal relationships between financial market or institutional sophistication or structure (including legal origins and conditions), and economic development, commonly measured by growth in national output. While not unanimous, these generally suggest that finance often has a positive effect on growth, although contrary to popular belief there is no theoretical school that asserts the contrary: that the primary causal flow is from economic growth to financial development.28
The remainder of this article contains summaries of appraisals of the effectiveness of current law and practice as to collateral and creditor rights in eleven prominent East Asian jurisdictions. In particular, it examines discrete aspects of the creation and treatment of secured creditor interests, processes for insolvency, securitization, and the functional relationship between these related aspects of law. The effects of globalization on both market practice and harmonization of financial regulation mean that the private law governing international financial transactions differs less by virtue of the location of parties or the place of transaction execution than by issues of judicial enforcement, including the willingness of courts to provide equitable and predictable judgments to domestic and foreign creditors.29 The quality of legal and practical provisions for insolvency is also central to the willingness of lenders and investors to provide funds for capital investment. By contrast, legal frameworks for the taking or enforcement of collateral may be influenced by informal or traditional national or local commercial custom, although remaining subject also to the prevailing form of law and the roots of national law.