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Law Democracy And Economic Growth

Recently it has become fashionable to emphasize that "rule of law" is necessary for economic growth. When applied to the problems of crony capitalism and eliminating corruption the idea makes some sense. But when we say "rule of law," do we mean to extend the concept to human rights? Is it necessary to protect basic human rights to ensure economic growth? Is a western view of law necessary for economic growth or can economies grow even in countries where the legal system is based on local customs and special circumstances? It is my premise that although law is relative to a local culture the legal requirements for economic growth are not.

When we view legal systems of various countries there is always a strong component of moral judgement or national prejudice involved in our analysis. Over the past decade we have often read about 'Asian values' or "Anglo-Saxon" business rules. We also tend to view a legal system as a problem of enforcement. Breaking the law or violating the contract must be subject to an immediate state imposed punishment.

Breaking the law or violating the contract must be subject to an immediate state imposed punishment.


This view seems to imply a parent child relationship. Citizens are the children of the state family. Each family is a bit different. Parents have the right to bring up their children according to own moral code. Moral codes change with time and geography. Most of Europe has abolished the death penalty. United States and Japan have. Under Sharia law and Talmudic custom, women have a restricted role in society. Communist constitutions protected basic human rights subject to the supremacy of the state. Each of these are examples of 'rule of law'. Which ones are necessary for economic growth? Would an anti corruption program work better with a death penalty? Would Islamic countries grow faster if women were given equal status as men? Is India's version of English common law better at restricting crony capitalism than Indonesia's version of Dutch civil law?

Rather than become involved with ethical or cultural debates, economics has attempted to free itself from this issue by providing a quantitative analysis. Its goal is not to differentiate between good or bad. Its goal is to make everyone richer. Economists speak of wealth maximization, enhancing society's wealth producing capacity, or Pareto-efficiency all basically reflecting a utilitarian concept of the most good for the greatest number.

The problem with this analysis is that it leads to some conclusions that seem troubling. The Communist government of People's Republic of China has laws that exert a firm hand over both the economy and severely limit human rights. Yet the PRC's growth has been spectacular. Since the death of Mao Tse Tung and the rise of Deng, they have been able to achieved phenomenal economic growth, sometimes even in double digits. Despite the one party system and lack of basic human rights, it is hard to argue that all members of society are not better off.

China has been rewarded for its successful "rule of law." Massive amounts of direct and indirect foreign investment have flowed into China. Despite rates of return that generally do not exceed an average of 3%, global corporations, lured by the enormous market, line up to form joint ventures and build factories.

This is in contrast to either established democracies like India, or new ones like Russia. These two countries, despite their multiparty system, cannot seem to achieve sustainable economic growth. The central and local governments, despite their popular mandates, cannot seem to pass or enforce laws, that would provide a legal infrastructure, to attract even a fraction of the wealth going into China. Or to put it another way, there seems to be no direct correlation between democracy and economic growth.

Or to put it another way, there seems to be no direct correlation between democracy and economic growth.


But how can this be! Economics is supposed to be the science of choice[1]. How can an economy grow if choice is restricted by the government? Any citizen of a liberal democracy would find the concept distasteful. In search of the real culprit, commentators have fallen back or moral, cultural and even arguments about the effects of poverty. There is something in the culture that encourages disrespect for the law. Without the moral fiber and the history of democratic institutions, disrespect for the law is bound to flourish. Under paid or ill educated officials are subject to bribes by unscrupulous wealthy multinational corporations. In such an environment corruption poisons the market and discourages foreign investment. So the cycle is repeated.

This argument, although attractive, has a major problem in that it limits the possibility of a cure. How can we graft respect for law into these countries? Do we impound an American Bar Convention and ship them to the relevant country? Do we spend money rewriting the local law and retraining local judges and lawyers? Do we transfer wealth to buy countries out of poverty? Or as it was suggested in Indonesia, import judges from its former colonial master, the Netherlands, to give honest interpretations of its Dutch-based law. Perhaps over time the educational system can be remade to instill values of goods citizenship. Or if there was a religious revival, people would have a great respect for civilized mores. I do not believe that any of these solutions will ever be effective, because I do not believe in the strength of the moral, cultural or poverty argument. I believe that the reason lies in economics, not ethics. Part of the problem is that in dealing with societies that lack rule of law, is that the concept of the "reasonable man" does not exist. This creature, the bane of law students, is the creation of traditional legal theory. He (she) is an individual, who it is assumed, conforms his behavior to norms and conventions of the community. In societies without the rule of law, or a legal societies, the reasonable person does not exist, because a reasonable individual would never do anything illegal[2]. However, another creature has no problem with illegal activity, the economic or 'rational man'. This person makes the reasonable man look like a woose. A rational man after balancing out the potential rewards with the potential risk would have no problem dealing drugs if it were to offer profit maximization at a low marginal cost. The universal being is the rational being not the reasonable one. If we are to come up with an efficient legal infrastructure we must deal with this low brow rather than his civilized cousin.

As we know, intelligence is sometimes without ethics. Some very cunning autocrats have been able to devise exceptionally clever legal systems that have been able to satisfy the needs of a rational man. Stalin was one such individual. Modern economists[3] have reexamined Stalin's methods to answer one question, why were they so effective? How could a brutal socialist dictatorship develop a system that was able to grow in leaps and bounds without the benefit of a free market? The answer is, that he used the law.

Through trial and error, Stalin developed a very efficient method of taxing both enterprises and individuals to gain the maximum amount of effort from each. Stalin was able to create an innovative process of taxation, in a manner that guaranteed growth of the economy and his power. He was able to pass laws that expropriated all property for his tax collections. He was able to avoid the collapse of investment by controlling the level of consumption and investment to insure the highest rate of savings. He introduced tax price discrimination that captured a larger part of the output of relatively productive individuals. Finally, he was able to create a regulator system to increase the amount of labor supplied[4].

Stalin had a vision. In synch with kings, autocrats and 'stationary bandits'[5], he had an encompassing interest in the success of the Soviet Union. He wanted to build the strongest, most productive economy, so he could build the strongest country, all for the benefit of himself. It was not in his interest to increase tax theft to the point where productivity was harmed, a problem that has hobbled many kings. Rather, he changed the rules. Through his innovations, he was able to impose the highest rate of savings and investment necessary for rapid economic growth. Law was successfully put into the service of the interests of economic growth and wealth maximization.

Law was successfully put into the service of the interests of economic growth and wealth maximization.


Stalin was not unique, though probably the most successful. Mao was able to accomplish a similar feat. The techniques are not restricted to 'socialist' states. Other leaders have also been effective in utilizing a legal system to control investment and savings. In Singapore and in Chile, single party states used the law to force savings and control investment. The methods used were far more benign, utilizing incentive rather than mass murder, but the result was the same. The countries grew at rapid rates. Wealth was maximized. Is this then our ideal of an efficient legal infrastructure? A Platonic enlightened (and sometimes ruthless) ruler dispensing economic growth and stability through sophisticated taxation in a restricted society. Thankfully, no. Quite the contrary, there was a major problem in Stalin's system and in the systems that he bequeathed to other communist countries. The problem was time.

It is unfortunate that great leaders with encompassing interests cannot clone themselves. Then they could be everywhere and see everything. Unfortunately, they can't. They must empower agents. Initially the interests of the agent and the autocrat are identical. The agent cannot exist without the autocrat and the autocrat realizes his encompassing vision through the agent. Over time this changes. The agents, as rational wealth maximizing economic men, use their position to gather wealth and power independent of their principal. As they do so, their interests begin to diverge from that of their creator. The agent wants his heir to inherit. The autocrat wants the best man for the job. The autocrat may want to sunset an industry, which the agent owns or controls.

Unless, like Stalin and Mao, the autocrat is fond of purges or cultural revolutions, these agents and their organizations tend to multiply. Information, once only available to the autocrat for his use, begins to be hoarded by the agents for their benefit. The information either does not get to the principal, or is so distorted by the time it does, that it becomes useless. Worse, the information may be traded between agents for their own benefit to the detriment of the autocrat.

Over time the agents could gain sufficient power to destroy the principal. Henry the VIII empowered and enriched the English middle class as agents in his struggle against the church and nobility. With their help, he created an absolute monarchy. Less than a hundred years later, his agents' progeny chopped off his great great nephew's head. According to the great historian Fernand Braudel, the wealth and power of the great Dutch East India Company was eventually drained away[6]. Enterprising agents were able to trade amongst each other throughout the Orient to the detriment of the company.

According to game theory the problem of agency represents one of non verifiable asymmetrical information. Translated this means there is no way to know if your employee is sleeping on the job. In the autocrat's case, there is no way to know whether the agent is stealing state assets or plotting his overthrow or both. To solve this problem, a principal, owner or autocrat must choose between either and incentive or punishment. Autocrats must control information to retain power. So, their response to hoarded or traded information is to punish the agent severely. Incentives typical in democratic market systems are simply not an option. Therefore, all of the agents have an even greater incentive to conceal the information from the center. The autocrat, of course, now needs a secret police, but who will watch the watch dog?

Although this is a problem for all autocrats, it is especially significant in socialist economies. In these economies with no price mechanisms, the distributional system invariably provided either to many or two few resources to any given enterprise. Information passed through layers of bureaucracy becomes distorted in proportion to the bureaucracy's size[7]. In order to balance the process, managers colluded with each other to make up for shortages or oversupply. Since collusion was illegal, managers had strong incentives to keep the information to themselves.

Over time, as the need to correct inefficiencies in the system grows, so does the collusion until it becomes commonplace and finally institutionalized. Yet since the process is still at least theoretically, illegal. The agents and their coalitions have more incentive to gain more reward and to conceal more information. The interest of these agents and their coalitions become more parochial, more narrow. Telling the truth or obeying the law to benefit the encompassing state interest could be a dangerous process. Far better to protect oneself and gather wealth and power in support of the narrow interest of oneself, one's enterprise or one's group.

Despite the phenomenal growth rates possible early in autocratic governments, it is hardly surprising that they eventually sclerose into corrupt and inefficient economies. Laws and regulations, which were supposed to grant all power to the autocrat and the state, devolve over time to become meaningless words or bad jokes. Power devolves into various groups at the expense of the economy as a whole. Growth once vibrant ceases, and the economy stagnates.

But communist countries are not the only places riddled with corruption. Market economies both autocratic and democratic are often plagued with similar problems. Although market economies are not as inefficient as socialist economies, the same forces are at work. According to the logic of collective action, small groups, special interest organizations or coalitions have far greater incentive than large groups to collude in order to maximize their wealth, power and advantages. Once these groups have been able to obtain the distribution of a larger share of an economy's wealth, they have an obvious incentive unless restricted to try to hold on to it.

These groups, or in the great economist Mancur Olson's phrase "Distributional Coalitions," have one aim, more for us less for them. Their interests are extremely narrow. These groups can include any number of different types of organizations. They include professional organizations, big businesses of all types, oligarchies, Mafias, political parties, unions, government agencies, bureaucracies, security forces etc. These organizations are far better equipped to protect their share of the economy than the rest of us. The us are the unorganized demos of democracy, voters, consumers, patients, citizens, and taxpayers.

Whether in established democratic countries with market economies or socialist totalitarian states, Distributional Coalitions use any and all means to get more of their society's wealth and consolidate power. The most effective tool used to accomplish their ends is the law. It is also their most efficient limit.

All states use laws to distribute power and impose limits. Both powers and limits can be allocated to people and organizations. These people and organizations can be part of formal government (executives, legislators, judges and bureaucrats), part of the enforcement power of the state (military, police, tax collectors, fish and game wardens, pollution inspectors etc.) organizations outside of government (corporations, business and professional organizations, religious sects, unions, lobbying groups, political parties, criminal organizations and other non governmental organizations). The way in which a government allocates these powers or imposes these limits determines the efficiency of its legal infrastructure.

All states use laws to distribute power and impose limits. Both powers and limits can be allocated to people and organizations.


For example, the Liberal Democratic Party of Japan has been in power, almost uninterrupted, for over fifty years. They represent, at the expense of consumers and taxpayers, their constituents, construction companies, farmers and small businesses. One of the main problems with the Japanese election system is the high cost of campaigns. These costs are the source of corruption. They are the ties that bind the LDP to powerful businesses and groups, who can afford the contributions. It also acts as a barrier for new candidates and parties. The Internet, with the possibility of reaching millions of people for a small fraction of normal costs, is obviously a threat. So the LDP has made it illegal to campaign on the Internet.

An obvious limit to the power of a Distributional Coalition would be antitrust law. Bill Gates and Microsoft used their enormous power and influence to thumb their nose at the Justice Department and the courts for several years. Through campaign contributions, lobbying efforts and even television commercials, Microsoft attempted to retain its wealth maximizing position at the center of the computer industry. Eventually, it was limited by an efficient use of the law.

If you read the constitution of the former Soviet Union, you will soon realize, that all of the power resides in the state (originally Stalin) with practically no limits. As we have seen, the result was the growth of Distributional Coalitions were not checked. They eventually brought down the government. In contrast, the constitution of the United States is a series of powers and limits. The government can be the most powerful Distributional Coalition of all, unless its power is curtailed by the law.

Antitrust, antipollution, anti-fraud, health safety and welfare legislation are some of the most obvious limits imposed by governments on Distributional Coalitions. Less obvious is the need for basic rights. Without freedom of speech transparency would be impossible. Without transparency secret deals between government and Distributional Coalitions would be the norm rather than the exception. Bribery is a problem not because it is immoral. It is a problem because it undermines the price mechanism.

Agents or officials of all governments are in the business of allocating scarce resources. If they are able to give it away in secret to the Coalition with the best connections or the most money, the rest of us will be injured, because the highest price for our property was not obtained. The incentives of agents of democratic are the same as the agents of autocrats, except agents of democratic governments run a higher risk. They can be exposed by free speech. They can be voted from office. They can be censored, fined or imprisoned by other branches of government, who have different incentives.

Corruption is part of the normal process of government. It only differs in degree. The more corruption, the more chance that Distributional Coalitions have of gaining a larger share of wealth and hence, a less efficient economy. Public officials can be bought as often with campaign contributions as with secret bank accounts. The power of a lobbyist to legally influence legislation to benefit his or her group can be just as damaging to the public as if the transaction had been the result of a bribe. We rarely know what transpires behind closed doors. We will never know unless we have free speech.

To make a rational economic choice, we must have information. Free information is an absolute necessity for an efficient economy. An efficient legal system must provide it. The problem with corruption is not that it is illegal or immoral. The problem is that it is secret. Once Distributional Coalitions are ascendant in any society they are exceptionally hard to dislodge. They can use their wealth and power to use all the levers of government and the media to retain control[8]. They can be eliminated by wars as in Japan and Germany. New frontiers and immigration[9] also change the balance of power as does a new technology[10]. The impact of Admiral Perry on Japan and the resulting Meiji restoration is an example of dramatic change in a stagnant society.

The most effective and least intrusive is the limit of law. Since law can also be used to protect local groups, the legal limits imposed by higher jurisdiction become more important. In the United States, federal investigations of local intrusions upon citizens rights are a constant and often unwelcome limit of local power. In the same way, influence of super national organizations is beginning to make an impact. For example, the great banana war between the US and the European Union to stop discriminatory economic barriers against poorer Central American countries is evidence of the impact by the WTO. By limiting national Distributional Coalitions, the WTO is beginning to establish more efficient world trade.

World trade and competition from efficient multinationals are exceptionally dangerous to the wealth and power of local industries. These industries, their owners, their unions, and their local officials are very successful in passing laws and tariffs to keep them out[11]. When these protective measures are removed by membership in the WTO, the power of the local Distributional Coalitions may fail with their businesses despite an often ferocious rearguard action[12].

Like the rational economic man, Coalitions will always attempt to maximize their wealth. In the competition over society's resources, some coalitions like firms or individuals will be more successful than others. Like firms they will attempt to protect their market share, their power and their wealth. One way they can perpetuate themselves is by using the law to exclude the competition. The result will eventually be disastrous. The multiplication (breeding) of these groups at the expense of demos will eventually slow and stop economic growth. Like an earthquake, where the pressures build up over centuries, the pressures of an inefficient system will often burst forth in a dramatic economic collapse or a political revolution.

Law is a conservative force in all societies. Its effect both for or against change is sometimes glacial, but over time the sustainability of economic growth will ultimately depend on its efficient use.


In an efficient democracy, there is always a process of creative destruction. The pressures are never able to build up. Small adjustments are always taking place. New technologies, new immigration will create new centers of wealth and new voting blocks. With each new center of power, new coalitions will arise to challenge and change the old. It is only in a democracy, where rights are protected, that free competition among Distributional Coalitions fosters a healthy balance. In an efficient legal system, the law should always be dynamic. The scales of justice should always be in motion. Over time they will protect some interests and later limit them. It is only when this process ceases and power ossifies around a group of haves, that corruption will multiply and the economy will stagnate. Law is a conservative force in all societies. Its effect both for or against change is sometimes glacial, but over time the sustainability of economic growth will ultimately depend on its efficient use.

References
  1. [1] Economic and the law p.55
  2. [2] Economics and the law p58
  3. [3] Power and Prosperity p 115 citing ronald Mckinnon taxation, money and credit in a liberalizing socialist economy.
  4. [4] Olson, Mancur Jr., Power and Prosperity, 2000, New York, NY: Basic Books. p. 129.
  5. [5] Ibid
  6. [6] Braudel, Fernand, The Perspective of the World, 1979, 1992 University of California Press, p.228.
  7. [7] Gordon Tullock and Oliver Williamson cited in Olson Williamson The Economics Institutions of Capitalism
  8. [8] All autocrats control the media. China's attempt to control the Internet
  9. [9] In the US the enormous impact of Hispanic immigration in beginning to be felt including a beneficial impact on growth
  10. [10] The industrial revolution took power from landed Aristocracy and transferred it to manufacturing middles class. Internet is changing the power of distribution in favor of consumers to the detriment of suppliers
  11. [11] Japanese zoning restrictions were notorious for keeping out superstores including foreign ones like Walmart and Toys'R Us
  12. [12] Enron had enormous problems with the Regulatory Raj in entering the Indian energy market. Health complaints against McDonalds in New Dehli. Chinese banks and insurance companies putting up barriers to foreign competition from WTO membership




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