As a result, businesses tend to sidestep the law, relying on reputation, relational contracting and interpersonal trust to support economic and financial transactions, in preference to state-backed legal enforcement through the courts.
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These two studies correctly highlight the limits of using law as a mechanism of economic coordination in developing economies. As Gilson and Milhaupt show, it is effective state capacity, and not the rule of law alone, which is generally essential to overcoming collective action problems which may inhibit the production of the public goods on which a market economy depends.
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The relative rigidity of the formal law and its tendency to lag behind economic and technological developments, leading to avoidance strategies, is also well established in socio-legal studies on contracting. However, the contrast between formal and informal institutions in these critiques of the rule of law orthodoxy may be somewhat overdrawn.
A minoritarian but still significant strand in the empirical literature on contracting suggests that while informal institutions may provide a foundation for inter-personal trust in small-scale settings with repeated exchange, formal laws, where they enjoy legitimacy and effectiveness, constitute important trust-assurance mechanisms in the context of large-numbers, impersonal exchange. The impartial administration of the law can operate as a check on the exercise of governmental authority and on the power of incumbents in contexts where economic development continues to be shaped by an activist state and informal commercial and business networks.
This implies a sequencing approach to building legal institutions: a given mix of public and private enforcement may work well at early stages of development but may not be sustainable over the longer term. Country-specific industrial and political factors shape the path of legal and economic change in particular middle-income economies. Bank-led finance, which makes fewer demands on judicial and regulatory resources than arms-length finance through equity or bond markets, may be expected to play a major role in countries where growth is led by manufacturing and natural resources firms and where judicial and legal institutions are still in the course of developing.
At local level this takes the form of state support for the Town and Village enterprises and the use of local government mechanisms to enforce contracts and property rights. China also appears to have benefited from the sequencing of legal and financial reforms. The economy has been liberalised gradually, in tandem with efforts to build elements of a more formal legal system and institutions. We may hypothesise on the basis or emerging evidence from the Chinese case that a rule of law state is both cause and effect of sustainable economic development.
This insight is supported by coevolutionary models of law—economy relations of the kind that are found at the intersection of game theory, systems theory and the economics of law. According to this theoretical framework, formal legal institutions meet needs which arise in the context of an economy which is moving from interpersonal trust with small numbers exchange to large-scale, impersonal transacting.
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In this approach, legal institutions are endogenous to the economic growth path of a particular country. It follows that they are unlikely to be functional in the absence of certain social and commercial practices to which public enforcement is complementary. Once functioning legal mechanisms are in place, however, they have the potential to foster further growth. Thus the relationship between legal institutions and economic growth is one of incremental coevolution. While the quality of institutions does matter for economic performance, 37 the polity is not prior to the economy.
Rather, as Masahiko Aoki puts it, 38 the polity and economic organisations and thus economic performance coevolve through a long historical process, rather than the former [being] prior to the latter as shorter-run observations might often appear to suggest.
Theoretically, this view is derived from a game-perspective in which institutions both in the polity and the economy are regarded as emerging, sustaining themselves and changing endogenously through strategic behaviours of agents. Specifically, the political state is identified with a deep stable state of the political game. Thus it may sometimes appear that changes in the polity are prior to changes in other institutions, but at a deeper level they can only co-change.
Otherwise, they would not be stable and sustainable. In this game theoretical perspective, the law assists coordination among boundedly rational agents by signalling to them the likely strategies that will be followed in particular market or other social settings. The state is not so much a sovereign power as an endogenous normative order which reflects the society in which it is embedded. Coevolutionary models in game theory 39 and systems theory 40 recognise the domain-specific quality of legal rules: in other words, legal relations and market relations are distinct, with neither being reducible to the other.
The development of impersonal exchange and the deepening of the division of labour in a market economy create demand for public mechanisms of contract enforcement and for a contract law which instantiates notions of commercial good practice and thereby serves as a guide for action.
However, to say that the law reflects practice and evolves over time in response to commercial developments is not to say that it is reduced to social practice: the law is not simply private ordering writ large. Legal rules which are publicly enunciated and applied have a number of features which complement the emergence and extension of impersonal exchange.
A further feature of publicly articulated rules is their neutrality : legal rules in a functioning rule of law state are capable of being applied in a way which is independent of the wealth or status of the parties concerned. Judicial independence from private interests, and not simply from the executive power of the state, is key to the claim of the rule of law state to ensure equality of market access for all citizens.
A third feature of public-legal rules is their stability. Purely private rule systems such as those based on commercial arbitration or private dispute resolution rarely acquire the features of doctrinal consistency, predictability and constancy which are associated with the legal order.
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This stability of legal rules need not, however, imply their immutability. While the rigidity of the law may be a problem in rapidly developing economies, a developed system of commercial law is capable of responding to changes in the technological or commercial context of particular transactions. Legal systems possess mechanisms for and receiving filtering information from society or the economy, for example through litigation which can operate as a mechanism of selection and deselection of rules, 42 or through the legislative process, which can generate knowledge through commissions of inquiry and public debate.
The fit between legal rules and their context may not always be precise or exact. Misalignments and lags are more likely than not to occur, particularly in periods of rapid change. Legal evolution displays tendencies towards path dependence and institutional lock-in. But this is not the same thing as saying that the legal system is inherently rigid or fixed, or incapable to adjusting to a changing context. In a coevolutionary framework, the debate about enforcement can be seen in a new light.
As Aoki stresses, 45 for a given law to operate as a social institution requires that, at some level and to at least a minimal degree, it is accepted by social actors, and internalised in their practices. At the same time, the non-acceptance of a given legal norm by the community of social actors to which it is addressed does not, in itself, deprive that norm of its formal status as a rule of positive law.
In a society characterised by the rule of law, the attribution of legal validity to a given norm necessarily creates the potential for the implementation of that norm at the level of social and commercial practice. One way for this to be achieved is through the public sanctioning of conduct which departs from a given norm. However, enforcement may be less effective as a strategy than legitimation. Strict public enforcement of norms is double-edged: if the rule is not accepted as legitimate, actors will invest in strategies of avoidance.
The normative force of legal rules depends partly on the severity and likelihood of sanctioning but to a greater extent on the degree of its acceptance by the community of actors. A rule of law state is one with the unusual and distinctive capacity to actualise legal rules simply by virtue of their formal adoption as positive rules of law, but this power is not self-generating at the level of the legal system.
It cannot be enacted or enunciated using legal formulas. It depends rather on the existence of a meta-norm, shared across a population of actors, of respect for norms which have a public-legal form, irrespective of their precise content. Empirical studies based on field experiments and similar behavioural methodologies suggest that meta-norms of this kind are more widespread in democracies than in authoritarian states.
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Strictly speaking, there were no transactions in the sense of commodity exchange. All disputes were settled by the government in its capacity as common owner, and legal rules governing market transactions were completely redundant. Even prior to the effective abolition of the legal system during the Cultural Revolution, the legal system had ceased to function in any meaningful sense, as central planning determined the content of economic policy. The irrelevance of formal law persisted into the early part of the reform era and it was guanxi that played a crucial role in attracting foreign direct investment and market building in this period.
The law had little impact, however.
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Foreign investment was deterred by the lack of clear protection for property rights and the fear of policy reversal. Interpersonal trust or guanxi between Hong Kong investors and businesses in Guangdong province, rather than the legal framework, was responsible for the subsequent growth of FDI.
The majority of Hong-Kong based Chinese originate from Guangdong and they have various familial and lineage-based links to communities based there. While at the outset of the reform period there was in effect no market in China and state ownership of the means of production excluded a role for private property rights, private actors were able to access economic resources through guanxi -type relations with government officials and managers of state-owned enterprises. This led to the emergence of organised forms of production outside the state sector.
The rapid expansion of market relations in China during the s cannot be attributed to the legal system. Rather, trust-based mechanisms of the kind identified by the literature on informal contracting — the threat of loss of future trading opportunities and the costs of exclusion from dense, interpersonal networks — enabled the economy to grow. However, even from this early stage the limits of guanxi were becoming clear. FDI was concentrated in the coastal areas where guanxi was well established. As a result, the income gap between the coastal provinces and other Chinese regions grew rapidly, and became a challenge to economic policy and to the maintenance of social order.
Maintaining guanxi came at a cost. Although guanxi worked as a coping strategy for dealing with abuses of bureaucratic power, it also catalysed new forms of bureaucratic corruption. Guanxi -type relations made it possible for political insiders to make fortunes from the sale of quotas and permits. Corruption of this kind was a direct trigger of the Incident, the gravest political crisis after The limits of guanxi have become clearer as the economy has continued to grow.
Guanxi is a localised phenomenon and its benefits are generally confined to members of closed networks. Guanxi engenders high transaction costs as firms have to invest in building interpersonal ties each time they enter a new market. The larger the firm, the greater the investment it has to make in guanxi. At some point the deadweight costs of the guanxi system will begin to outweigh its benefits. As private enterprise has continued to grow to the point where it has outstripped the state sector, demand for formal legal rules which would limit the costs of relying on guanxi has developed.
This accounts in large part for the rapid increase in the rate of adoption of new commercial laws since the s. While many of the components of these laws are borrowed from mature market economies, they also reflect social practices within China and are increasingly tailored to meet the needs of market actors based there. Parties have strong incentives to tilt the interpretation and application of legal rules in their own favour. Unless there is an independent court system which has the remit of ensuring that laws are impartially and neutrally enforced, the potential of formal laws in reducing transaction costs and providing a basis for impersonal exchange will not be realised.
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A feature of emerging markets is that the societal meta-norm of respect for publicly enunciated legal rule is lacking. A meta-norm of this kind can only be established once there is a common belief in the ultimate sovereign effect of the legal order, that is, its equal application to all actors including those of the state itself. As long as some actors stand above the law and state power is intermingled with private interests, complying with legal norms will not become the first best strategy of most social or commercial actors.
Bringing political elites within the reach of the legal process and recognising the domain-specific character of legal rules are complementary strategies for embedding the rule of law in emerging markets. One means of catalysing the rule-of-law state in emerging markets is the diffusion or transplantation of legal norms and institutions across national boundaries.
The impetus for this process started with econometric studies which sought to test for correlations between cross-national variations in shareholder and creditor protection, on the one hand, and the extent of financial development across regions and countries, on the other.