Academic journal article Brigham Young University Law Review

Rethinking the "Law and Finance" Paradigm

Academic journal article Brigham Young University Law Review

Rethinking the "Law and Finance" Paradigm

Article excerpt


The label "Law and Finance" stands for a body of literature that has dominated policy-making and academic debates for the past decade. The literature has its origin in a series of papers co-authored by Andrei Shleifer, Rafael La Porta, Florencio Lopez-de-Silanes and a cohort of other researchers, including Robert Vishny, Simeon Djankov et al. (hereinafter referred to as LLS et al.).1 More than ten years after "Law and Finance" was first published, it seems appropriate to step back and consider the contribution this literature has made, but also to point out where it has gone astray and deviated attention from what the critical issues are for Law and Finance and, more broadly, for law and development. The lead authors of this literature have given their own assessment of theirs as well as of related work in a paper that has recently been published by the Journal of Economic Literature, which I will refer to throughout this essay.2 The second part of this essay will be devoted to a critique of the Law and Finance paradigm. The third part will sketch out alternative strategies for analyzing the role of law and legal institutions and the relation between legal and economic change in comparative perspective.


Before developing the critique it seems useful to summarize the key arguments of the Law and Finance literature. First, countries can be divided into different legal traditions, or legal origins. The most important divide is between the common law system and the civil law system.3 Second, legal indicators that measure the protection of owners, investors, and those that are generally "business friendly"4 differ among countries with different legal origins. In general, common law countries are more business friendly than civil law countries. Third, common law countries are also associated with better-developed financial markets. Fourth, law is a determinant (cause) of the observed economic outcomes.

My critique of this paradigm can be summarized in three points: (1) the extrapolation fallacy; (2) the transmission problem; and (3) the exogeneity paradox.

A. The Extrapolation Fallacy

The practice of developing theories about complex systems, such as markets, society, or law, from simple micro-level models (contractual relations) gives rise to an extrapolation fallacy. This strategy assumes that a market is equivalent to the sum of all contracts or can be fully explained by multiplying stakeholder relations at a single firm by the number of firms in the market. The extrapolation fallacy permeates economic theories and thus is not a critique specifically of the work of LLS et al. Indeed, economics has so far failed to offer a comprehensive theory of the market, and instead focuses on contracts, property rights, and firms. As is well known, even this categorization is a relatively late development and one that has not come easy to classic economics, which treated a firm simply as a production function. In 1937, Ronald Coase famously posed the question why firms exist, i.e., why we observe not only arms length contractual relations among individuals, but also vertically integrated organizations.5 This question triggered (with some lag effect) a new sub-discipline: the theory of the firm.6 Explaining who or what populates markets does not answer the question, what markets are and how they are constituted. To most economists this is not a relevant question, as markets are assumed and therefore don't need to be explained. According to this view markets represent the state of nature. Firms, law, and other features are the non-market features that require explanation. It is fully consistent with this basic assumption to explain the emergence of firms as a response to market imperfections - whether rooted in transaction costs7 or incompleteness of contracts.8 Law and legal institutions feature as accidentals to these market imperfections. …

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