by Kenneth W. Dam. Washington: Brookings Institution Press, 2006. 320pp. Cloth. $36.95. ISBN: 9780815717201.
Reviewed by Joshua Hall, Assistant Professor in The Department of Economics & Management, Beloit College. Email: halljc [at] beloit.edu.
Why are some countries rich and others poor? While economists have tried to answer this question since before Adam Smith’s (1776 ) inquiry into the wealth of nations, it has only been since the late 1940s that economists have systematically focused on less developed countries such as those in Africa (Arndt 1997). The African “growth tragedy,” a period between 1965 and 1990 where average real per capita GDP in Africa was stagnant, has stimulated considerable research into the causes of economic development (Easterly and Levine 1997).
One prominent strain of this literature that began with the pioneering work of Douglass North (1990) has focused on the importance of institutions in explaining cross-country differences in economic growth (Rodrik, Subramanian and Trebbi 2007). The institutional approach to economic growth is based on the idea that the productivity of a country’s citizenry and resources depends in large part on the quality of that country’s social, political, and economic institutions. Competitive markets, freedom of exchange, and secure private property rights are all examples of institutions that contribute to economic growth (Gwartney, Holcombe and Lawson 2004).
Beginning in the mid-to-late 1990s, a team of economists began to take a closer look at the importance of legal institutions (La Porta, et al. 1998). The primary focus of their research was on whether there existed a relationship between a country’s legal rules and financial sector. La Porta, et al. (1998) found that countries whose legal systems are derived from the English common law have higher rates of economic growth than countries whose legal systems are based on civil law. While this finding has been subject to considerable criticism, this and subsequent research on the relationship between law and finance has led to the widespread belief that well-functioning legal institutions (i.e., the “rule of law”) are of utmost importance to economic development.
In THE LAW-GROWTH NEXUS: THE RULE OF LAW AND ECONOMIC DEVELOPMENT, Brookings Institution senior fellow Kenneth Dam provides an excellent contribution to this burgeoning literature. In the introduction, he clearly sets out his primary goals for the book. Dam’s first goal is to move the debate beyond the well-accepted perspective that legal institutions are important. The really interesting (and more difficult) question is how and why legal institutions are important for economic growth. A secondary goal is to provide some sort of guidance for policymakers who are aware of the importance of the [*264] rule of law but do not know how to act upon that knowledge.
This book is divided into 4 parts. The first part is titled “Perspectives on Law and Economic Development” and is comprised of four chapters. The first chapter is an in-depth discussion of the rule of law and its effect on economic development. Chapter 2 is an overview and analysis of the “law and finance” literature that started with the initial research of La Porta, et al. (1998) and is, in my opinion, the strongest chapter in the book. Dam does an excellent job of succinctly explaining the assumptions and methodology that led the law and finance literature to conclude that the common law is superior to the civil law in terms of being conducive to economic growth.
The highlight of the chapter occurs when he finishes summarizing the literature and begins to slowly poke holes into it. In his critique, Dam raises an important issue with respect to the methodology of the law and finance literature. He notes that in order to run their cross-country regressions, La Porta, et al. (1998) need to code all the countries in their sample as being of a distinct legal origin. For many countries this is not problematic, as their current legal system has distinct roots in either the English common law or the French civil law. Coding Brazil as being of French civil law origin is a bit more problematic when it is clear from the country’s legal history that its civil code drew not only from the French civil code but also the German, Italian, Portuguese, and Swiss civil codes.
As an economist familiar with the law and finance literature, I found Dam’s summary to be excellent and his criticisms both fair and informative. Not only does he have an excellent eye for what is lost with an excessive reliance on cross-country regressions, but he also has an appreciation for what is gained. For example, while he criticizes the law and finance literature for drawing policy conclusions from data on only 49 countries, he notes that “49 countries may be enough for an academic paper aimed at a general conclusion (and at the time a new perspective)” (p.53).
Chapter 3 is a short chapter where Dam discusses geography and culture, two alternative explanations for cross-country differences in growth. Chapter 4 concludes Part I with an analysis of how the developed world was able to obtain the rule of law. In the chapter Dam discusses the work of Weingast (1993), North (1990), and others on legal evolution in England to see if any lessons can be learned from their experience. Unfortunately, there are no easy lessons to be drawn from the English experience.
Part II is comprised of four chapters on a key component of the rule of law, namely the enforcement and protection of property [*265] rights. Chapter 5 focuses on the role that the judiciary plays in the enforcement of contracts. In the sixth chapter Dam turns his attention to the issue of contracts, clearly noting the difference in how contracts are treated between civil and common law countries, and addresses the relationship between contracts and property as well as discussing the general concept of property rights.
The second part of the book concludes in Chapter 7 with a discussion of enforcement, contracts, and property rights, all in the context of agricultural land in the developing world. Here Dam ties together the concepts covered in the three previous chapters. Land is important because it is a primary source of real wealth for most households and the productivity of agricultural land is very important to economic development for a country as a whole. Secure property rights contribute to economic development by giving farmers the incentive to invest in improving the land and to produce the goods that yield the highest return.
The historical experience of current developed countries is a witness to the importance of secure property rights. A recent paper by Hornbeck (2008), for example, shows how in the United States the invention of barbed wire lowered the cost to farmers of establishing property rights where timber for fencing was scarce. He finds that the secure property rights created by the introduction of barbed wire increased crop productivity by 23 percent from 1880 to 1890.
The security of property rights through the combination of cultural norms, technology, and the legal system is clearly important to the productivity of land and, consequently, economic development. Dam details how the legal insecurity of property rights in the developing world has large costs to the economy as resources spent on protecting and securing property cannot be employed in productive activities. In addition, he notes that, without a clear title to their property, farmers cannot obtain loans to invest in machinery that would increase agricultural productivity.
Dam also adroitly discusses the costs and benefits from land titling and the problem of communal property. He finds no clear a priori for communal property to always be less efficient than private property, but after examining the issue, he concludes that “formal legal recognition of individual rights to a plot in a larger tract of communal land may have some economic value” (p.156). Underlying the titling process, however, there needs to be a strong and competent judiciary, a point that is often overlooked by policymakers.
Part III looks specifically at the issue of legal institutions and a country’s financial sector. Chapter 8 focuses on the role of corporations historically and today, as well as how corporations and equity markets interact. Chapter 9 looks at legal institutions and credit markets, banks, and bankruptcy. These are very good chapters, but they cover so much ground it is hard to do them justice in a book review.
The fourth and final part of the book finishes with two chapters. Chapter 10 provides a review of the author’s conclusions drawn from the previous nine chapters of analysis. Dam highlights for policymakers the key factors to implementing an institutional approach to economic development focused on legal institutions. For example, he suggests that international aid organizations should devote resources to improving the quality and independence of the judiciary in less developed countries as part of their legal reform efforts.
Chapter 11 concludes the book with a case study of China. By some measures, China is the fastest growing country in the world. Yet it is not at all clear that China is characterized by the rule of law. [*266] What implications does this have for the legal institutions and growth perspective? After a detailed analysis of China’s growth record, judiciary, and economic and legal structure, Dam concludes that, while it is correct to say that China is currently not characterized by the rule of law, this should not be taken as evidence that the rule of law does not matter for economic growth. China is still a very poor country, and its legal institutions reflect that stage of development.
In summary, I found THE LAW-GROWTH NEXUS to be an excellent book. There are useful and practical insights into the issue of reforming legal institutions in the developing world in every chapter. Teachers of development economics already assigning La Porta, et al (1998) should really consider adding Chapter 2 to their reading list. Not only would it introduce students to some important criticism of the legal origins literature, but it would also show students how serious scholars can be both respectful and critical at the same time.
Arndt, H. W. 1997. ECONOMIC DEVELOPMENT: THE HISTORY OF AN IDEA. Chicago, IL: The University of Chicago Press.
Easterly, William, and Ross Levine. 1997. “Africa’s Growth Tragedy: Policies and Ethnic Divisions.” 112 QUARTERLY JOURNAL OF ECONOMICS 1203-1250.
Gwartney, James, Randall Holcombe, and Robert Lawson. 2004. “Economic Freedom, Institutional Quality, and Cross- Country Differences in Income and Growth.” 24 CATO JOURNAL 205-233.
Hornbeck, Richard. 2008. “Good Fences Make Good Neighbors: Evidence on the Effect of Property Rights.” Cambridge, MA: Massachusetts Institute of Technology Working Paper.
La Porta, Rafael, Florencio López-de-Silanes, Andrei Shleifer, and Robert Vishny. 1998. “Law and Finance.” 106 JOURNAL OF POLITICAL ECONOMY 1113-1155.
North, Douglass C. 1990. INSTITUTIONS, INSTITUTIONAL CHANGE AND ECONOMIC PERFORMANCE. New York, NY: Cambridge University Press.
Rodrik, Dani, Arvind Subramanian and Francesco Trebbi. 2004. “Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development.” 9 JOURNAL OF ECONOMIC GROWTH 131-165.
Smith, Adam.  1998. AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS. Washington, DC: Regnery.
Weingast, Barry R. 1993. “Constitutions as Governance Structures: The Political Foundations of Secure Markets.” 149 JOURNAL OF INSTITUTIONAL AND THEORETICAL ECONOMICS 286-311.
© Copyright 2008 by the author, Joshua Hall.