10. Market Institutions and Judicial Rulemaking

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BENITO ARRUNADA and VENETA ANDONOVA

1. INTRODUCTION AND SUMMARY

The proper functioning of a market economy requires that freedom of contract be protected effectively. This can be achieved in different ways. A major design decision concerns the rulemaking discretion that the legislator delegates to the courts. When taking this decision, the legislator should take into account the specialization advantages and transaction costs that come with more or less specialized rulemaking. Factors influencing this trade-off explain the different solutions adopted in the two main legal traditions of the West. Common law evolved keeping more rulemaking powers in the judiciary, and thus was characterized by unspecialized rulemaking. The civil law tradition, however, was transformed during the 19th century, reserving greater rulemaking power for the legislative branch and thus reducing the discretion that judges had enjoyed during the Ancient Regime.

By stressing this difference, some recent studies claim that common law legal systems provide superior solutions to those developed in the civil law tradition, in which judges have less rulemaking power. This chapter criticizes these claims by developing and testing an alternative “self-selection” hypothesis, according to which both common and civil law supported a transition to the market economy adapted to local circumstances. In particular, judicial discretion, which is seen here as the main difference between the two legal systems, is introduced in civil law jurisdictions to protect, rather than limit, freedom of contract against a potential judicial backlash. This protection was unnecessary in common law countries, where free-market relations enjoyed safer judicial ground mainly due to their relatively gradual evolution, their reliance on practitioners as judges and the earlier development of institutional checks and balances that supported private property rights.

From this adaptation perspective, we see that much of the discussion on the “efficiency” of both legal traditions (pioneered by Posner, 1973; Priest, 1977; Rubin, 1977, 2000; and further developed by Cooter and Kornhauser, 1980; Terreborne, 1981, and Katz, 1988) focuses on relevant but relatively minor matters. This is compounded in recent comparative studies by the difficulty for such empirical comparisons of distinguishing causalities from correlations and by the fact that performances are observed only for those choices that were

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C. Menard´ and M. M. Shirley (eds.), Handbook of New Institutional Economics, 229–250.C 2005 Springer. Printed in the Netherlands.

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effectively taken, while the relevant comparison would be between the chosen option and its unobserved alternative. Such analyses therefore provide shaky grounds for policy recommendations and this may explain the recurrent paradox that, even though these empirical comparisons support the claim that common law is superior to civil law for the development of financial markets (e.g., La Porta et al., 1998: 1148) and economic growth (Mahoney, 2001), both transition and emerging economies opt for statute law for creating the legal basis of such markets, following the regulatory model of developed economies, which for many decades has been based on statutes.1

Our discussion therefore broadens the argument by Rubin (1982) that both common law and civil law facilitated freedom of contract and were efficient in the 19th century. Without claiming anything regarding “efficiency,” however, we argue that both common law and civil law solutions were well adapted to their particular circumstances. Considering that the value of legal systems depends not only on their specific traits but also on good environmental fit, we aim to identify the local circumstances which defined the balance of the institutional trade-off. Further work is needed, however, to develop and test the conjecture that the problem of transition and developing economies resembles the challenge of creating market institutions in 19th century Europe rather than the remote, evolutionary emergence of such institutions in common law countries.

The remainder of the Chapter is organized as follows. In Section 2 we state our hypothesis concerning the evolution of common and civil law. We argue that common law countries featured greater judicial discretion because, given their more gradual evolution away from the Ancient Regime, judges did not threaten the development of a modern market economy. Civil law reformers, in contrast, placed more rulemaking in the hands of the legislature and limited the discretion of judges in an attempt to shelter free-market relations, especially freedom of contract, from a potential judicial backlash. Both of these policies, promulgating systematized default rules and reducing judges’ discretion, shared the same goal, that of protecting freedom of contract and promoting market relationships and economic prosperity in areas previously suffering from mandatory rules and judicial regulation of private contracts. We then confirm the consistency of our argument by reviewing the relevant historical evidence, in Section 3, and the alternative explanations provided in recent comparative performance of legal systems, in Section 4. In particular, Section 3 analyzes the historical evidence on the evolution of both legal traditions which seemingly culminated at the end of the 19th century. Then, in Section 4, we compare our argument with those produced in the recent debates on the comparative efficiency and performance

1 This selection of statute law has even been interpreted as a selection of specific legal origins within civil law, as in the first of the annual Doing Business reports, which are based on methodologies developed within the “Law and Finance” literature and, specially, La Porta et al. (1998) and Djankov et al. (2002, 2003). In particular, Doing Business 2004 classified 19 of the 30 jurisdictions which had formerly been considered of Socialist legal origin within that literature (La Porta et al., 1999) as of either French or German legal origin. At the same time, 11 of these 30 countries remained classified as being of Socialist origin, and none was reclassified as having a common law origin (World Bank, 2004, 115–117).

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of common and civil law. We contend that both theoretical and empirical claims on the superiority of common law remain unproven. Legal systems are not efficient in a vacuum, but rather their performance depends on environmental conditions. Section 5 concludes offering some conjectures on viable policies, acknowledging the idea that legal systems must fit their environment.

2. THE ALLOCATION OF RULEMAKING POWERS

In modern economies, wealth creation depends substantially on market exchange, which requires a legal environment capable of increasing the capacity of parties to define the wealth-enhancing terms of trade and to enforce their agreements. Two key elements of this legal environment are rules and courts. Rules, given by customs, previous judicial sentences and statutes, provide parties with a detailed default contract and also predetermine the terms of trade when the law so mandates. Courts fill in the gaps in the contract and the received set of rules, define the terms of exchange for all remaining unforeseen contingencies, and also provide last-resort enforcement of contractual agreements. The presence of courts thus saves on contractual and enforcement costs for all parties. They also perform various functions with respect to rules: from merely enforcing statute law to creating and modifying rules.

For our purposes, rules may be made by a central authority, like the legislature, or by courts. In addition, judicial rulemaking becomes more centralized when low-level courts must decide according to jurisprudence exclusively produced by some higher courts. Both of these dimensions of judicial discretion—the rulemaking authority enjoyed by the judicial system versus the legislature and the decentralization of its powers—are usually positively correlated, which allows us to treat judicial discretion as a single organizational variable on which the main difference between legal systems hinges.

The idealized model of common law, as it finally emerged in the 19th century, is characterized by greater discretion for courts because statute law plays a minor role and each court is relatively free to rule, originally even with respect to precedent. Common law developed in England and was imposed on the former British colonies. It creates legal rules in a relatively decentralized and bottom-up manner. Initiatives for new rules start at the local level when a case is decided by a judge who creates a new rule, which remains local until other judges use it in their rulings. Successful rules may eventually become accepted by all courts in the state. Rules therefore result from the interaction between plaintiffs, defendants, lawyers, judges and jurors, as courts are relatively free to decide each case by distinguishing from, reconciling with or disapproving an earlier case.

In contrast, the civil law model, as crystallized more or less at the same time, gives priority to legislative rulemaking. Courts are instructed to enforce the received law and, even for filling gaps in rules and contracts, lower-level courts have to comply with the jurisprudence created by higher courts. Civil law is more

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the political struggle and the resulting balance between Crown and Parliament. The English Parliament was one of the few to survive from the Middle Ages, constantly increasing its control over the Crown (North and Thomas, 1988; Pipes, 1999). The result was a creeping shift of power from the Crown to the Parliament, eventually culminating in the Glorious Revolution, which limited further the Crown’s right to tax and thus to interfere with private property rights but was only one more step in a relatively continuous process (North and Weingast, 1989). The English Parliament, staffed by merchants and landed gentry, then used its enhanced powers to ignite a series of market-oriented reforms based on the principle of non-interference with private property (North, 1981; North and Weingast, 1989).4

The success of the reforms was guaranteed as the common law courts and the English judiciary shared the Parliament’s appreciation of property rights and its understanding of market mechanisms. The appointment of English judgeships depended to a much greater extent than elsewhere in Europe on professional practice, as English judges were chosen from among barristers. As such, they had seen the world from the perspective of the parties they had represented and were therefore more familiar and educated on the intricacies of the incipient market economy (Duman, 1982: 29; Abbott and Pendlebury, 1993). The understanding by English judges of the fundamentals of the market economy also benefited from the early checks imposed on royal authority, as these checks limited the ability of the Crown to sell new public offices (Swart, 1980), making judgeships secure investments and converting early common law judges into defenders of private property rights. As a result, the transformation of the feudal economy spurred on by Parliament received an early ally in the English judiciary which, by making incremental changes in long-standing customs, assisted the evolutionary development of common law toward the new market order.

The expansion of market opportunities by the Industrial Revolution demanded more substantial changes in terms of both more developed and uniform rules. Common law satisfied these demands during the 19th century, mainly through the introduction of many Roman law solutions, and the strengthening of the doctrine of binding precedent, by which courts are reluctant to interfere with principles established in previous decisions (stare decisis). Despite these changes, however, the development of common law towards more

4 This view has been criticized by some historians for exaggerating the role of the English Parliament in creating a market-friendly institutional environment (for example, Carruthers, 1990; Clark, 1996; Epstein, 2000). These arguments do not question, however, the fundamental point that the English Parliament exerted much greater control over the Crown. In a similar vein, researchers point out that, even in the absence of strong parliaments, there were well-developed markets on the Continent, specifically credit markets (for instance, Hoffman, Postel-Vinay and Rosenthal, 2000). The dominance of agriculture in the economies of the 16th to 18th centuries should be kept in mind, however, when considering these markets as well as that market relations for trade in goods had been well-established in some areas of the Continent, earlier than in England, as shown by the history of Italian cities in the Middle Ages, the Hanseatic League or the Champagne fairs, to give just a few examples. This also applies, in particular, for ascertaining the importance of merchant law. The challenge for those creating the institutions of the modern market was to develop institutions not only for trade but mainly for transactions among non-merchants.

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market-oriented institutions remained evolutionary in nature and its courts retained a high degree of discretion, both in England and the USA. This was for two reasons. First, because the introduction of Roman law took place mainly at the level of concepts, as codification attempts did not succeed, arguably because they were less necessary than on the Continent. (This divergence in the success of codification is consistent with the argument that continental codification was driven by the need to constrain judges, more than to systematize the law, which probably was equally unsystematic in England and on the Continent). In addition, common law lawyers did not merely borrow ideas from Continental jurists, but developed and adapted such ideas in their own way. Moreover, the legal development of common law, which supported the huge economic development of the 19th century, remained almost exclusively the work of courts, with few legislative initiatives. Second, the strengthening of the doctrine of binding precedent did not divert common law from its evolutionary path, as precedents could still be overturned with relative ease by distinguishing the case at hand from the one in the precedent. Together with the right of appeal, it was, however, important in ensuring consistency and equality across increasingly wider markets (Manne, 1997: 13–19). In any case, it is consistent with our argument that the doctrine of binding precedent was introduced at this time, as cheaper transportation via canal, rail and steamship, increased the size of the market, requiring faster adoption of legal standards in a wider geographic area.

American common law, to the extent that it was independent of English law, shows remarkable similarities. Until the 20th century, the US had an arrangement similar to the English system of competing courts, with State and federal courts. Court competition, however, was not so intense and judges were not paid on a fee basis. Many judges, however, were elected and this probably served as a substitute incentive mechanism in the absence of a fee for service. American common law judges also enjoyed great discretion which was marginally reduced in the 19th century by the adoption of the doctrine of binding precedent, first for procedural and later for substantive rules (Zywicki, 2003: 22).

Continental Law

Legal history in what are now civil law jurisdictions originally resembled that of English law. The evolution of civil law, however, was influenced by a relatively different balance of powers among the main political actors, as Parliaments in Continental Europe, with a few exceptions, rapidly lost their ability to impose controls on the Crown. Most monarchies became financially independent and a considerable part of their income no longer came from taxes needing previous parliamentary approval. As a result, absolutist Continental kings enjoyed unchecked power and interfered with relative ease with private property rights, thus hampering the development of market relations based on secure private property (North and Thomas, 1988; Pipes, 1999).

These institutional limitations were reinforced by the fact that Continental judges were appointed without previous practice (Doyle, 1996). In addition,

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market for land.6 Property law provides another interesting case in its treatment of a particular kind of externalities, those caused in the Ancient Regime by the proliferation of property rights and their enforcement as rights in rem even when they remained hidden to third parties. During the 19th century, land law reform and the creation of land registers led to a stricter policy of numerus clausus in most European countries—that is, the legal system started to enforce in rem only a limited number of rights, enforcing the rest as mere personal (in other words, contractual) rights. In parallel, publicity was increasingly required to produce rights enforceable in rem. Both of these constraints seem to diminish parties’ freedom to produce rights in rem but in fact are essential for making some of them possible, reducing transaction costs in land and, in particular, making it possible to use land as collateral for credit (Arrunada,˜ 2003), precisely the declared purpose of the reforms in this area.

Furthermore, operationally, civil law bound the judge to the law. This has often been seen only as a tool to enforce state law, disregarding the fact that, when the law set default rules, its main effect was to protect freedom of contract, because it made sure that the judge was constrained by the will of the parties. Therefore, the law protected the private legal order freely created by the parties, whereas under a system of greater judicial discretion this private legal order would have been in danger.7 This fear drives the efforts of 19th century legislators to purge many dogmatic rules from received law, often rooted in Canon law, that were contrary to freedom of contract. A prominent example is the liberalization of credit transactions, which were still subject to substantial constraints, including the prohibition of interest and foreclosure.8 Similarly, they often prohibited the judge from reducing the amount of penal clauses contractually established to punish the debtor for default in paying back a loan (Danet, 2002: 218). Most codes also derogated rules that had allowed courts to disregard some “unequal”

6 Notice that, by the 17th century, common law had already developed the Rule Against Perpetuities, which enabled a court to declare void future or postponed interests in property that might possibly vest outside a certain perpetuity period. The goal was also to prevent land being tied up and to protect free markets.

7 We pay no attention to private legal order solutions (of the type analyzed, for instance in Benson, 1989; Ellickson, 1991; Milgrom, North and Weingast, 1990; Bernstein, 1992, 1996, 2001; Greif, Milgrom and Weingast, 1994; Shavell, 1995), as we think they involve intrinsic difficulties for becoming the legal order for a modern capitalist economy. First, because the reliance of private enforcement on group membership limits its effectiveness to intra-industry trade, often on a personal level. Second, because they are only effective when state judges abstain from acting as appellate courts and they are permanently threatened by this possibility. Otherwise, private enforcement is only based on informal social sanctions, increasing its personal nature. This happened in particular with merchant courts, which, by being subordinated to royal courts in terms of appeals and enforcement, can be seen as mere local courts with an additional functional specialization.

8 Until the 18th century, for example, French laws against usury outlawed short-term credits that were indispensable for commerce, industry and banking. Borrowers and debtors therefore had to spend substantially on circumventing the prohibition, which hindered the development of the financial market (Taylor, 1967: 480). Understandably, one of the main goals of the Napoleonic Code was to empower contractual parties to act on their own behalf, protecting them from anybody, including judges, who could alter the terms of their agreement (Mattei, 1997).

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contractual clauses on the basis of scholastic “just price” arguments, such as the doctrine of “lesion.”9 More importantly, the scope of “cause” as a necessary element of any enforceable contract was considerably reduced (by reversing the burden of proof, for instance), and even fully eliminated in the “abstract” transaction of the German civil code, as well as, more generally, in the laws of mortgages and bills of exchange. This pruning of the concept of cause curtailed notably the possibilities of constraining contractual freedom with moral principles that the canonist interpretation of the original Roman concept had previously offered.

Understandably, legislators also tried to shelter legal reform from any reactionary backlash, including the possibility that judges would exert their discretion to issue sentences on the basis of abstract principles and against the new rules,10 thus rendering the reform ineffective and hindering development towards the market economy. Legislators therefore subordinated the judiciary to the law and to jurisprudence, and restructured the professional career of judges.

Not only were codes and statutes given priority as a source of law, but the production of binding precedents was allocated to the higher court of appeals, which was conceived, at least originally, more as a court-controlling body than as a proper court. Its function was to supervise the legal interpretations given by lower courts, guaranteeing uniformity, making sentences predictable and enhancing legal security. Furthermore, no court had powers to question the constitutionality of legislation. In the French model, even controlling the legality of governmental action was assigned to a quasi-governmental body, the Conseil

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d’Etat.

In parallel, the practice of purchasing judicial offices was abolished and judges were converted into civil servants. They started their judicial career young and inexperienced, by passing specific exams after law school. Even today their promotions and salaries increase with seniority and sometimes with discretionary governmental appointments to the higher courts and other public offices. This meant that judges could lose substantial quasi-rents if they opposed the government or, even worse, were expelled from their positions. Compliance was further constrained in some countries by modifying their liability, making judges personally liable if they issued sentences contrary, not to dominant doctrinal opinion, as before, but to the statute law and formally established jurisprudence.

Summing up, our explanation as to why pro-market reformers in civil law countries reduced the discretion of the judiciary lies in the fact that in such

9 Ascribing the doctrine of lesion to “the civil law,” without warning of its removal or reduction by 19th century codifiers (as made, for example, by Cooter and Ulen, 1997: 191, 253), exemplifies the ambiguities that complicate comparisons between legal systems. See, for a detailed analysis, Abril Campoy (2003: 42–70).

10 For example, Hayek (1960), among many others, emphasizes that the revolutionaries distrusted judges and their desire to control judicial discretion led them both to issue codes and to adopt more formalized legal procedures. This is confirmed by recent empirical evidence showing that civil law countries regulate the judicial process more thoroughly (Djankov et al., 2003).

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countries the transition to market economies was more revolutionary than in those under common law. Institutional change in England did not suffer the radical transformations that took place in Continental Europe at the end of the 18th and during most of the 19th century but followed a relatively smooth, evolutionary process, which started much earlier. In contrast, judiciaries in Continental Europe were structured with greater central control with a view to achieving and enforcing an intended change.11

4. A CRITIQUE OF ALTERNATIVE EXPLANATIONS

Our interpretation of 19th century civil law as an adaptive top-down introduction of the market has important consequences for the arguments given in debates on the comparative efficiency and performance of common law versus civil law. The first of these debates started when part of the American “law and economics” school argued in favor of the efficiency of the solutions being used in 19th century common law. Later, the quest for institutional explanations of differences in economic performance has led to quantitative comparisons of multiple performance indicators across legal systems. Even though both of these explanations involve evolutionary arguments and path-dependency, they differ in an important way from our hypotheses, as they do not consider the possibility of adaptation to local circumstances as the main force behind divergent legal systems. Moreover, these alternative explanations fail to prove the universal superiority of common law arrangements which many of them more or less explicitly advocate. Consequently, they can lead to flawed policy when they neglect local circumstances which might strongly limit the feasibility of legal reforms.

The Efficiency Debate

The Efficiency of Common Law

The efficiency of common law was first suggested by Posner (1973), based on the metaphor that the decentralized creation of common law mimicked how the market worked, leading judges to unconsciously pursue an efficiency standard. This hypothesis has been successfully used to explain many common law rules, related to negligence, contributory negligence, strict liability, restitution and

11 The evolutionary versus revolutionary nature of the transition was not the only historical accident having an influence on the adaptiveness of legal systems. Technological innovation after common law became entrenched may have also reduced the comparative advantage of judicial discretion. The conjecture is that, in common law jurisdictions, the market economy was established before the emergence of national markets, which mostly waited until the development of railways. Most codification in Europe took place when, thanks to the impact of rail transport, it became clear that markets would become much wider in scope. Understandably, legislatures strove to provide unified legal standards for the whole of the national market, as local rulemaking made less sense after the development of national markets.

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collateral source, to name just a few (Posner, 1998). For instance, Landes and Posner (1987) illustrate the argument by examining the application of the Hand Formula, a special type of cost and benefit analysis applied in the field of torts, and conclude that judges do actually, even though not necessarily consciously, use this method when assessing liability and thus take efficiency-enhancing decisions. This kind of argument has been criticized, however, for its lack of verifiability. In particular, there is no evidence that judges consciously perform this calculation. Furthermore, the information needed to apply the rule is not readily available. In addition, even if a rule in common law is shown to be efficient, it does not follow that it is the common law system that has produced such efficiency, as many of these rules were developed in older legal systems (Simpson, 1998) and are also applied in civil law jurisdictions (Faure, 2001) or, when different, differences are functional and fit well into other design features of legal systems (Rubin, 1982).

The efficiency hypothesis has also been grounded in more detailed models of the judicial process. Adapting Harold Demsetz’s (1967) seminal argument on property rights, Rubin (1977) argued that inefficient rules tend to be abolished as an unintended by-product of litigation between self-interested parties who share a common interest in changing the rule. To encompass cases in which parties do not share such a common interest, the argument has been extended to model common law as an evolutionary process (Priest, 1977; Terreborne, 1981; Katz, 1988). Litigation, however, is often unable to produce the same legal rules as the ones that the parties would have introduced if they had explicitly agreed ex ante on the issue being litigated ex post, because litigation does not aggregate over all parties’ interests and it can therefore aspire to achieve only local instead of global efficiency (Wagner, 1998). Taking this critique into account and extending the argument, Rubin (1982) argues that ingrained, albeit different, mechanisms drive both common law and civil law to efficiency. He claims that this drive to efficiency lasted until well into the 19th century and that the susceptibility to interest group pressure that characterizes the later evolution of rulemaking institutions corrupted both common law and civil law. This idea has been further explored by Crew and Twight (1990), Bailey and Rubin (1994) and Osborne (2002), among others; it remains silent, however, on why the two centuries differed so drastically on the extent of rent-seeking.12

Furthermore, common law understood as judge-made law may be imperfect for deeper reasons. Its nature is retrospective and thus unsuitable for creating completely new rules or for making rapid legal changes. As with any design produced in an evolutionary process, it suffers path dependency because innovations are introduced not by designing them from scratch but by tinkering with a received solution. Paraphrasing Tooby and Cosmides, common law then evolves “like the proverbial ship that is always at sea. The ship can never go into dry dock for a major overhaul; whatever improvements are made must be implemented

12 For an extensive review of the literature on the efficiency of judge-made law, see Rubin (2000).

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plank by plank, so that the ship does not sink” (Tooby and Cosmides, 1992: 60). Statute law, in contrast, is produced in what can be described as a rational process, benefiting from planning and foresight, and it is less constrained by the previous legal order. It suffers from rent-seeking, but the severity of this varies greatly and the evolutionary processes in common law are not free of their own versions of it as, for example in the case of politically-motivated judges, who implement their own version of morality (Bork, 1990). Even Richard Posner (1973: 569) concedes that “legislative law-making is apt to be more efficient than judicial law-making” because the litigation of cases often fails to raise the pertinent questions for initiation of a legal reform. As argued by Wagner (1998: 315), common law can probably pass the test of local efficiency but is bound to fail the test of global efficiency.

Lastly, the claim that case law is more efficient than statute law remains unproved because most of the discussion has been on the internal consistency of common law and not on its advantages with respect to civil law. Internal consistency, however, is not exclusive to common law, as many rules in civil law also seem to reflect or lead to efficiency (Faure, 2001: 179; Harnay, 2002: 237). Robert Cooter (1994), for example, suggests that the efficiency of common law depends on the enactment of efficient customs by judges. This is as much a characteristic of common law as it is of civil law. According to this argument, judges make common law efficient when they find customary law and raise it to the level of law. However, the selection of social norms is also frequently carried out in the codification process. For example, the most successful US code, The Uniform Commercial Code, was built by identifying and systematizing the best business practices, and most of the rest of the common law of contracts has also been codified in the Restatement of Contracts published by the American Law Institute and state statutes revising the Statute of Frauds (Cooter and Ulen, 1997: 205, 378). This argument leads us to the debate of the efficiency of statute law.

The Efficiency of Civil Law

Work asserting the economic efficiency of common law often suggests, more or less implicitly, that statute law does not achieve the same degree of efficiency. This claim has been opposed, however, by scholars arguing that civil law also strives towards efficiency through both of its sources of rules—legislation and judicial activity.13

Legislation may produce superior rules because its centralization provides an advantage in terms of standards and innovation. Industrial organization shows that markets do not always provide universal standards and do not fully guarantee that the surviving standard is the best. A possible solution is an industrial

13 In a survey among members of the American Law and Economics Association, Moorhouse, Morriss and Whaples (1999) find that 84% of respondents believe that common law is generally efficient and 42% consider it more efficient than civil law.

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agreement or some kind of coordination mechanism guaranteeing the compatibility of all elements of the network. By analogy, Harnay (2002) sees legal codes as standards within a social network, providing legal coordination in a setting of adoption externalities. Codified law can then avoid the emergence of inefficient legal rules in the process of decentralized litigation that characterizes common law systems. The argument has been applied to explain codification as a conscious effort to systematize and organize previous statutes and customs.14 Civil law is also thought to have some advantages, perhaps being more innovative than common law. It is grounded on legal rules, which may be easier to create than social norms (Garoupa, 2001). Although this argument obviously begs the question as to whether or when such creativity is desirable, it also indicates that civil law has the potential to be flexible despite often being perceived as rigid.

The concept that civil law is more concerned with distribution than with efficiency has also been opposed by pointing out the extent to which civil law principles rely on a logic of economic efficiency (Faure, 2001). For example, even though French tort law does not use a Learned Hand test to evaluate the standard of care, it does not exclude the use of costs and benefits analysis. Furthermore, it is questionable whether judicial practice strays away from economic efficiency and favors redistribution more in civil than in common law. For example, it has been argued that case civil law tends to apply strict liability when this application is more consistent with compensating victims than with economic efficiency, perhaps reflecting different social priorities (Faure, 2001). However, the scope of strict liability has also been taken in common law to probably inefficient extremes (Priest, 1985).

The capacity of civil law judges to modify and adapt inefficient legal rules is also greater than might be imagined because judges retain some normative capacity (Michelman, 1980). It has been observed on numerous occasions that, when the efficiency of a codified rule is doubtful, civil law courts end up circumventing it, usually by stretching the interpretation of flexible standards such as “good faith,” “reasonably,” “fairly” and so on. This happened, for instance, in areas as diverse as encroachments, ostensible possession and formal contract requirements. For example, according to the Spanish Civil code, encroached constructions should be demolished if the two neighboring owners do not reach an agreement, which would be inefficient in cases of minor goodfaith encroachments; consequently, the jurisprudence came to enforce a liability rule (Paz-Ares, 1995: 2860–65). It is also common for land registration laws to deny property (that is, real or in rem) status to mere possession. However, case law often interprets good faith requirements extensively, considering ostensible possession as proof of bad faith on the part of a third party acquiring from a registered owner without possession.15 As a last example, the requirement of

14See, for instance, the analysis of the French civil code by Josselin and Marciano (2002).

15The judicial proclivity to transform “crystal” property rules into “muddy” liability rules, originally analyzed by Rose (1988) in common law but also present in civil law (Arrunada,˜ 2003).

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works that showed significant correlations between belonging to a particular legal system and the measured level of regulation, property rights protection, the efficiency of government, the level of political freedom, economic growth and judicial independence. The punch-line in all these works is that the civil law tradition and, in particular, its French version, shows consistently worse performance than the common law tradition.

This line of research is valuable because it is a pioneer effort in quantifying differences in performance across the legal institutions that sustain modern economies, and this motivates further discussion and allows it to proceed in a more systematic, albeit some would claim distorted, fashion. It suffers substantial weaknesses, however, related to selection bias, measurement difficulties and questionable causation.

First, even if performances were perfectly measured, their comparisons suffer from an intrinsic self-selection problem because actual observed levels of performance result from those choices that were effectively taken in the past, and we lack information on their alternatives. If we recognize that not all legal systems perform well in all contexts, the relevant comparison is between the performance of the chosen option and that of its alternatives, but these alternative performances are by definition never observed. For example, even if someone demonstrates that the economic performance of the US is better than that of France because France has a civil law system, this would not prove that it was a mistake for the French to mold their Ancient Regime legal system in the direction of what is now known as civil law. To show that such a move was a mistake, one would have to compare the actual performance of France with the performance France would have exhibited under common law.17

Second, the value of measurement is not greater than its accuracy, and measuring institutions is hampered by methodological difficulties. Thus, most findings are based on indices that capture only a few of many relevant dimensions, such as the index of shareholders’ rights in La Porta et al. (1998), which does not distinguish between the mandatory or default character of the rules, a major issue if they are to be properly understood. In addition, they measure shareholders’ rights along dimensions that do not necessarily capture the real degree of protection. For example, the index considers the fact that German shareholders cannot vote by mail as a shortcoming of German corporate law, disregarding

17 La Porta et al. (1998, 1999) claim that their studies do not suffer endogeneity because in most cases the actual origin of the legal system is imposed by conquest. This is doubtful, however, because it is applicable neither to colonizing powers nor to former colonies, which often enacted their codes after independence—in the case of former Spanish colonies, many decades later. In addition, even when introducing new legal institutions, there was a choice of system and the decision was often to delay its introduction in the colonies, thus implicitly opting for temporarily maintaining the older system, which provided greater judicial discretion. Furthermore, as a version of this self-selection problem, the legal origin variables fail to consider the indigenous legal institutions (Berkowitz et al., 2001). The prior strength of indigenous institutions, which made it unnecessary, more costly and less effective to introduce Western law, has also often been disregarded as an explanatory factor. See, however, Acemoglu, Johnson and Robinson (2002) about the potentially negative effect of pre-colonial institutions in long-run economic growth.

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the fact that most German shareholders send their instructions by mail to their banks and that banks do vote (Roe, 2002). The problem is even worse, however, as what is lacking is a global measure of institutional performance that takes into account interactions among a number of institutions, determining what we define as present-day common law or civil law jurisdictions.18

More generally, advancing causation arguments is dangerous in the absence of theory. For example, concluding from a correlation that concentrated ownership is due to allegedly weak legal protection of investors’ rights might look intuitively correct but it is nevertheless superficial. As Roe (2002) shows, a complex mix of economic, social and political conditions affects managerial agency costs and determines the degree of ownership dispersion.

In the same way, legal systems are imbedded in a complex network of political structures and social preferences that cannot be studied in isolation, which apparently La Porta et al. (2004) do, when they take as a symptom of inefficiency of the legal procedure their finding that courts in civil law countries are slower to decide a case of eviction of a tenant or collection of a bounced check. Suggested inefficiencies, however, are difficult to substantiate without considering factors such as the incidence of these events, the complementary enforcement mechanisms that are at work and the costs incurred in each system for a comparable level of quality.

Within this literature, the superior economic performance of common law countries has been attributed not only to the statutory protection of property rights but also to the greater judicial independence supposedly enjoyed by common law judges (La Porta et al., 2004). The benefits of greater judicial independence and, as a consequence, the inferred relationship with economic performance, however, have been severely questioned in a period where politically-motivated judges implement their notion of fairness and morality in an institutional setting in which they are not accountable to a considerable degree to anybody (Bork, 1990: 5).

Lastly, causation is also in doubt when superior performance is attributed to common law in legal fields which are everywhere based on statute law. This happens not only in corporate law but also in regulation and administrative law, as well as with some specific indicators, like eviction time. With this in mind, it is unsurprising that these legal origin variables also “explain” such phenomena as sports success,19 showing once more that correlation does not imply causation.

18Some steps towards a more detailed analysis have already been taken. See, for example, Beck, Demirgu¸c¨ -Kunt and Levine (2003), who defend the importance of the legal system’s adaptability to evolving economic conditions; Acemoglu, Johnson and Robinson (2002), who defend the primary importance of local conditions for the development of strong property rights institutions; and Acemoglu and Johnson (2003), who show a statistical relationship between growth and protection of property rights against state expropriation but not between growth and the quality of contracting institutions, a variable that other works link to legal origin.

19West (2002) finds that FIFA rankings of national soccer teams correlate in a statistically significant manner with countries’ legal origins.

246 Benito Arrunada˜ and Veneta Andonova

The Need for Further Detail

More generally, both the efficiency and performance debates opposing common law and civil law have been formulated at a high level of abstraction that may lead to a focus on ambiguous categories and to mistaken conclusions. This abstraction takes place both vertically and horizontally.

Vertically, because the various “civil law” labels are defined by country and are therefore applied to related but separate and historically variable phenomena, such as statute, codified and systematic law versus case law, mandatory rules versus default rules, judicial dependence versus judicial discretion, and even rigid versus flexible rules of judicial procedure. These dimensions are better seen as variables in institutional design. All legal systems use them as ingredients but mix them in different proportions and manage them differently through history. Comparison among systems should aim to consider the weight of each ingredient and their interdependencies. In doing so, the analyses should ideally incorporate the institutional determinants that lie beyond the legal system and are frequently found in the nature of the political process (Backhaus, 1998; Wagner, 1998, 1992; Andonova, 2003), as well as wider economic factors relevant in specific fields of law, such as, in the field of property, the expected number of transactions, the risk of political opportunism and regulatory consistency (Arrunada,˜ 2003).

Something similar happens horizontally, as legal systems often adopt structures pertaining to foreign traditions. This is also clear in the field of property law, in which legal traditions do not explain the adoption of the most relevant institutions. For example, until recently England had a system of private transactions akin to that of the Romans, but moved in the last century to the German system of registration, the same as Australia and most of Canada. Most of the US, however, introduced early a system of publicity by recording that is typically French (Arrunada,˜ 2003). Similarly, the numerus clausus of property, in rem, rights is now almost unrelated to the common versus civil law divide. It remains to be documented to what extent this institutional cross-breeding also happens in other fields of law.

5. CONCLUDING REMARKS

It is time now to present some policy considerations, which aim to be pertinent for the unsolved problem of how to build market institutions in transition and developing economies.

In previous sections we argue that the evolution of both common and civil law in the 19th century was instrumental in protecting freedom of contract and developing market economies. We also explain the different degrees of discretion granted to courts in both systems as optimal adaptations to particular circumstances. In this way, greater judicial discretion in classic common law courts emerges more as a historical and perhaps unique exception than as a replicable solution.

Market Institutions and Judicial Rulemaking 247

This casts an additional doubt on the normative interpretation of some results on the efficiency and performance of legal systems which, asserting the superiority of common law, seemingly recommend applying it. We have sketched above why such superiority is open to question and likely to depend on environmental factors. But, more clearly, even if common law were shown to be superior today, the normative consequences of such superiority might be insignificant. Both common and civil law were probably well adapted to their original circumstances. Those creating the institutions of the market in Continental Europe did not opt for constraining judicial discretion to control the market but to protect it.

In line with this interpretation, our analysis does not advise any specific system for transition and developing economies in general but instead suggests that institutional development and academic research should aim at identifying the contextual circumstances which affect the costs and benefits of the different solutions. The problems of these economies may, in some cases, be more similar to those faced on the Continent at the demise of the Ancient Regime than to those enjoyed by England more or less at the same time. If so, restraining judicial discretion may be now necessary in developing economies in order to guarantee freedom of contract.

Lastly, if we are correct in considering both legal systems as adaptations to local circumstances, our analysis points out the risk that the debates on the relative efficiency and performance of common and civil law may be sterile because the comparison does not take place between viable alternatives.

ACKNOWLEDGEMENT

´

The authors thank Jesus´ Alfaro Aguila-Real, Douglas W. Allen, Marco Casari, John Drobak, Paul S. Edwards, Pierre Garrouste, Fernando Gomez´-Pomar, Emily Kadens, Pierre-Cyrille Hautcoeur, Claire Hill, Marta Lorente, Thomas Lundmark, Bertrand du Marais, Armelle Maz´e, Claude M´enard, Fernando P. M´endez Gonz´alez, John Nye, Elinor Ostrom, Celestino Pardo Nu´nez,˜ C´andido Paz-Ares, Mary M. Shirley, Stefan Voigt, Will Wilkinson, several anonymous referees and participants at several workshops and conferences for their comments and criticism. This work has received financial support from the MCYT, an agency of the Spanish Government, through Project SEC2002-04471-C02-02.

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11. Legal Institutions and

Financial Development

THORSTEN BECK and ROSS LEVINE

1. INTRODUCTION

A burgeoning literature finds that financial development exerts a first-order impact on long-run economic growth. Levine and Zervos (1998) show that banking and stock market development are good predictors of economic growth.1 At the microeconomic level, Demirguc-Kunt and Maksimovic (1998) and Rajan and Zingales (1998) find that financial institutions are crucial for firm and industrial expansion. While disagreements remain, the bulk of existing evidence points to a strong finance-growth nexus.

The finding that financial development influences economic growth raises critical questions, such as why do some countries have well-developed growthenhancing financial systems, while others do not? Why have some countries developed the necessary investor protection laws and contract-enforcement mechanisms to support financial institutions and markets, while others have not?

The law and finance theory focuses on the role of legal institutions in explaining international differences in financial development (La Porta, Lopez- de-Silanes, Shleifer, and Vishny, 1997, 1998, 2000a, henceforth LLSV). The first part of the law and finance theory holds that in countries where legal systems enforce private property rights, support private contractual arrangements, and protect the legal right of investors, savers are more willing to finance firms and financial markets flourish. In contrast, legal institutions that neither support private property rights nor facilitate private contracting inhibit corporate finance and stunt financial development.

The second part of the law and finance theory emphasizes that the different legal traditions that emerged in Europe over previous centuries and were spread internationally through conquest, colonization, and imitation help explain cross-country differences in investor protection, the contracting environment,

1 Furthermore, King and Levine (1993a,b) show that bank development predicts economic growth. Panel investigations indicate that the relationship between finance and growth is not due to reverse causality (e.g., Beck, Levine, and Loayza (2000), Levine, Loayza, and Beck (2000), and Beck and Levine (2004). For a review of the literature, see Levine (1997, 2004).

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C. Menard´ and M. M. Shirley (eds.), Handbook of New Institutional Economics, 251–278.C 2005 Springer. Printed in the Netherlands.

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and financial development today. More specifically, legal theories emphasize two inter-related mechanisms through which legal origin influences finance (Hayek, 1960). The “political” mechanism holds that (a) legal traditions differ in terms of the priority they attach to private property vis-a`-vis the rights of the State and (b) the protection of private contracting rights forms the basis of fi- nancial development (LLSV, 1999). The “adaptability” mechanism stresses that

(a) legal traditions differ in their formalism and ability to evolve with changing conditions and (b) legal traditions that adapt efficiently to minimize the gap between the contracting needs of the economy and the legal system’s capabilities will more effectively foster financial development than more rigid systems (Merryman, 1985).

Countervailing theories and evidence challenge both parts of the law and finance theory. Many researchers accept that effective investor protection facilitates efficient corporate financing and growth-enhancing financial development, but reject the law and finance’s view that legal origin is a central determinant of investor protection laws and financial development (Roe, 1994; Pagano and Volpin, 2001; Rajan and Zingales, 2003). Furthermore, while some scholars accept the importance of legal tradition in shaping the efficiency of financial contracting, there are sharp disagreements about which legal systems work best to promote the efficient evolution of the law (Rubin, 1982). Alternatively, some studies directly question the importance of investor protection laws by arguing that changes in investor protection laws did not drive the evolution of corporate ownership and financial development in the United Kingdom and Italy (Franks, et al., 2003; Aganin and Volpin, 2003).

Given debates about the role of legal institutions in shaping financial development, the remainder of the Chapter is organized as follows. Section 2 describes the law and finance theory along with skeptical and competing views.2 Section 3 reviews empirical evidence on both parts of the law and finance view. That is, we assess (i) whether legal origins account for cross-country variations in property rights protection, support of private contractual arrangements, investor protection laws, and financial development and (ii) the degree to which cross-country differences in investor protection laws explain differences in corporate finance and financial development. Besides examining supportive and conflicting evidence on these two parts of the law and finance theory, we also summarize recent findings on the mechanisms—the political and adaptability mechanisms— through which law and finance may be related. Section 4 concludes.

2 To qualify our approach, however, we recognize that many participants in the law and finance debate may not agree that the law and finance view is necessarily composed of the two parts mentioned above. This is not crucial for our review. We simply note that many contributors to the debate on the links between legal institutions and financial development examine (i) the impact of legal origin on property rights protection, support for private contractual arrangements, and investor protection laws, (ii) the impact of investor protection laws and their enforcement on financial development, or (iii) both. This review examines these different components.

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2. LEGAL THEORIES OF FINANCIAL DEVELOPMENT

This section describes the law and finance theory. We devote considerable space to tracing the historical evolution of legal institutions because the law and fi- nance theory stresses that historically determined differences in legal heritage continue to shape private property rights protection, investor protection laws, and financial development today. Furthermore, this section describes two mechanisms through which legal origin may influence the contracting environment: the political and adaptability mechanisms. Finally, we review countervailing views that question the law and finance theory.

Law, Enforcement, and Financial Development

The first part of the law and finance theory stresses that legal institutions influence corporate finance and financial development (LLSV, 1998). As LLSV (2000a) emphasize, the law and finance view follows naturally from the evolution of corporate finance theory during the past half century. Modigliani and Miller (1958) view debt and equity as legal claims on the cash flow of firms. Jensen and Meckling (1976) stress that statutory laws and the degree to which courts enforce those laws shape the types of contracts that are used to address agency problems. Furthermore, as summarized by Hart (1995), financial economists have increasingly focused on (i) the control rights that financial securities bring to their owners and (ii) the impact of different legal rules on corporate control. From this perspective, we may view finance as a set of contracts. Thus, a country’s contract, company, bankruptcy, and securities laws, and the enforcement of these laws fundamentally determine the rights of securities holders and the operation of financial systems.

At the firm level, Shleifer and Vishny (1997) note both that inside managers and controlling shareholder are frequently in a position to expropriate minority shareholders and creditors and that legal institutions play a crucial role in determining the degree of expropriation. Expropriation may include theft, as well as transfer pricing, asset stripping, the hiring of family members, and other “perquisites” that benefit insiders at the expense of minority shareholders and creditors (LLSV, 2000a). The law and finance theory emphasizes that cross-country differences in (i) contract, company, bankruptcy, and securities laws, (ii) the legal systems’ emphasis on private property rights, and (iii) the efficiency of enforcement influence the degree of expropriation and hence the confidence with which people purchase securities and participate in financial markets.

Within the broad vision that legal institutions influence corporate finance and financial development, there are differing opinions regarding the degree to which the legal system should simply support private contractual arrangements and the degree to which the legal system should have specific laws concerning shareholder and creditor rights. Coasians hold that the legal system should simply

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enforce private contracts. Effective legal institutions allow knowledgeable and experienced financial market participants to design a vast array of sophisticated private contracts to ameliorate complex agency problems (Coase, 1960; Stigler, 1964; Easterbrook and Fischel, 1991). For this to work effectively, however, courts must enforce private contracts impartially and have both the ability and willingness to read complex contracts and verify technically intricate clauses that trigger specific actions (Glaeser, et al., 2001, p. 853). Given the difficulty in enforcing complex private contracts, there are potential advantages to developing company, bankruptcy, and securities laws that provide a framework for organizing financial transactions and protecting minority shareholders and creditors. While standardization may improve efficiency by lowering the transactions costs associated with many financial market contracts, the imposition of too rigid a framework may curtail customization and thereby hinder efficient contracting.3 Whether assuming a Coasian reliance on enforcing complex private contracts or an approach that augments the support of private contracts with company, bankruptcy, securities laws, etc., the law and finance view’s first part argues that the degree of protection of private investors is a crucial determinant of financial development.

The Historical Development of Europe’s Legal Systems

The second part of the law and finance theory stresses that a country’s legal heritage shapes its approach to property rights, private contracting, investor protection, and hence financial development. Comparative legal scholars note that the world’s major legal families were formed in Europe over many centuries and then spread internationally. Thus, we begin our discussion with Roman law.

Hayek (1960) notes that when Emperor Justinian had the Roman law compiled in the sixth century, he attempted to implement two substantive modifications. First, while Roman law placed the law above all individuals, the Justinian texts placed the emperor above the law. Second, Justinian broke with Roman law by attempting to eliminate jurisprudence. Roman law had developed over centuries on a case-by-case basis, adjusting from the needs of a small farmer community to the needs of a world empire with only a minor role left for formal legislation. Justinian changed this doctrine and “. . . asserted for himself a monopoly, not only over all law-making power, but over legal interpretations.” (Dawson, 1968, p. 22). This “Justinian deviation” did not take root; jurisprudence continued to shape the law.

From the 15th century, France’s legal system evolved as a regionally diverse m´elange of customary law, law based on the Justinian texts, and case

3 There may exist complex tradeoffs between law-making and enforcement conducted by the courts versus regulation. One difference is that courts enforce the law reactively, while regulators enforce laws proactively. For analyses of the conditions under which these different approaches work best, see Glaeser, Johnson, and Shleifer (2001) and Pistor and Xu (2002).

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enrichment, alter the law on obligations, re-work the law of contracts regarding gifts, and change the system of administrative law (Dawson, 1968, 400–415). From this perspective, while the theory of the Napoleonic code rejected jurisprudence and embraced judicial formalism, practicalities in conjunction with a legal tradition grounded in jurisprudence produced in France a legal system that has increasingly employed judicial discretion over the last two centuries and thereby circumvented inefficient qualities of the Code.

Others disagree and argue that antagonism toward jurisprudence and the exaltation of the role of the state produced a comparatively static, rigid legal tradition.8 The French situation encouraged the development of easily verifiable “bright-line-rules” that do not rely on the discretion of judges (Glaeser and Shleifer, 2002). While simple and clear, Johnson et al. (2000) argue that bright-line-rules and excessive judicial formalism may not allow judges sufficient discretion to apply laws fairly to changing conditions and therefore not support evolving commercial needs.

Turning to Germany, Bismarck—like Napoleon—unified the country (in 1871) and placed a high priority on unifying the courts through codification. Although Bavaria and Prussia codified parts of the law during the 18th century, it was Bismarck’s decision in 1873 to codify and unify the whole of private law in Germany that led to the adoption of the German civil law in 1900.

The parallels between France and Germany’s legal history, however, can be exaggerated. Unlike in France, German courts have published (since at least the 16th century) comprehensive deliberations that illustrated how courts weighted conflicting statutes, resolved ambiguities, and addressed changing situations (Dawson, 1968). Law faculties at German universities worked directly with courts and tried to reconcile emerging situations with the logic of the Justinian texts. Through active debate between scholars and practitioners, Germany developed a dynamic, common fund of legal principles that then formed the basis for codification in the 19th century.

Moreover, in contrast to the revolutionary zeal and antagonism toward judges that shaped the Napoleonic Code, German legal history sheds a much more favorable light on jurisprudence and explicitly rejected France’s approach.9 Thus, the German Code “was not intended to abolish prior law and substitute a new legal system; on the contrary, the idea was to codify those principles of German law that would emerge from careful historical study of the German legal system.” (Merryman, 1985, p. 31)

Whereas the Napoleonic code was designed to be immutable, the Burgerliches¨ Gesetzbuch was designed to evolve. For instance, France technically denies judicial review of legislative actions, while Germany formally recognizes this power and German courts actively exercise it (Glendon, et al.,

8 See, Posner (1973), Rubin (1977), and Priest (1977).

9 The German legal scholar Karl von Savigny argued that the law of a people was a product of the history and culture of that people’s development (Merryman, 1985, p. 30).

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1982, p. 57). Similarly, in terms of adjudicating disputes involving the government, France’s administrative courts are within the executive branch itself. In Germany, the judiciary handles these disputes. Further, the Court of Cassation in France was originally viewed as an institution to assist the legislature. It had powers to quash decisions, but not decide cases. This is different from the Bundesgerichtshof in Germany that can reverse, remand, modify, or enter final judgment on cases, and where the judicial decision-making process tends to be more openly debated.10 Thus, while codification had a similar role in Germany and France in unifying the country and reasserting the power of the central state, Germany had a very different approach toward jurisprudence.

The Scandinavian Civil law developed relatively independently from the other traditions in the 17th and 18th centuries and is less closely linked with Roman Civil law than the French or German traditions (Zweigert and Kotz,¨ 1988, henceforth ZK). Moreover, neither the construction, nor the subsequent evolution, of the Scandinavian Civil law has been used to eliminate jurisprudence and boost the role of the State relative to private investors to the same extent as in the French Civil law (LLSV, 1998).11 While extensive, active scholarship examines differences between French, German, and British law, comparatively less effort has been devoted to understanding the functioning of the Scandinavian civil law tradition and its influence on the development of financial systems in Scandinavia.

The historical development of the British common law is unique both in terms of (a) the relationship between the State and the Courts and (b) jurisprudence. From 1066, the English law evolved based on the resolution of specific disputes and increasingly stressed the rights of private property. While landholding rights in England were originally based on William I’s feudal system, the courts developed legal rules that treated large estate holders as private property owners and not as tenants of the king. Indeed, the common law at the dawn of the 17th century was principally a law of private property (e.g., Littleton, 1481, and Coke, 1628).

The English Common law asserted its independence from the State during the tumultuous 16th and 17th centuries, during the great conflict between Parliament and the English kings. The Crown attempted to reassert feudal prerogatives and sell monopoly rights to cope with budgetary shortfalls. Parliament (composed mostly of landowners and wealthy merchants) along with the courts took the side of the property owners against the Crown. While King James I argued that royal prerogative superseded the common law, the courts asserted that the law is king, Lex, Rex. This political struggle culminated in 1688, when the Stuarts were thrown out. This allowed the courts to place the law above the

10See Zweigert and Kotz¨ (1998, p. 264) and Glendon, et al. (1982, p. 96–100, 123–133).

11Coffee (2001) points to the superior performance of the Scandinavian countries relative to other Civil Law countries and even to Common Law countries and explains this with the high level of social cohesion in these countries.

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Crown and limit the Crown’s power to alter property rights and grant monopoly rights.12

Besides the power of the law vis-a`-vis the State, the Common law’s history is also importantly different from France’s in terms of jurisprudence and legal formalism. Unlike in Pre-Revolutionary France, the courts in England were frequently viewed more favorably and sometimes as supporters of progressive reforms, so that judges were afforded greater discretion. In terms of legal formalism, English law typically imposes less rigid and formalistic requirements on the presentation of evidence, witnesses, etc., and instead offers judges greater latitude (Schlesinger, et al., 1988). In terms of jurisprudence, the English common law tradition is almost synonymous with judges having broad interpretation powers and with courts molding and creating law as circumstances change. The common law is obsessed with facts and deciding concrete cases, rather than adhering to the logical principles of codified law. Thus, the popular dictum: “The life of the law has not been logic: it has been experience.” (ZK, 1998, p. 181). Unlike the Napoleonic doctrine, judges continually—and as a matter of general practice—shape the law through their decisions.

The Spread of Europe’s Legal Systems

The English, French, and German legal traditions spread throughout the world through conquest, colonization, and imitation. Napoleon secured the adoption of the Code in all conquered territories, including Italy, Poland, the Low Countries, and the Habsburg Empire. Also, France extended her legal influence to parts of the Near East, Northern and Sub-Saharan Africa, Indochina, Oceania, French Guyana, and the French Caribbean islands during the colonial era. Furthermore, the French Code heavily influenced the Portuguese and Spanish legal systems, which helped spread the French legal tradition to Central and South America. The English common law spread through colonization and conquest to all corners of the world. The Austrian and Swiss civil codes were developed at the same time as the German civil code and the three influenced each other heavily. In turn, Czechoslovakia, Hungary, Yugoslavia, and Greece relied on German civil law in formulating and modernizing their legal systems in the early part of the 20th century. The German Civil Code was not imposed but exerted a big influence on Japan. At the end of the 19th century, Japan looked toward Europe as it sought to draft a commercial code. While Japan considered the French civil code, Japanese legal scholars were attracted to the systematic theorizing of the German code and its emphasis on fitting the evolution of the law into a country’s historical context (ZK, 1998, p. 296–302.) The Japanese commercial

12 There are two additional related issues. First, England was unified during the formative period of the Common law. This reduced political incentives for codification. Second, English courts were a liberalizing force that helped dismantle the feudal system and protected the rights of landowners against the Crown (Hayek, 1960). Whereas the French Revolution sought individual rights through strict prohibitions on the discretion of judges, England found liberty through an independent and influential judiciary.

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code of 1899 is squarely based on the German counterpart. Although Japan came under the influence of the Common law during the post World War II occupation period (especially in the area of public law), it is not uncommon to classify Japan as a German civil law country, particularly when focusing on Commercial and Company law. Similarly, the German code influenced the development of commercial law in Korea, especially through the Japanese occupation. During the early decades of the 20th century, China (and hence Taiwan) examined European law in seeking to improve the operation of their commercial law. China introduced civil codes in 1925 and 1935 that, except for family and inheritance law, were shaped by German civil law. Of course, China has its own ancient legal tradition and also experienced Mao and the Cultural Revolution. The Scandinavian legal system was not spread to any country outside Northern Europe.

While the subject of active debate, Merryman (1996) advances four interrelated reasons for why the exportation of the Napoleonic Code had more pernicious effects in French, Belgian, Dutch, Spanish and Portuguese colonies than in France itself. According to this view, the adoption of the French civil code has crippled the judicial systems of many French legal origin colonies and hindered their ability to develop efficiently adaptive legal systems.

First, the French rigidly imposed the Code Civil in its colonies even though there were—and remain—serious conflicts between the Code and local laws (ZK, 1998, p. 109–13).13 Tensions between local law and the transferred doctrine may impede the efficient development and application of the law with negative implications for financial development (Berkowitz, Pistor, and Richard, 2002).

Second, when the French instilled the Code, they brought the theory of the Napoleonic doctrine with its antagonism toward jurisprudence and its reliance on judicial formalism to minimize the role of judges. The French did not also bring the practical knowledge of how to circumvent some of the negative attributes of the Code and create an efficient role for judges (Merryman, 1996).

Third, given the Napoleonic doctrine, judges frequently “. . . are at the bottom of the scale of prestige among the legal professions in France and in many nations that adopted the French Revolutionary reforms, and the best people in those nations accordingly seek other legal careers” (Merryman, 1996, p. 116). Consequently, it is more difficult to develop efficiently responsive legal systems if the courts do not attract the best minds. Also, the static theory of the Napoleonic doctrine may become self-fulfilling: the best minds choose other professions, which hinders efficient legal flexibility. As a consequence, the legislature will have a tendency to write “bright line laws” to limit the role of the

13 England did not try to replace Islamic, Hindu, or unwritten African law and the flexibility of the Common law eased its transfer. For instance, the English courts in India were instructed to apply Islamic or Hindu law depending on the faith of the parties in cases of inheritance, marriage, caste, etc. In Africa, judges were to apply the English law only to the extent that local circumstances permitted and matters were to be decided by equity and good conscience as rendered necessary by local circumstances (ZK, 1998, 225–9). While somewhat chaotic, this arguably set the stage for the evolution of an independent, dynamic common law in the post-colonial era.

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courts. As argued by Pistor et al. (2002, 2003), once a country adopts the “bright line” approach to law making, it is very difficult to change. Courts will not be challenged to develop legal procedures and methods to deal with emerging conditions. Thus, according to some scholars, these characteristics of the French law have worked to retard the development of efficiently adaptive legal systems that support financial development.

Fourth, France has a long history of avoiding open disputes about legal interpretation (Dawson, 1968). Moreover, Napoleonic doctrine formally inhibits open disputations by judges on how they weigh competing statutes, ambiguous laws, and past court decisions in deciding new cases. The exportation of this characteristic to French legal origin colonies, i.e., the absence of a legal culture of openly discussing the application of the law to evolving conditions, hindered the development of efficient legal systems around the world accordingly. From this perspective, French legal origin colonies imported a restrictive, formalistic legal doctrine under particular conditions that enhanced the probability that their legal systems would be less efficiently adaptable than Common and German civil law countries and even than the legal system in France itself.

From Legal Origin to Finance: Political & Adaptability Mechanisms

We now describe two mechanisms through which legal origin may influence financial development. The political mechanism is based on two premises. First, legal traditions differ in the emphasis they place on protecting the rights of private investors relative to the rights of the State. Second, private property rights protection forms the foundation for financial development. Thus, historically determined differences in legal origin can help explain existing differences in financial development according to this component of the law and finance view (LLSV, 1998).

Some scholars argue that the Civil law has tended to support the rights of the State, relative to private property rights, to a greater degree than the Common law with adverse implications for financial development. Indeed, La Porta, et al. (2003) find that in civil law countries, the State is less likely to grant judges tenure, give courts jurisdiction over cases involving the government, or permit judicial review of the constitutionality of laws. LLSV (1999, p. 231–2) state that a civil legal tradition, then, can be taken as a proxy for the intent to build institutions to further the power of the State. A powerful State with a responsive civil law at its disposal will tend to divert the flow of society’s resources toward favored ends, which is antithetical to competitive financial markets. Furthermore, a powerful State will have difficulty credibly committing to not interfere in financial markets, which will also hinder financial development. Thus, the law and finance theory holds that Civil law countries will have weaker property rights protection and lower levels of financial development than countries with other legal traditions.

In contrast, the Common law has historically tended to side with private property owners against the State according to this view. Rather than becoming a tool

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of the State, the Common law has acted as a powerful counterbalance that promotes private property rights. Rajan and Zingales (2003) note that governments in Civil Law countries were more effective than governments in Common Law countries in expanding the role of government at the cost of financial market development during the Interwar period 1919–1939. They attribute this to the stronger role of the judiciary vis-a`-vis the legislature in Common Law countries. Thus, the law and finance theory holds that the British Common law supports financial development to a greater degree than the Civil law systems.

The second mechanism linking legal origin with financial development is the adaptability mechanism, which is built on two premises. First, legal systems differ in their ability to adjust to changing circumstances. Second, if a country’s legal system adapts only slowly to changing circumstances, large gaps will open between the financial needs of an economy and the ability of the legal system to support those needs.

An influential, though by no means unanimous, line of inquiry holds that legal systems that embrace case law and judicial discretion tend to adapt more efficiently to changing conditions than legal systems that adhere rigidly to formalistic procedures and that rely more strictly on judgments based narrowly on statutory law (Coase, 1960). Posner (1973) argues that while legislators consider the impact on particular individuals and interest groups when writing statutes, judges are forbidden from considering the deservedness of specific litigants and therefore more likely to render decisions based on objective efficiency criteria (Rubin, 1982, p. 205). Rubin (1977) and Priest (1977) hold that common law systems are more efficient than statutory-based systems because inefficient laws are routinely litigated and re-litigated pushing the law toward more efficient outcome. In contrast, Posner (1973) and Bailey and Rubin (1994) argue that statutory law evolves slowly and is subject to a greater degree of inefficient political pressures than the Common law.14 If statutes are constantly playing “catch-up” and are constantly pushed in inefficient direction by the legislative process, then this will hinder efficient corporate finance and financial development.

Thus, while subject to countervailing views presented below, the adaptability channel predicts that French legal origin countries, albeit not necessarily France itself, have a lower probability of developing efficiently flexible financial systems than German civil law and especially Common law countries. The adaptability channel holds that the Common law is inherently dynamic as it responds case-by-case to the changing needs of society. This limits the opportunities for

14 For example in the United States, corporate officers and directors have a legal responsibility to maximize firm value for shareholders. Macey and Miller (1993) argue that the efficiency justification for these broad fiduciary responsibilities is to fill in gaps because it is impossible to pre-contract for all contingencies. This gap-filling role of fiduciary duties can lower transactions costs and improve corporate governance by requiring directors to promote the interests of shareholder above their own interests. For example, in a legal system where judges do not got beyond the statutes, “ . . . a corporate insider who finds a way not explicitly forbidden by the statutes to expropriate outside investors can proceed without fear of an adverse judicial ruling” (LLSV, 2000a, p. 9).

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large gaps to grow between the demands of society and the law. Indeed, La Porta, et al. (2003) show that common law countries are more likely to admit judicial decisions as a source of law. In addition, Djankov, et al. (2003a) stress that differences in legal formalism also influence the adaptability of the law. They find that common law countries tend to have less legal formalism in terms of regulating the collection and presentation of evidence, requiring elaborate and extensive procedures throughout judicial processes, insisting on written documentation at every stage of the process, and setting rigid procedural requirements on communication between parties. In contrast, the Napoleonic doctrine’s distrust of judges induces a reliance on judicial formalism. This hinders the flexibility of the legal system in many French law countries, with adverse implications on financial development. Furthermore, as noted, many legal scholars argue that the German law falls close to the Common law in terms of adaptability since it rejected the Napoleonic doctrine and instead maintained its historical roots in jurisprudence.

While the political and adaptability mechanisms are inter-related parts of the law and finance theory and while they both predict that legal origin shapes financial development, they make conflicting predictions regarding French versus German civil law countries. The political channel holds that the Civil law tradition—both French and German—tends to centralize and intensify state power and therefore takes a more wary stance toward the development of free financial systems than the Common law. In contrast, the adaptability channel stresses that Common law and German civil law countries have notably more adaptable legal traditions than French civil law countries.

The two mechanisms also make different predictions concerning the channels through which legal systems influence the development of financial markets. The political mechanism contends that State control of the judiciary produces a system that focuses more on the power of the State and less on the private contracting rights of individual investors than a legal system characterized by an independent judiciary. Thus, the political channel stresses that cross-country differences in the independence of the judiciary are critical for explaining cross-country differences in financial development. In contrast, the adaptability mechanism stresses that cross-country differences in the flexibility of the law are critical for explaining cross-country differences in financial development.15

One can overemphasize the differences between the political and adaptability channels, however. The political channel focuses on the power of the State while the adaptability channel highlights differences in the ability of legal systems to

15 Proponents of the political channel argue that historically Germany had much more efficient institutions than France did. Citing Ertman (1997) and Finer (1997), LLSV (1998, 1999) note that Germany built a professional bureaucracy based on the military and professional civil servants, while France developed a patrimonial bureaucracy with strong links to political elites. Arguably, these differences have also worked to create German courts that are more independent from the State, more efficient at protecting private contracting rights, and less focused on the rights of the State than in France. Proponents of the legaladaptability channel would counter that this cannot explain why other German legal origin countries, such as Korea and Japan have developed relatively efficient financial markets.

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evolve with changing conditions. Jurisprudence, however, may be much less likely in a system where the State controls the judiciary than in a system where the judiciary enjoys greater independence (Damaska, 1986; Glaeser and Shleifer, 2002).

Skeptical Views Regarding the Law and Finance Theory

Many influential legal scholars and economists question each of the premises underlying the law and finance theory. There are disagreements about the comparative flexibility of the Common and Civil law traditions, doubts about the view that the common law places greater emphasis on private property rights protection than the Civil law, skepticism about classifying countries by legal origin, questions about whether legal origin is a fundamental determinant of financial development, and doubts about the central role of investor protection laws in promoting financial development.

Specifically, Backhaus (1997) and Blume and Rubinfeld (1982) argue that precedent can stymie the efficient evolution of the law. Indeed, Epstein (1975) and Rubin (1982) provide a rich set of examples, including the evolution of the law of property during 19th century and the design of private clauses in contracts, when statutory law changes were necessary to produce more efficient outcomes in the United States. As another example, English law has clung with remarkable tenacity to the principle that “only a person who is a party to a contract can sue on it.” (ZK. 1998, p. 468) In contrast, the Continental countries granted greater rights to third parties through statutory changes. Furthermore, Lamoreaux and Rosenthal (2002) provide a fascinating comparison of the laws of incorporation and partnerships in the United States and France. They argue that the French civil law system responded more effectively to evolving economic conditions than the U.S common law system. Finally, Bentham (1789) noted that the Common law’s lack of coherence hinders its ability to evolve efficiently.

Another line of criticism questions Posner’s (1973) argument that the courts have better incentives to select socially efficient outcomes than the legislature. Galanter (1974) and Tullock (1980) argue that rich disputants and well-endowed special interest groups can litigate and re-litigate cases, which blurs Posner’s (1973) delineation between the processes of legislation and litigation. Furthermore, the choice of litigation and legislation may be primarily a strategic, decision regarding which avenue offers the greatest probability of success. From this perspective, there is no reason to presume that Common or Civil Law systems will produce more efficient outcomes.

Research also questions whether Common law systems emphasize property rights relative to the rights of the State to a greater degree than Civil law systems. For instance Ekelund and Tollison (1980) and Rubin (1982) argue that while the courts in England sided with Parliament against the Crown’s efforts to grant monopolies in 16th and 17th centuries, this should not be viewed as a general characteristic that Common law legal systems favor private property rights and competition more than Civil law systems. Arguing along similar lines,

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Coffee (2000) argues that Civil law systems are not inherently against minority shareholder rights, but rather the law has evolved sufficiently in Civil law countries to protect minority shareholder effectively given the patterns of corporate ownership in those countries.

Furthermore, many question whether it is appropriate and analytically useful to categorize countries as simply having British, French, German, or Scandinavian legal origins. As stressed above, Dawson (1960, 1968) and Merryman (1985, 1996) stress than when the French legal system was exported to colonies around the world, it operated less effectively than in France itself. One may further refine the categorization of legal systems. For instance, Franks and Sussman (1999) describe differences in the adaptability of two Common law countries: the United Kingdom and the United States. Also, legal scholars study differences across the French civil law countries of Latin America. Along the same lines, Berkowitz, Pistor, and Richard (2002) stress that the manner in which national legal systems were initially transplanted and received, e.g., through conquest, colonization, or imitation, around the world is very important for economic development. They stress that the transplant process—not just whether countries are classified as having British, French, German, or Scandinavian legal origins—is important for establishing well-functioning legal systems. Thus, many observers question the usefulness of using legal origin to explain property rights protection, the efficient adaptability of legal systems, and hence financial development.

Some researchers question whether legal heritage is a crucial determinant of legal and financial institutions and instead stress that politics determines the degree of investor protection laws, the energy devoted to private contract enforcement, the extent to which legal systems emphasize the rights of property owners relative to the rights of the State, and hence the development of competitive financial markets (Pound, 1991; Roe, 1994; Pagano and Volpin, 2001; Rajan and Zingales, 2003; Haber, et al., 2003). From this perspective, those in power shape policies and institutions—including legal and financial institutions—to stay in power and enrich themselves. The elite may or may not favor financial development, which ultimately influences the operation of legal and financial institutions. This view does not reject the importance of legal institutions in shaping financial systems. Rather, it stresses the political roots of differences in legal and financial institutions.16

Skepticism about the central role of legal institutions in shaping financial development also emanates from those highlighting culture. Stulz and Williamson (2003) note that different religions have different attitudes toward the rights of creditors. In particular, the Catholic Church has historically taken a negative

16 Glaeser and Shleifer (2002) model the evolution of legal institutions, while Glaeser and Shleifer (2003) show that legal and regulatory institutions may evolve together and sometimes substitute for each other depending on specific conditions. For broad discussions of the co-evolution of legal, regulatory, and political institutions see Olson (1993), North (1981, 1990), Djankov, Glaeser, LaPorta, Lopez-de-Silanes, and Shleifer (2003b), and Barth, Caprio, and Levine (2003). Easterly and Levine (1997) show that ethnic division may shape the wide range of institutions and policies.

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stance toward the charging of interest and creditor rights. Similarly, the Qur’an prohibits the charging of interest, so that some countries still impose this prohibition. In contrast, according to this culture-religion view, the Reformation advanced a different religious attitude towards finance, whereby the payment of interest was considered a normal part of commerce, so that the rights of creditors were more naturally emphasized in countries dominated by Protestant religions. From this perspective, countries with a predominantly Catholic religious heritage would tend to have less developed credit markets and more poorly developed loan issuing financial institutions.

An additional line of attack comes from geography. The endowment view stresses that differences in geography and disease have critically shaped patterns of political, institutional, and economic development (Diamond 1997; Jones 1981; McNeill 1963; Crosby 1989; Engerman and Sokoloff 1997, 2002; Sokoloff and Engerman, 2000; Acemoglu, Johnson, and Robinson, 2001, 2002).

Acemoglu, Johnson, and Robinson (2001, henceforth AJR) base their theory of how endowments influence enduring institutions on three premises. First, AJR note that Europeans adopted different types of colonization strategies. At one end of the spectrum, the Europeans settled and created institutions to support private property and check the power of the State. These “settler colonies” include the United States, Australia, and New Zealand. At the other end of the spectrum, Europeans sought to extract as much from the colony as possible. In these “extractive states,” Europeans did not create institutions to support private property rights; rather, they established institutions that empowered the elite to extract gold, silver, etc. (e.g., Congo, Ivory Coast, and much of Latin America). Second, AJR’s theory holds that the type of colonization strategy was heavily influenced by the feasibility of settlement. In inhospitable environments, Europeans tended to create extractive states (AJR, 2001). In areas where endowments favored settlement, Europeans tended to form settler colonies. The final piece of the AJR theory of institutional development stresses that the institutions created by European colonizers endured after independence. Settler colonies tended to produce post-colonial governments that were more democratic and more devoted to defending private property rights than extractive colonies. In contrast, since extractive colonies had already constructed institutions for effectively extracting resources, the post-colonial elite frequently assumed power and readily exploited the pre-existing extractive institutions. AJR (2001, 2002), Beck, Demirguc-Kunt, and Levine (2003a, henceforth BDL), and Easterly and Levine (2003) provide empirical support for the view that endowments influence institutions, including financial institutions.

Other work questions the central role of investor protection laws in shaping the efficient flow of capital to corporations and overall financial development. For instance, Dyck and Zingales (2003) find that non-traditional corporate control mechanisms, such as an open, competitive media and a high degree of product market competition, are as important as statutory protection of minority shareholders in explaining the private benefits of controlling a corporation.

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Furthermore, Guiso, et al. (2000) hold that “social capital” the informal rules that govern social interactions play a critical role in determining financial development in Italy. Similarly, Franks, et al. (2003) argue that implicit contracts enforced by informal mechanisms fostered small shareholder participation in fi- nancial markets in late 19th and early 20th century England. Johnson, McMillan, and Woodruff (2002a), however, note that while informal, relational contracting has been important in post-communist countries and can sustain old relationships, effective formal court systems are crucial in fostering new commercial relationships and boosting the overall level of trust in society.

3. EMPIRICAL EVIDENCE ON LAW AND FINANCE

In this section, we review the empirical evidence on the law and finance view. The first sub-section discusses evidence on the links between legal origin and financial development, investor protection laws, and private property rights protection. Next, we assess whether investor protection laws influence corporate valuations, corporate governance, and the operation of financial markets? The third subsection reviews emerging evidence on the mechanisms—the political and adaptability mechanisms—linking the law to financial development.

Legal Origin and Financial Development

To measure legal origin, many researchers follow LLSV (1998) in classifying a country as having either a British common law, French civil law, German civil law, or Scandinavian civil law based on the source of each country’s Company or Commercial code. David and Brierley (1985) argue that commercial legal systems of most countries derive from these four major legal families. Reynolds and Flores (1989) provide information on the origins of national laws for over 100 countries. Using these legal origin dummy variables, researchers have initiated an energetic examination of the relationship between legal and financial institutions.

LLSV (1997, 1998) find that French civil law countries have the lowest levels of financial development even after controlling for the overall level of economic development. French civil law countries have smaller stock markets (as measured by market capitalization divided by GDP), less active initial public offering markets, and lower levels of bank credit as a share of GDP. These results are broadly consistent with the theories of law and finance discussed above.17

Empirical work also examines the connection between legal origin and specific laws governing the rights of external investors in firms. To the extent that the legal system protects shareholders and creditors, this may tend to (1) foster

17 Additional work further shows that Common law countries have significantly greater Market Capitalization than the combined group of civil law countries (BDL, 2001).

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better functioning stock and debt markets and (2) facilitate the flow of capital to firms.

Consider LLSV’s (1998) Shareholder rights measure, which is an index aggregates the following six measures. The index is created by adding 1 when (a) the country allows shareholders to mail their proxy vote to the firms, (b) shareholders are not required to deposit their shares prior to the General Shareholders Meeting, (c) cumulative voting or proportional representation of minorities on the board of directors is allowed, (d) an oppressed minorities mechanism is in place, (e) the minimum percentage of share capital that entitles a shareholder to call for an Extraordinary Shareholders Meeting is less than the sample median (10 percent), or (f) shareholders have preemptive rights that can only be waived by a shareholders vote. Higher values indicate greater minority shareholder rights such that majority shareholders have less discretion in exploiting minority shareholders.

LLSV (1998) show that French civil law countries have lower levels of Shareholder Rights. LLSV (1997) and Levine (2003) go on to show that low levels of Shareholder Rights are associated with poorly developed equity markets. In contrast, Common law countries have high levels of Shareholder Rights with correspondingly high levels of equity market development. Furthermore, LLS (2003) find laws and regulations that force information disclosure and that foster private enforcement through strict liability rules enhance market development. Moreover, LLS (2003) show that French legal origin countries tend to have relatively weak liability rules and weak information disclosure requirements, such that the legal and regulatory environment in French civil law countries tends to emphasize private contract enforcement less effectively than in Common law countries.

Next, consider Creditor Rights, which is an index that is formed by adding one when (a) the country imposes restrictions, such as creditors consent or minimum dividends, to file for reorganization, (b) secured creditors are able to gain possession of their security once the reorganization petition has been approved (no automatic stay on assets), (c) secured creditors are ranked first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm, and (d) the debtor does not retain the administration of its property pending the resolution of the reorganization. Higher values indicate greater creditor rights.

As shown by LLSV (1998), countries with a Common law tradition tend to have greater Creditor Rights than French civil law countries. Furthermore, LLSV (1997) and Levine (1998, 1999) show that greater Creditor Rights are positively associated with financial intermediary development.

Furthermore, Levine (1998, 1999) and Levine, Loayza, and Beck (2000) empirically trace the chain of connections from legal origin to financial development to economic growth. Specifically, legal origin importantly accounts for cross-country differences in the development of bank and stock markets and these differences in financial development explain international differences in long-run rates of economic growth. Thus, a growing body of work suggests that

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legal institutions influence the operation of financial institutions with substantial implications for corporate finance and investment decisions, along with the overall rate of economic growth.

Nevertheless, legal origin is certainly not the whole story. Rajan and Zingales (2003) argue that financial development does not always evolve monotonically over time and that cross-country differences in financial development also change materially over time. Thus, time-invariant factors such as legal origin cannot fully explain time-variation in the relative levels of financial development across countries. Rajan and Zingales (2003) stress the important role of political forces in shaping policies toward financial markets and intermediaries and hence the development of financial systems. Pistor, et al. (2002, 2003) disagree with Rajan and Zingales (2003) in the area of corporate law and argue that even acute political changes in Germany, France, and England during the 20th century did not substantively alter the evolution of corporate law.

While recognizing the limitations of the law and finance theory’s ability to explain intertemporal changes in relative levels of financial development across countries, recent research has conducted a number of robustness checks regarding the linkages between legal origin and financial development. Levine, (1998, 1999, 2003a), Levine, Loayza, and Beck (2000), and BDL (2003a) use different measures of financial development and also expand the set of countries to over 100. This research confirms that legal origin helps explain cross-country differences in financial development. In particular, French civil law countries, though not France itself, tend to have particularly low levels of equity market development. To the extent that competitive securities markets rely more on legal institutions than banks, these results are very consistent with theories that suggest a strong link between legal institutions and financial development.

Furthermore, BDL (2003a) show that French civil law countries tend to have lower levels of private property rights protection. Again, this is consistent with the view that French legal origin countries place comparatively less emphasis on the rights of private property holders than countries with a Common or German civil law tradition.

While still in its nascent stages, research is also running statistical horse races between theories that stress the role of legal institutions and alternative theories. As noted earlier, an influential body of works stresses the dominating role of political forces in shaping financial development. While it is extraordinarily difficult to measure cross-country differences in political institutions, BDL (2003a) make an initial attempt to control for differences in political systems in assessing the law and finance relationship. They include measures of the degree of competitive and executive elections, measures of the number of influential veto players in legislative process, and an overall index of national openness based on trade openness. BDL (2003a) continue to find that legal origin explains differences in equity market development, banking sector development, and the level of private property rights protection even when controlling for these proxies for characteristics of the political environment.

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BDL (2003a) also control for natural resource endowments and religion in examining the robustness of the connection between legal heritage and financial development. To control for religion, BDL (2003a) measure the percentage of the population adhering to different religious faiths. To proxy for natural resource endowments, BDL (2003a) use the AJR measures of settler mortality. As a further check, they use measures of each country’s latitude (the absolute value of either the geographic mean of the country or of the country’s capital city) as an exogenous proxy for the degree to which the country is in a tropic environment. They find that endowments importantly explain cross-country differences in financial institutions, confirming the AJR and Engerman and Sokoloff (1997) theories of institutional development. Nevertheless, legal origin continues to explain property rights differences and stock market development even when controlling for endowments.

Similarly, Stulz and Williamson (2003) examine the impact of legal origin on financial development while controlling for cross-country differences in culture, as measured by the dominant religion in each country. They find that legal origin is more important than religion in explaining laws protecting equity holders, while religious differences are more closely tied to laws protecting creditors. Thus, while culture matters, legal origin still explains cross-country differences in financial development, especially equity market development, after controlling for differences in religious heritage.

Investor Protection Laws, Corporate Finance, and Financial Development

We now examine the empirical evidence concerned with the relationship between investor protection laws and the corporate financing decisions of firms and the operation of financial markets. This subsection discusses this more microeconomic-based work.

Recent work suggests that legal institutions influence the valuation of firms and banks and hence the cost of capital. Claessens, et al., (2002), LLSV (2002), and Caprio, et al, (2003) find that stronger investor protection laws, as measured by higher values of the Shareholder Rights indicator defined above, tend to enhance corporate valuations. Furthermore, LLSV (2000b) show that countries with strong Shareholder Rights are able to force firms to disgorge cash and pay higher dividends. This evidence is consistent with the view that investor protection laws influence corporate governance with measurable implications on stock prices and dividend policies. In related work Johnson, McMillan, and Woodruff (2002b) show that countries with strong private property rights protection tend to have firms the reinvest their profits, but where property rights are relatively weakly enforced, entrepreneurs are less inclined to invest retained earnings.

Empirical analyses also find a strong connection between investor protection laws and both ownership concentration and the private benefits of corporate control. The data are consistent with the view that stronger legal protection of investor rights makes minority investors more confident about their investments,

270 Thorsten Beck and Ross Levine

which reduces the need for firms (Claessens, et al., 2000; LLS, 1999) and banks (Caprio, et al., 2003) to use concentrated ownership as a mechanism for alleviating corporate governance problems. Furthermore, Dyck and Zingales (2003) and Zingales (1994) show that greater statutory protection of minority shareholder rights and more effective legal enforcement of those rights lowers the private benefits of controlling a corporation.

Legal institutions also influence the ability of firms to raise capital. Thus, laws may influence the degree to which firms operate at financially constrained levels. Kumar, Rajan, and Zingales (2001) and Beck, Demirguc-Kunt and Maksimovic (2002) find that countries with legal institutions that more effectively protect property rights tend to have larger firms. This is consistent with the law and finance theory that in countries with better legal institutions, firms are less constrained by retained earnings and operate at more efficient scales.

Recent work has also drawn a connection between legal institutions and the efficiency of equity markets. Morck, Yeung, and Yu (2000) examine the relationship between legal institutions, the availability and precision of information on firms, and the efficiency of stock prices. They find that the degree to which legal institutions protect private property rights and the rights of minority shareholders help account for cross-country differences in stock market synchronicity. That is, in countries where legal institutions do not protect shareholders effectively, domestic stock prices move together, so there is less information in individual stock prices.

The impact of legal institutions on corporate finance may also play a role in explaining the Asian financial crisis. Johnson, Boone, Breach, and Friedman (2000) show that weak legal institutions—legal institutions that do not effectively support the claims of outside investors—help account for cross-country differences in stock market declines and exchange rate depreciations during the Asian crisis. Specifically, if managers expropriate more firm assets as expected rates of return on firm investment fall, then adverse shocks to the economy will lead to greater expropriation, larger stock declines, and bigger incipient capital outflows in countries with weak legal institutions. Johnson, Boone, Breach, and Friedman (2000) find evidence consistent with this legal institution explanation of exchange rate and stock price declines.

Wurgler (2000) and Beck and Levine (2002) examine whether legal institutions influence the allocation of capital across firms and industries. They show that legal institutions influence the efficiency with which financial systems reallocate capital across industries. Specifically, countries with legal institutions that define and enforce strong rights for small, outside investors more effectively reallocate the flow of finance toward growing firms and away from declining firms. Thus, well-functioning legal systems boost the efficiency with which financial systems allocate capital.

Also, Demirguc-Kunt and Maksimovic (1998) show that countries with legal institutions that protect outside investors tend to create better functioning financial systems that fund faster growing firms. Claessens and Laeven (2003) show that legal rules regarding investor protection influence the types of firms that get financed. Specifically, in countries with strong investor protection laws,

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investor protection laws and corporate financing efficiency, researchers are only beginning to examine the mechanisms through which legal origin operates. The political channel postulates that legal traditions differ in terms of the priority they give to private property rights relative to the rights of the state. The adaptability channel stresses that legal traditions differ in terms of their responsiveness to changing socioeconomic conditions.

BDL (2003b,c) study whether legal origin influences financial development primarily through the political or adaptability mechanism by exploiting the data assembled by Djankov et al. (2003a) and La Porta, Lopez-de-Silanes, PopEleches, and Shleifer. (2003). To proxy for the political channel, Supreme Court Power is a dummy variable that takes on the value one if Supreme Court Judges have both life-long tenure and power over administrative cases, and zero otherwise. The political channel predicts that (i) Civil law countries are less likely to grant Supreme Court Power and (ii) Supreme Court Power will be positively associated with private property rights protection and financial development. To proxy for the adaptability channel, Case Law is a dummy variable that indicates whether judicial decisions are a source of law. The adaptability channel predicts that (a) Common law and German civil law countries are more likely to admit judicial decisions as a source of law than French law countries and (b) countries in which judicial decisions are a source of law will adapt more efficiently to changing financial conditions.

BDL (2003b) find that, French and German civil law countries have significantly less Supreme Court Power than British common law countries. This is consistent with the view that the State grants less independence in a civil law tradition than in a common law system. The results also indicate that French civil law countries have significantly less Case Law—i.e., a significantly smaller role for judicial decisions as a source of law—than in German civil law or British common law. This is consistent with the view that German civil and British common legal traditions rely more on jurisprudence than French civil law systems.

BDL (2003b) next examine whether the proxy for the political channel or the proxy for the adaptability channel is better able to account for international differences in stock market, financial intermediary, and private property rights development. They use two-stage least squares, where the instrumental variables are legal origin dummy variables.

The results provide support for the adaptability channel but not the political channel. Specifically, the political channel predicts that Supreme Court Power will enter positively: less State control of the courts will translate into greater financial development. In contrast, however, Supreme Court Power enters either insignificantly, or negatively. Instead, the data are consistent with the adaptability channel: Case Law is positively associated with stock market development, bank development, and private property rights protection.

Research also focuses on judicial formalism, which is related to the adaptability mechanism. Excessive formalism may slow legal processes, increase legal costs, and hinder the ability of courts to arrive at fair judgments due to

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the rigid adherence to bright-line-rules (Johnson et al., 2000; Djankov et al., 2003a; Glaeser and Shleifer, 2002). Indeed, Djankov, et al. (2003a) construct an index of legal formalism that measures the need for legal professionals, written documents, statutory justification, the statutory codification of evidence, and the formal procedural steps associated with legal processes. They find that legal formalism is lower in common law countries and that less legal formalism is associated with shorter proceedings and less corruption.

In terms of finance, Acemoglu and Johnson (2003) examine the impact of legal formalism on financial development using legal origin as an instrumental variable. Although legal formalism is not linked with banking sector development, they find that the exogenous component of legal formalism is associated with stock market development. Greater legal formalism lowers stock market development, which is consistent with the adaptability mechanism.

4. CONCLUSIONS

A rapidly growing body of research examines the role of legal institutions in explaining financial development. The law and finance theory holds that (i) historically determined differences in legal tradition influence national approaches to private property rights protection, the support of private contractual arrangements, and the enactment and enforcement of investor protection laws and (ii) these resultant legal institutions shape the willingness of savers to invest in firms, the effectiveness of corporate governance, and the degree of financial market development. Each of the components of the law and finance theory is being dissected, critiqued, and evaluated from a broad array of perspectives. Many economists, legal scholars, political scientists, and historians are questioning, testing and modifying the law and finance theory. This promises to be an exciting and important area of inquiry in coming years.

ACKNOWLEDGEMENTS

We have received very helpful guidance from Mary M. Shirley, Andrei Shleifer, and three anonymous referees. All remaining errors and omissions, however, are our responsibility. This chapter’s findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.

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12. A New Institutional Approach

to Organization

CLAUDE MENARD

1. INTRODUCTION

Modern economic theory has long neglected, even ignored, the analysis of the different modes of organization that characterize a market economy. Notwithstanding the efforts of Alfred Marshall, one of its founding fathers, in identifying the properties of “business organizations” (1920, Book IV, chap. 10 sq.), standard microeconomics relied for decades on the concept of firms as production functions, an umbrella to the technologically determined combination of inputs.

This situation has changed under the influence of the celebrated paper by Coase on “The Nature of the Firm” (1937). There are now several alternative theories of organization in economics1, with “transaction cost economics”, “agency theory”, “property rights theory”, and a mix of resource-based and evolutionary perspective as the leading approaches.2 Beyond serious divergences, this diversity of approaches is striking. The development of competing explanations reflects an increasing interest for the nature of organizations. This becomes particularly obvious when looking at the resurgence of the literature on the theory of the firm, but also at the booming number of papers on other modes of organizations, e.g., strategic alliances, joint ventures, etc. However, it also suggests that we still miss an integrated theory.

This chapter reviews what we have learned and some unsolved problems about alternative modes of organization. It does so by focusing almost exclusively on contributions rooted in the new institutional approach, which is

1 The analysis of organization actually developed initially in other disciplines, generating a field of its own (Organization Theory).

2 The hard core of these theories can be summarized as follows. Transaction cost focuses mostly on explaining the existence and properties of alternative modes of organization and the tradeoffs among them. Agency theory primarily examines incentives, i.e., the way a principal can induce agents to behave according to his interest. The property rights paradigm, “old” or “new”, centers on ownership and the related allocation of decision rights as a determinant for understanding relationship-specific investments. The resource-based–evolutionary view explores mainly how organizations develop internal characteristics, such as routines and know-how, in order to deal with their environment. Gibbons (2004) proposes a slightly different typology.

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markets would be a “black box” in NIE. Section 6 concludes with an overview of some unanswered questions.

2. A LONG STORY MADE SHORT

The development of a theory that allows identifying and characterizing alternative ways to organize transactions and that provides tools for analyzing the tradeoff among these modes remains a major contribution of NIE. The model emerged through several papers, mostly from the 1970s, in which Williamson played a key role in putting the pieces together.5

Some Landmarks

As it is now well-known, we owe to Coase (1937) the initial formulation of the problem, later summarized by Goldberg: “ . . . which imperfect institutions should govern particular sets of transactions”? (1976, p. 46). Almost simultaneously, Chester Barnard published The Functions of the Executive (1938), in which he emphasized the role of “authority” as demarcating firms from markets. Simon (1951) modeled this idea in his paper on the employment relationship, while Arrow (1964) developed the role of control in hierarchies.6

Several publications built on these preliminaries in the 1970s, shaping the NIE approach to organization. Williamson initiated the movement with his paper from 1971, in which he put at the forefront the role of transaction costs in examining “Vertical Integration” and simultaneously pointed out contracts as a key organizational device.7 The controversial paper by Alchian and Demsetz (1972) followed almost immediately, re-examining the Coasian approach and interpreting firms as a nexus of contracts. Arrow then pushed organizational issues higher on the agenda of economists with his Limits of Organization (1974). However, the publication of Markets and Hierarchies (1975) signaled a turning point. In this influential book, Williamson assembled disperse elements (including his previous contributions) into a coherent framework that linked transaction costs, contractual arrangements, and modes of organization, thus providing a model that remains at the core of the micro-analytical branch of NIE. Klein et al. (1978) closed the decade, focusing the attention on the role of specific investments and the risks of hold-up as the explanation to the choice of a mode of organization. A stream of research, and of controversies, was born.

5 North took the leadership in the other branch of NIE, focused on the analysis of institutional environments.

6 Others could be mentioned, e.g., Commons (1934), Hayek (1945), Malmgren (1961), Macaulay (1963), etc. I do not pretend to develop a historical review here, I only point out major landmarks.

7 Amazingly, Davis and North published the book that imposed the other branch of NIE the same year.

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The Analytical Framework: A Reminder

The heuristic model that summarizes these contributions and that has inspired most institutional analysis derives from Williamson (1975; 1985). Its underlying logic can be decomposed in the following sequence.8

The entry to the model is the central problem identified by Coase: how can agents take advantage of the division of labor without loosing the potential advantages of cooperation? The division of labor implies decomposition of tasks, which raises the issue of coordination, its organizational modalities, and their costs. Cooperation has to do with the behavior of agents and relates to incentives, that is, devices that can make agents with diverse goals efficiently complementing each other. The two concepts are distinct; even when cooperation prevails, coordination issues remain.

The argument supporting the model looks for the answer in the organization of transactions: in order to specialize, agents must be able to transfer rights on goods and services that they control. Therefore, economics must analyze and compare the different modes of processing and monitoring transactions. Two important consequences result: (1) there are various ways of organizing transactions, and choosing the right way is a fundamental issue; (2) all forms of organization are costly, and their respective advantages can be assessed only comparatively. In the post-Coasian world of positive transaction costs, all devices for transferring rights consume resources. For example the elaboration, negotiation, monitoring, and enforcement of contracts involve costs (Dahlman, 1979). Sources of these costs are twofold. First, transactions relate agents, so behavior matters. The model assumes agents who have a propensity to behave opportunistically. Opportunism can generate contractual hazards: costly safeguards need to be defined and implemented. Second, transactions develop in environments plagued with uncertainties. Although probabilities can be attached to some so that reallocation of resources can be specified ex-ante in Arrow-Debreu type contracts, Knightian uncertainty cannot be discarded: significant decisions remain noncontractibles. The combination of these two sources of hazards makes all devices (including technology) needed to support transactions flawed. At the micro level, these devices take shapes in different modes of organization. At the macro level, they are embedded in complex institutions required for arranging transfers of rights at acceptable costs (North, 1981; 1990).

In order to compare alternative ways of organizing transactions, the analysis focuses on the attributes of a transaction that determine variations in its

8 This sequence reflects the Coase-Williamson approach to organization and differs from the AlchianDemsetz story. Demsetz in particular has become increasingly critical to the framework presented here, going as far as considering the coasian approach as misleading (1988a; 2002). In his view, economies of scale, particularly those resulting from managerial knowledge, are the main explanation to why firms may overcome markets. However, he also challenges mainstream economists, arguing that they are wrong in seeing prices as a coordination mechanism: prices do not coordinate, they signal opportunities. The real trade-off would not be between markets and hierarchies, but between firms and households. With high transaction costs or without advantages to specialization, production would be carry on by households. Otherwise, firms organize production.

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costs. Following Williamson (1985, chap. 3), most new institutionalists now routinely refer to three major characteristics: the specificity of assets involved, the uncertainties surrounding the transaction at stake, and the frequency of that transaction. Specificity of assets has been defined as the value of investments that would be lost in any alternative use. Highly specific assets create mutual dependence that opens the possibility of “hold-up”, defined as the detrimental ex-post appropriation of the quasi-rent by one or some partner(s) (Klein et al., 1978; Alchian and Woodward, 1987, p. 114).9 Uncertainties surrounding the organization of a transaction may also involve significant costs, whether it comes out of agents’ behavior or organizational deficiencies; or from inadequate institutions or the state of nature. A third attribute, frequency, proved to be more difficult to enter into operation. According to Williamson, “The frequency of a transaction matters because the more often it takes place, the mode widely spread are the fixed costs establishing a non-market governance system” (1985, p. 76). However, there is little empirical research about frequency and that research show ambiguous effects on governance. Together, these three attributes determine the following relationship (signs show the predicted impact of a positive variation of each characteristic on transaction costs):

Of course these three variables are notoriously difficult to measure, and almost all the empirical literature avoids any attempts at measuring transaction costs directly, using instead a reduced-form model in which transaction costs are assumed to be minimized (see Joskow, chap. 13, and Klein, chap. 17 in this book). Note also that all transactions involve the three variables.10 What differentiates them are the level of each variable and their respective weight in the determination of transaction costs. It also makes the transactions complex, an important point for understanding why contracts are usually incomplete. Indeed, the more complex a transaction is, the more difficult and costly it is to encapsulate all its characteristics (ex-ante) and to predict all adaptations required (ex-post) in a contract; a simple framework may be preferable or even the only possible solution. Moreover, this complexity suggests ways to develop a dynamic approach: attributes combine differently over time, change at different speeds,

and overlap with other transactions. Not much has been done in that direction yet.11

9 Coase has vigorously challenged the significance of hold-up and it remains a highly controversial issue in NIE (see Klein, 1988; Coase, 1988; Coase, 2000; Klein, 2000; and Klein, 2004). More on this in section 6.

10In the continuity of Klein et al. (1978) and under the influence of the property rights approach, numerous studies consider appropriability as an important variable. However, there are few empirical tests available (see Whinston, 2003).

11One important dimension of transaction costs that may result from the variables above is the measurement problem emphasized by Barzel (1982). This is discussed in section 5, “The Costs of using market organization”.

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The next step in the reasoning connects transaction costs with modes of organization. If transaction costs vary with their attributes, how does this affect the choice of a mode of organization, or its comparative performance? Williamson linked the two pieces through what he called the “discrete alignment principle” (1985, Preface; and chap. 3 of this book): calculative agents operating in a competitive environment will adopt the mode of organization that fits comparatively better with the attributes of the transaction at stake. In doing so, Williamson provided a way for empirical studies to go around the difficulty of measuring directly transaction costs, making organizational form the dependent variable. If agents have incentives to reduce transaction costs so that these costs tend to be minimized, the attention then turns to the mode of organization chosen over alternatives in order to allow the development of contractual relationships that economize on bounded rationality while safeguarding transactions against opportunism.

One may also consider going further, using the transaction costs apparatus to better understand characteristics of the alternative modes of organizations and how that could explain the prevalence of one mode over others. For example, what properties of firms can make their administrative costs lower than those of a hybrid arrangement when the assets involved are highly specific? Transaction costs economics clearly overlaps with organization theory here. Not much has been developed in that direction yet, and there is even some debate about whether this is relevant or not.12 The following sections explore these aspects further.

This short reminder summarizes the central argument of transaction costs analysis on the tradeoffs among modes of organization and their determinants. The underlying model provides the background to the rest of the chapter. In what follows, I assume the transaction cost explanation to the tradeoffs is known (see chap. 13 and 17 of this book), and I focus on the comparative properties of the different modes of organization.

3. FIRMS

The new institutional approach to firms and, more generally, to integrated “formal organizations” (Barnard, 1938) looks at them primarily as governance structures. This demarcates NIE from the neoclassical view, still prevailing in most textbooks, that represents firms as “a unitary profit-maximizing entity defined by a technologically determined production function” (Yarbrough and Yarbrough, 1988, p. 2).13 NIE does acknowledge the role of technology in delineating the

12Demsetz (1988a), among others, considers transaction costs as strictly applicable to market exchanges, while internal characteristics of firms, e.g. administrative costs, would require other analytical tools. More generally the problem is that transaction costs may be orthogonal to the internal costs of the firm (hence the tradeoff).

13Models built on these premises assume that: (1) monitoring is costless, or can be endogenized at no cost through an adequate contract; (2) shirking can be detected and punished, which requires perfect revelation of information and no enforcement problems; and (3) employees do not accept a job, really, but a fully contingent contract.

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of the firm as a “team” based on a nexus of contracts, pooling specific assets owned by distinct entities, the difficulty being to explain why some entities have more power than others in directing resources. An alternative conception emphasizes the firm as a hierarchical structure grounded in an asymmetric relationship, the difficulty being to explain the source of this asymmetry. However, these diverging views meet in acknowledging the key role of the allocation of property rights.

The first explanation views firms as means for coordinating holders of different assets, the nature of these assets being central to the explanation of what a firm is. Two complementary arguments have been developed here. The “old” property rights approach focuses on the issue of the efficient coordination of assets’ holders and interprets an entrepreneur as the agent who holds a specific asset, his or her competence in processing information, which he/she uses for directing resources efficiently, his or her incentives for doing so coming from his or her status as a residual claimant. Therefore, a firm could be properly characterized by “a team use of inputs and a centralized position of some party in the contractual arrangement of all other inputs” (Alchian and Demsetz, 1972, p. 778). Other ‘members’ of the team-firm accept this visible hand because of the expected gains from this efficient coordination. The “new” property rights approach rather puts the emphasis on incentive to invest as the core of what a firm is, with the type of rights held as the main issue. Indeed, property rights over physical assets would be distinctive because they give holders control over decisions to invest and because they give them leverage over the activity of those who do not own such assets, or who do not own enough rights to have direct leverage over their use. As stated by Holmstrom (1999, p. 76): “ . . . ownership confers contracting rights that allow the firm to decide who should be offered the opportunity to work with particular asset and on what term”.

This last expression brings us close to the alternative analysis, viewing firms as hierarchical systems, based on the key role of authority. This approach prevails in organization theory, but also predominates among those who view the employment relationship as distinctive and typical of the firm, from Barnard (1938) and Simon (1951) to Williamson (1975), Beckmann (1988), Radner (1992) and Aoki (2001). The difficulty here lies in explaining what the foundations of this accepted asymmetry are. I see two potential and likely intertwined answers, based on the idea that asymmetries in property rights may play a different role from the one described above.15 Indeed, the interpretation of the firm as nexus-of-contracts presumes the standard neoclassical assumptions that all participants do have “survival endowments” and that the labor market works perfectly well: in the ‘team’ approach, all asset holders are symmetrical in that they can always leave the firm at will because they can redeploy at no significant cost and/or because they have endowments that allow them to keep full flexibility in the allocation of their assets. But what happens if it is not so? Constraints

15 Holmstrom (1999) is probably the one who comes closer to this interpretation, although there were already indications in Simon (1951).

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on their endowments and high costs of going on the labor market may provide a powerful explanation to why agents accept the direction of a Visible Hand. In doing so, they relax these constraints by securing their income. Plainly, one may need a job or need to keep a job to make a living! This does not preclude the acceptance of authority as a potential source of benefit through entrepreneurial coordination. However, it prioritizes the arguments. Symmetrically, holders of rights on physical assets accept that internal governance prevails because it can “ . . . shield and protect the transaction and insure the full utilization of the specialized assets.” (Teece, 1986)16

My interpretation clearly leans in this second direction, acknowledging that hierarchy matters. Beyond the convergence between the two explanations that allocation of property rights shapes the nature of the firm, I thereafter endorse the view that agents make the organization called “firm” possible because they surrender significant decision rights to a “central coordinator”. As noted by Barnard (1938, chap. 12, p. 184): “Authority is another name for the willingness and capacity of individuals to submit to the necessity of cooperative systems.”

What can make Firms more Efficient than Markets?

Although he later mitigated his view on this issue (1991 [1988] chap. 5, p. 64), Coase initially emphasized that the comparative advantage of firms does not result from market failures or externalities, but rather from their capacity to organize transactions through command rather than by using the price system when the latter becomes too costly. “If a workman moves from department Y to department X, he does not so because of a change in relative prices but because he is advised to do so” (1937, p. 387). At about the same time, Barnard defined formal organizations as “. . . a system of consciously coordinated personal activities or forces” (1938, p. 72; his emphasis), the efficiency of which depends on: (i) communication; (ii) willingness to serve; and (iii) shared purposes. In his view, supervisors in charge of implementing this system form the core of the firm and their role characterizes employment relationship. In other terms command, understood as a relationship in which an agent who performs a job has to report to the person who is in charge and who can be held accountable for the performance of the job thus assigned, forms the distinctive characteristic of hierarchy (Barnard, 1938, chap. 12; Beckmann, 1988, p. 3). With some nuances, Williamson concurs when he emphasizes that what distinguishes commercial and employment contracts is that in the latter employees “must obey first, then seek recourse” (1985, p. 249).17 The very title of his book from 1975, Markets and Hierarchies, already suggested this view. His later emphasis on ‘forbearance law’ (1996 [1991], pp. 97–100) understood as the reluctance of courts to

16Therefore, we are far from the risk adverse story, an interpretation not very popular among the new institutional crowd, which is a significant difference with agency theory.

17Masten (1988) substantiated this difference through a study of the American jurisprudence on contracts.

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intervene in intra-firm disputes, reinforces the concept of hierarchy as distinctive.

What comparative advantages can be expected from that hierarchical relationship? Again, this remains an open question, subject to vigorous controversies. In what follows I develop three sets of arguments. First, the capacity of supervisors to reallocate human resources without negotiation reduces transaction costs and provides a powerful tool for dealing with uncertainty (Simon, 1951; Beckmann, 1988, chap. 1 and 2). Second, internalizing transactions provides means for extending the domain of rationality, thus improving decisions, thanks to “the division of cognitive labor” that hierarchies make possible (Aoki, 2001; chap. 5). Third, the communication system developed and coordinated by the “entrepreneur” is a potential gain when information provided by markets is costly and difficult to process (Alchian and Woodward, 1987, p. 112).

In sum, I remain of the view that command constitutes the central adaptation mode of firms (Williamson, 1996, p. 31). It provides supervisors with the capacity to choose among possibilities delineated by contracts. This capacity relies on many different tools: allocating tasks, pairing human capabilities with physical assets, monitoring agents, checking the adequacy of actions to orders, according rewards, etc. (Radner, 1992; Miller, Chap. 14 of this book).

How Command Works

In order to provide a credible alternative to markets as an adaptation device when tight coordination is needed, command requires a complex combination of control, cooperation, and communication. The potential advantage of formal organizations lies in this combination; however, it also generates “administrative” or “bureaucratic” costs.

Control

Control makes command credible. It provides means for implementing orders, for evaluating the adequacy of actions chosen, and for checking on members tempted to renege their commitments (Williamson 1985, chaps. 9 and 10; Beckmann, 1988, chap. 3; Demsetz, 1995, first and third commentaries). It determines a major function of managers within the firm, and it substantiates the role of corporate governance in finding “ways to govern the manager in the use of assets entrusted to the firm” (Aoki, 2001, chap. 10, section 1). It also provides important indications for understanding why firms have limits, a problem already discussed by Coase (1937, p. 394–395) and developed by Williamson in his pioneering paper on the loss of control (1967).

There is an extensive literature on the issue of control over employees as well as over managers in managerial sciences. However, as noted by Radner (1992, p. 1383), economics seemed little concerned until recently. One set of contributions comes from agency theory (Miller, Chap. 14 of this book). It mostly focuses on incentives issues, trying to find contractual solutions to two

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problems: How to prevent employees from shirking? and how to keep managers align with the interests of property rights holders? These are relevant questions in a new institutional perspective, although they provide a very restrictive view of the role of managers and of the “[many] control problems [that] plague complex organizations” (Demsetz, 1995, p. 42; also Roe, chap. 15 of this book).

What might distinguish the NIE approach is its emphasis on the advantages control can provide over the use of prices as a device to coordinate and adapt when specificity of assets makes mutual dependence unavoidable. First, control provides some flexibility in giving supervisors the capacity to evaluate the adequacy of action to orders and the right to reallocate tasks accordingly, without renegotiating contracts and using the price system. In that respect, central coordination can be faster than decentralized adaptation (Bolton and Farrell, 1990). Second, control provides powerful tools for constraining opportunism through interactions among levels of management, although this may also give senior managers the possibility to appropriate gains from subgroups (Tirole, 1986). Third, and more positively, some authors have recently suggested that central control may allow performing “controlled experiments” to learn how to organize assets more effectively (Foss et al., 2002). Fourth, control allows settling disputes without the time and costs that arbitration by third parties would require (Williamson, 1975, p. 29; Dow, 1987). Fifth, internal control such as auditing might often be superior to external control (e.g., by courts) with respect to the capacity of collecting and processing the relevant information and to the rapidity in making required adaptations (Williamson, 1975, pp. 146–147).

However, the NIE literature has also emphasized that control is subject to rigidities and costs, which severely limits the efficiency of command. In the continuity of the property rights perspective, Demsetz has analyzed the costs of excluding non-owners from the use of resources as a major limitation to control in large corporations (1988b, 1995, and 2002). Similarly, Hansmann (1988) has emphasized that owners of physical assets are actually as much concerned by controlling the use of their assets as by controlling residual profits.18 The resulting costs represent a major limitation to the advantages of firms over markets. Another limit to control was pointed out by Williamson (1985, chap. 6, pp. 135–138): it originates in the non-replicativity (the impossibility of “selective intervention” in his terminology) within the firm of market devices that could alleviate control costs. If firms could replicate the powerful incentives provided by markets, the comparative disadvantage of administrative costs with respect to the cost of trading on markets could be overcome. The search for labor contracts that would allow perfect revelation of information represents an illusory effort in that direction. A third limit comes from influence activities among managers (Milgrom and Roberts, 1990, pp. 78 sq.). A last and related limit, discussed later, results from the loss of information along transmission lines that characterizes control in a hierarchical organization.

18 This aspect partially relates to the metering activity of entrepreneurs (Alchian and Demsetz, 1972), although command can hardly be reduced to metering.

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Cooperation

However, cooperation might partially relax these limits. Cooperation necessarily complements command in an efficient firm. No formal organization could rely exclusively on command and control (Simon, 1991). New institutional economists go further, emphasizing the important role of cooperation in understanding how firms can subsume markets and in understanding the positive role of managers. Cooperation remains a difficult concept to define if one wants to go beyond purely self-interested behavior (Dow, 1987; M´enard, 1994b). Here I understand cooperation as the willingness of agents to pool resources even when they cannot assess ex-ante the benefits expected or if there are benefits at all to be expected in doing so.

In their 1972 paper, Alchian and Demsetz in defining firm as a team already raised the measurement issue. More recently, Alchian emphasized that a firm is not “an output-generating ‘black box’ [but] a contractually related collection of resources of various cooperative owners”; and a corporation is “the organization of cooperative joint production” (1987, p. 1031). Williamson went further in analyzing the role of cooperation in formal organizations, noting particularly the importance of “atmosphere” as a source of efficiency. Following Commons’ valuation of mutuality (1934, p. 2) and Arrow’s emphasis on the economic value of social interactions (1974, chap. 1), Markets and Hierarchies (particularly chap. 2, sections 2 and 4; also chap. 3) examined how cooperation can limit the costs of control. “Attitudinal interactions” make formal organizations less prone to conflicts and more apt at settling disputes. Four advantages can result from a cooperative “atmosphere”: (1) scale economies in the acquisition of information; (2) risk-bearing among the group when facing unanticipated contingencies;

(3) mitigation of adverse selection and moral hazard; and (4) increased productivity due to a more developed “sense of responsibility” (see also Arrow, 1974, chap. 4). However, there are also limits and costs to cooperation, resulting from:

(a) free riding strategies through selection of members (ex-ante) and malingering behavior once selected (ex-post); (b) collective decision-making that may hamper the advantages of command; (c) incentives to collude and develop sidepayments; and (d) the high cost of processing information and communicating in a team-oriented organization.19 Williamson did not pursue the analysis of cooperation in subsequent books. Other institutionalists have tried to go further, notably Aoki (1988, chap. 3 and 8; 1990; and 2001, chap. 11).20

Information and Communication

The examination of control and cooperation and of their limits, as reported above, systematically exhibits the important role of information. New institutional

19Puterman (1986) and Dow (1987) criticized Williamson for having based his evaluation of cooperation exclusively on peer groups, thus ignoring other modes of cooperation, while Granovetter (1985) argued that Williamson shares with neo-classicists an under-socialization approach to agents.

20See also M´enard (1994a, 1994b, 1997); Vazquez-Vicente (2002).

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economists played a pioneering role here (Malmgren, 1961; Williamson, 1967; Alchian and Demsetz, 1972), partly because they had to deal with Hayek’s statement about markets as particularly efficient information processors (Hayek, 1945). On the one hand, if firms can overcome markets in organizing certain transactions, there must be some informational advantages to integration. On the other hand, information noises in firms may provide a rationale for defining the boundaries of firms. Both dimensions have been explored.

Formal organizations have ways to gain advantages in processing information. First, they can develop routines that make codification possible, thus reducing internal costs. Second, the development of a common language, e.g., corporate culture, provides efficient supports for sharing knowledge. Third, hierarchies introduce “filters” that reduce the number of messages circulating. Fourth, the combination of human resources extends the capacity of individuals to absorb information while the reallocation of tasks through command provides means for processing information and transforming it into action rapidly. Williamson (1975, chap. 2), Aoki (1986; 2001, chap. 5) and Demsetz (1988a, 1988b, and 1995) have played a particularly important role in exploring these factors and their consequences. These informational advantages also relate to the role of ‘entrepreneur’ or ‘business manager’, an aspect already emphasized by early contributors (Coase, 1937; Williamson, 1967; Alchian and Demsetz, 1972) who viewed these figures essentially as efficient information processors. As strongly put by Demsetz (1988a), the fundamental reason that makes management meaningful is their superior capacity to make sense of the signals provided by markets in a world of incomplete knowledge. They may also possess ‘decisive information’, partially due to their specialization in processing signals. Others have adopted a more structural approach, emphasizing how the internal mode of organization may allow efficiency gains and economies of scale in processing information (Williamson, 1975, chap. 2 and 8; 1985, chap. 10 and 11; Aoki, 1986) and, more generally, in making decisions (Demsetz, 1988a). These aspects open a bridge towards the evolutionary perspective on firms as set of competencies processing information efficiently (Witt, 1998; Jacobides and Winter, 2003).

On the other hand, the complexity of internal coordination generates noises, and therefore uncertainties of its own, making firms prone to loss of control. Williamson (1967) provides a pioneering reference, with the examination of how a small noise in the transmission of signals in a multi-layered hierarchy ends up imposing limits on the size of the firm. Demsetz (1988b, 1995) has explored the “decreasing returns” in the capabilities of business managers to monitor information, while Aoki (1986; 1990) has exhibited the trade-off in processing information between a centralized organization, which accumulates noises along the multiple layers of the hierarchical system; and a decentralized organization that confronts dispersion of information, a challenge to the advantages of integration. In other terms, different internal structures carry distinct administrative costs. Unfortunately we still do not know much about the costs involved, a limit that NIE shares with other approaches.

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More generally, the analysis of the internal characteristics of formal organizations and of their related costs remains an underdeveloped area. Since it is so crucial for better understanding the comparative advantages and disadvantages of these arrangements over other modes of organization, particularly the use of markets, one can expect significant developments in this direction in the future. Whether or not the transaction cost apparatus can help in doing internal investigations remains debatable. Some neo-institutionalists argue that transaction costs concern exclusively market exchanges, so that the analysis of the internal costs of firms requires other tools (Demsetz, 1988a; 2002). Others consider that beyond semantics, efforts are needed for better identifying the administrative costs that are involved in the “make-or-buy” trade-off and, more generally, in the trade-off among different organizational arrangements (Masten et al., 1991; Joskow, chap. 13 of this book). In doing so, we can expect more interactions between NIE, evolutionary economics, and some mainstream economists.

4. HYBRID ARRANGEMENTS21

Having focused on integration as an alternative to markets, NIE initially paid little attention to other modes of organizations, which were considered unstable and transitory. This situation began to change two decades ago. In 1985 (p. 83), Williamson acknowledged that: “Whereas I was earlier of the view that transactions of the middle kind were very difficult to organize and hence were unstable, [ . . . ], I am now persuaded that transactions in the middle range are much more common.” However, the expression “middle-range” maintained some ambiguity, suggesting modes of organization with no specific content. Williamson later (1991) called these arrangements “hybrids”, a more appropriate although not entirely satisfying term.

This section is about these forms, understood as alternative to firms as well as to markets. Firms integrate property rights, thus subsuming in last resort all transaction costs related to the production of a set of goods and/or services; hybrid arrangements cover only a subset of the transactions in which participating firms are involved. Traders making independent decisions commonly characterize markets; hybrids pool some resources, and share a subset of decisions in their domain of choice. A very preliminary notion of hybrids thus includes all forms of inter-firm collaboration in which property rights remain distinct while joint decisions are made, requiring specific modes of coordination. The emphasis is on the commitment of distinct property rights holders, operating distinct legal entities, but organizing some transactions through governance forms mutually agreed upon.

21 This section borrows from the more extensive analysis developed in M´enard (2004a).

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What are Hybrids?

The rapidly expanding literature on these “non-standard” organizational arrangements signals an increasing interest among economists for the issues at stake. Until the mid-eighties only a handful of exploratory papers were available on inter-firm contracts (Klein et al., 1978; Ouchi, 1980; Eccles, 1981; Cheung, 1983), franchising (Rubin, 1978), or “non-standard contracting” (Williamson, 1975; Palay, 1984; Masten, 1984; Joskow, 1985). The real takeoff dates from the 1990s, initially with a majority of contributions in non-economic journals. However, the concepts as well as the vocabulary of these analyses remain approximate. Hybrids, clusters, networks, symbiotic arrangements, and chain systems are used quite indifferently. The forms encapsulated by these fluctuating terms seem also heterogeneous. They include subcontracting, networks, alliances, franchising, collective trademarks, partnership, and even forms of cooperative.22 However, they are connected by the underlying idea that they participate to the same “family” of agreements among autonomous entities doing business together, mutually adjusting with little help from the price system, and sharing or exchanging technologies, capital, products, and services without a unified ownership.

Beyond the heterogeneity of cases and the fluctuating vocabulary, studies progressively revealed regularities that make hybrids distinctive. The first one is the importance of pooled resources. Whatever the form they take, hybrids systematically organize joint activities based on inter-firm coordination. Hybrids develop because markets are perceived as unable to adequately bundle the relevant resources and capabilities (Teece and Pisano, 1994), while integration would reduce flexibility, create irreversibility, and weaken incentives. Sharing some resources and coordinating some decisions in order to generate rents represents the fundamental motivation behind hybrids. However, it may also be a source of conflicts: distributing rents involves discretionary choices that can easily destabilize an agreement. On the other hand, pooling resources does not make sense without some continuity in the relationship, which requires cooperation. Legally distinct entities must accept to loose part of the autonomy that markets would provide without benefiting from the capacity to control that hierarchies have. Hence a first problem for hybrids: how can they secure cooperation in order to achieve coordination without losing the advantages of decentralized decisions?

The existence of relational contracting is a second characteristic shared by hybrids. Of course contracts play a role in other modes of organization. But what

22 Some significant references are: (1) on subcontracting: Eccles, 1981; Aoki, 1988, chap. 6; and Bajari and Tadelis, 2001; (2) on networks: Thorelli, 1986; Powell, 1990; Podolny and Page, 1998; (3) on alliances: Oxley, 1999; Baker et al., 2003; (4) on franchising: Rubin, 1978; Williamson, 1985; Lafontaine and Slade, 1997; (5) on collective trademarks: Dwyer and Oh, 1988; M´enard, 1996; Sauv´ee, 2002; (6) on partnership: Farrell and Scotchmer, 1988; Powell, 1996; and (7) on cooperatives: Cook, 1995; Cook and Iliopoulos, 2000.

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and by command in hierarchies (Jorde and Teece, 1989; Grandori and Soda, 1995; M´enard, 1997). Because they cannot or can only weakly rely on prices or on hierarchy to discipline partners, hybrids depend on specific mechanisms of governance for their survival.

Why Choose a Hybrid Arrangement?

Considering the difficulties involved, one may wonder why there are hybrid organizations at all. Williamson (1991) provides a convincing explanation, based on the model initially developed for understanding the “make-or-buy” tradeoff. The underlying idea is that when investments among partners are specific enough to generate substantial contractual hazards without justifying integration and its burdens, and when uncertainties are consequential enough to require tighter coordination than what markets can provide, parties have an incentive to choose hybrids. Empirical studies have begun substantiating this approach (M´enard, 2004a, section 3). I develop these two aspects successively.

Investing in Mutual Dependence

A fundamental determinant already noted comes from the incentive for partners to create durable mutual dependence while keeping property and decision rights distinct. Two investment strategies can be adopted, with distinct consequences. Each party may invest in specific assets, creating a network based on complementarities; or partners may pool resources, making joint investments for part of their activities. The first strategy was analyzed early by transaction cost economists, who highlighted the role of the duration of agreements. Most initial studies focused on bilateral contracts of that type (Masten, 1984; Palay, 1985; Joskow, 1985). The second strategy, requiring joint investments, typically develops with agreements for transferring products among organizations with different minimum efficiency scales, or involving technology transfers (Hennart, 1988; Teece, 1992; Gulati, 1998; Oxley, 1999).

These examples refer to investments in physical assets. Indeed, most empirical studies of the impact of specific investments on the choice of inter-firm agreements, particularly econometric tests, took inspiration from the paradigmatic analysis of vertical integration, with its emphasis on physical capital (site specificity, physical specificity, dedicated assets). Without ignoring this aspect, a significant contribution of the literature on hybrids is its concern with human assets (Loasby, 1994). This comes out quite naturally from the centrality of agents in charge of coordinating legally autonomous decision makers while checking their propensity to free ride. In franchising, success depends largely on the capacity of the franchisor to select and monitor adequately franchisees (Dnes, 1996; Raynaud, 1997; Lafontaine and Shaw, 1999). Specific human assets are also crucial in other hybrid forms, e.g., mutual investments in human resources among biotechnology firms (Powell, 1996) or transfer of competencies in networks confronted to rapidly changing technologies (Teece, 1992).

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The very existence of interdependent physical assets requires substantial investments in managers that can monitor the arrangement. As already pointed out by Palay (1985), acquiring inter-firm specific knowledge takes time and efforts, so that “go-betweens” are highly regarded as problem-solvers, contributing to the continuity of the relationship.

Another form of specific investments that creates incentives to choose a hybrid arrangement is brand name capital. The abundant managerial literature on distribution channels inspired by transaction cost economics emphasizes the strategic issue of what governance can control partners and maintain reputation (e.g., Brown, 1984; Dwyer and Oh, 1988; John and Weitz, 1988; Fein and Anderson, 1997; Fearne, 1998). Similarly, studies on collective trademarks show the importance of devices designed for guaranteeing quality and preventing opportunistic behavior. When the reputation of a collective brand depends on the quality of products highly correlated to human assets, training and networkspecific competences represent a key value (M´enard, 1996; Raynaud, 1997).

Hence, hybrids develop because of the advantages expected from mutual dependence. However, the level and forms of the specific investments required determine the significance of contractual hazards and the nature of safeguards needed for securing the agreement.

Monitoring Uncertainty

This brings in the issue of uncertainty, the second determinant of hybrids forms. Transaction cost theory suggests that the degree of uncertainty surrounding the transactions that hybrids organize also contributes to shaping the form adopted. Uncertainty is secondary to specific investments in that without some mutual dependence in assets, there would be no hybrid; parties would trade through markets. But once investment-specific relationships develop, uncertainty impregnates decisions about the level of resources pooled and their monitoring. Hybrids operate as a “buffer”: the more consequential the uncertainty is, the more centralized the coordination tends to be (M´enard, 1996, 1997; Nooteboom, 1999).

Internal as well as external factors of uncertainties among partners are relatively well identified. Internal uncertainty outgrows from problems with inputs, outputs, or the transformation process. Problems with inputs may come from non-observabilities in resources or services traded, as in supply chain systems (Fearne, 1998); from difficulties in the coordination of inputs, as in the construction industry (Eccles, 1981); or from outside suppliers with no specific commitment to the arrangement, as in the food industry (Maz´e, 2002). Uncertainties about outputs can result from difficulties in controlling that deliverables meet the standards agreed upon: from maladjustments to consumers’ preferences; or from lack of flexibility in adapting to a changing demand. (Anderson and Schmittlein, 1984; John and Weitz, 1988). The transformation process itself may generate uncertainties: hybrids pool resources that may overlap with activities excluded from the agreement thus making control and planning uncertain,

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and complex technologies and human skills may be involved, as with joint R & D projects. Defining rules for the distribution of rents or for supporting unexpected costs then becomes a potential source of conflicts (Ghosh and John, 1999, p. 131).

The role of the institutional environment as an external source of uncertainty, influencing the choice of one form of hybrid rather than another is often mentioned, although not often analyzed. North (1981, 1990, 1991) has repeatedly insisted on the importance of the rules of the game for understanding how actors play that game. Williamson (1991) went a step further, suggesting how shifts in parameters could explain changes in the modes of governance. Fortunately recent studies on hybrid forms have initiated a more systematic exploration of this issue (e.g., Khanna, 1998; Oxley, 1999).

But what really matters for understanding the choice and the form of hybrids is whether these uncertainties are consequential or not. Confronted to consequential uncertainty, hybrids must combine adaptation, in order to provide flexible adjustments; control, in order to reduce discrepancies among inputs, outputs, or quality in the process itself; and safeguards, in order to prevent opportunistic behavior that uncertainties make difficult to detect. The intensity of adaptation, control, and safeguards needed provides a good predictor of the degree of centralization in the governance of hybrids.

In sum, hybrids develop when specific investments can be spread over partners without losing the advantages of autonomy, while uncertainties are consequential enough to make pooling a valuable alternative to markets. It is the combination of these two dimensions that matters. If only one attribute is present, the governance leans towards contract-based arrangements. When the two attributes combine, the governance becomes more authoritarian. Therefore, it is the combination of opportunism, or the risk of opportunism, and of miscoordination, or the risk of miscoordination, which determines the governance characterizing hybrid organizations.

What Governance for the Hybrids?

There are basically two channels through which monitor hybrids: through contracts and/or through formal governing bodies. Both aspects have been explored by new institutional economists, although the literature on the former is much more abundant so far.

Contractual Safeguards

Indeed, most studies on hybrids in a transaction cost perspective emphasize the role of contracts as safeguards against the high risk of opportunistic behavior that threatens these arrangements, but also show their limits (Masten, 1996; M´enard, 2004b, vol. 3). For example, selecting partners is of utmost importance in hybrids because of what it could cost redeploying mutually dependent assets. However, competition as a selection process, e.g., through bidding, is used

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sparsely, mostly to “test the market” occasionally (Eccles, 1981; M´enard, 1996) and to discipline partners (Knoeber, 1989; Dyer, 1997). Similarly, provisions for constraining opportunism often remain at a very general level, likely because comprehensive-binding contracts would be far too complex and/or too costly to design and implement. This likely explains the highly relational dimension of contracts in hybrids, a regularity noted above.

Notwithstanding these limits, there are different ways through which contracts help coordinating, and new institutional economists have substantially contributed to the analysis of these aspects. Contracts may specify criteria for selecting partners and even fix their number.24 Choosing duration of the contract also provides means for testing willingness to commit and for guaranteeing some continuity in the relationship. As a consequence, formal duration of contracts does not necessarily correspond to the actual duration of the relationship (Joskow, 1985; M´enard, 1996; Dyer, 1997). Clauses determining quality standards, often complemented by annexes, also contribute thus making commitments as observable as possible (M´enard, 1996; Gaucher, 2002).25 Adaptation clauses, e.g., index clauses or clauses delegating adaptation to identifiable managers or arbitrators, can prove a framework that smoothens relationships among partners (Rubin, chap. 9 of this book). Safeguard clauses help to overcome the incompleteness of contracts (Hadfield, 1990), whether safeguards are formal (e.g., financial hostages a la Klein, 1980; mutual commitments guaranteed by specific investments a la Williamson, 1983) or informal, based on relations or reputation (Macaulay, 1963; Garvey, 1995; Baker et al., 2002).

The combination of these characteristics provides tools for governing hybrids. It also generates complexity and costs, which define a central issue: how to economize on the costs of extensive contracting among autonomous partners in order to maintain some advantages in comparison to the cost of administering a broader range of assets within one single firm (Klein et al., 1978)? The answer may well be that contracts provide only a framework, which must be completed by other mechanisms of governance.

Private Order: Forms of Governance

Indeed, empirical studies reveal an array of mechanisms developed by hybrids for economizing on transaction costs while smoothing relations among partners. The issue of rent sharing, not discussed here, is particularly important in that respect (M´enard, 2004a). However, these studies still lack a theoretical framework that could unify the analysis. What follows offers only a partial and provisory view.

24A difficult tradeoff concerns the choice, when possible, between bilateral or multilateral agreements. The former is easier to monitor but involves higher dependency; the latter makes monitoring more complex but allows comparisons and benchmarking, a powerful tool for constraining opportunism. Most hybrid arrangements are of the second type. One suspects it is because it better captures positive properties of markets.

25Studies on contracts, particularly econometric tests, ignore annexes, in which the essence often lies.

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Building on indications provided by Klein et al. (1978) and Williamson (1985, chap. 3; 1991), M´enard (1994a, 1996, 1997, 2004a) has developed evidence of the presence of regulating devices (or “authorities”, distinct from “hierarchies”) as a core element in the architecture of hybrids. These devices all share one common characteristic: they depend on the transfer by partners of subclasses of decisions to entities coordinating their action, while property and decision rights remain distinct. Thus, they rely on intentionality and mutuality, maintaining a formal symmetry that distinguishes hybrids from hierarchies.

Available studies mostly based on cases or on sector samples suggest that the degree of centralization adopted depends on the degree of mutual dependence among partners and on the complexity and turbulence of the environment (Dwyer and Oh, 1988; M´enard, 1996; Park, 1996). An illustration is provided in Raynaud (1997), who analyzed a brand name for high quality bread developed by a group of French millers. In order to prevent opportunism, the partners created a distinct legal entity holding the brand name and defining and implementing standards of quality; they also created a private “court” with peers elected as judges, who are in charge of solving conflicts. An amazing element of this arrangement is the power delegated to these judges to penalize and even expel a partner free-riding “excessively”. The group has grown successfully for the last 25 years. Sauv´ee (2002) examined another pattern, implemented by a firm holding a brand name of canned vegetables of high quality. Inputs come from a diversified set of growers operating under contracts. The formal side of the contract is quite standard, in line with characteristics described above. The interesting point though is that the success of the firm rapidly translated in the high transaction costs of monitoring all these contracts. In order to reduce these costs and secure the arrangement, growers have been structured in several groups with delegates for negotiating contracts and adjustments. A joint committee, with four representatives from the producers and two from the firm, is in charge of solving conflicts, deciding changes, and distributing the quasi-rents.

More generally, empirical studies show a highly variable degree of formalism and power embodied in governing entities adopted by hybrids, which likely reflects the significance of contractual hazards and the resulting transaction costs. I have suggested elsewhere that four forms deserve particular attention (M´enard, 2004a; see also Oxley, 1997). At one end of the spectrum, close to market arrangements, hybrids rely primarily on trust: decisions are decentralized and coordination relies on mutual “influence” and reciprocity. At the other end, hybrids come close to integration, with tight coordination through quasi-autonomous governing bodies or “bureaus” sharing some attributes of a hierarchy (e.g., the millers). Between these polar cases, mild forms of “authority” develop, based on relational networks or on leadership. Relational networks have attracted a lot of attention in organization studies (Powell, 1990; Hakansson and Johanson, 1993; Grandori and Soda, 1995). They rely on tighter coordination than trust, with formal rules and conventions based on long-term relationships, on complementary competences, and/or on social “connivance” (Powell et al., 1996). By contrast, hybrids coordinated by a leader leave little room for autonomy although some

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as with auctions monitored through Internet. We still know little about the costs and benefits of these different institutional arrangements.28

Third, this diversity in the ways markets are organized reflects in the variety of mechanisms involved in the formation of prices: posted prices, prices determined by auction, the different types of auctions, prices formed through negotiations, etc. These mechanisms repose on distinct processes, requiring different supports, arrangements and rules, and they likely translate in different transaction costs. Here again we do not have a clear picture of the procedures involved, the underlying logic and, above all, the comparative costs that result.

Fourth, market organization critically depends on enforcement mechanisms. New institutionalists have developed an extensive body of research on different enforcement mechanisms, from very informal ones, rooted in the beliefs and shared values of traders (Greif, 1993 and chap. 28 of this book; North, 2004) to more formal mechanisms of enforcement. North has played an important role in that respect, pointing out the crucial role of both formal and informal constraints for shaping markets.29 Among the formal mechanisms, two dimensions have been particularly explored that partially overlap: the role of legal regimes in establishing property rights (e.g., Alston, Libecap, and Schneider, 1996; Alston, Libecap and Mueller, 1997, pp. 145 sq.); and the role of the State as an enforcer of property rights on markets (Libecap and Wiggins, 1985; Barzel, 1999 and 2000).

The Costs of Using Market Organization

The neoclassical view of markets assumes these mechanisms as given and/or implementable at no costs. For example, notwithstanding their role in designing alternative solutions, which is the source of heated academic debates, mainstream economists have proposed no analysis that I know comparing the costs of the different institutional arrangements chosen for creating electricity markets, or the comparative costs of the different arrangements required by the distinct types of auctions used for selling licenses in the telecommunication sector. As a result, the mainstream approach misses substantial aspects of the importance and significance of the diversity of market organizations and the central role that supporting institutions play in their functioning, development, and success or failure. In the continuation of Coase (1937, 1960), NIE has clearly opened the way to the analysis of these underlying and indispensable mechanisms and to the examination of their costs.30 Here again the literature is considerable, and I touch only the tip of the iceberg.

28The tentative evaluation of transaction costs on the NYSE by Demsetz (1968) did not generate the flow of research one would have expected.

29For a synthesis of his ideas on this issue, see North, 1990, chaps. 5, 6, and 7.

30See for example Levy and Spiller (1994) and Joskow (1991; 1997) Although not always with due recognition of their debt to new institutionalists, mainstream economists are increasingly acknowledging the role of these institutions (e.g., La Porta et al., 1998).

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the complex arrangements associated to Internet. Costly devices allow these markets to exist and develop. Contracts are one of them.

Market contracting: Is There any Specificity?

Indeed, contracts represent an important arrangement for organizing market transactions. Of course, as shown in the previous sections, contracts play also a significant role in other modes of organization. However, their centrality may be specific to markets, besides and in connection with the price system. Firms rely mostly on the role of hierarchy for coordinating, while hybrids use contracts as a framework completed by complex institutional arrangements for planning their joint activities. In market transactions, there is not much besides contracts that parties can rely upon.

The question of whether or not market contracts are of the same nature than that characterizing firms or hybrids has generated controversies, following the provocative paper by Alchian and Demsetz (1972). In simplifying, two polar conceptions have developed. At one end of the spectrum, Benjamin Klein has continuously maintained that all contractual relationships are market relationships. In 1983, he stated: “The question what is the essential characteristic of a firm now appears to be unimportant. Thinking of all organizations as group of explicit and implicit contracts among owners of factors of production represents a fundamental advance” And again, in 2000 (p. 138): “. . . it is useful to think of all arrangements, including vertical integration, as forms of markets contracts chosen by transactors to supplement self enforcement when transactors have limited reputational capital”. In that respect, contracts on spot markets would represent the essence of all modes of organization. Williamson has adopted a distinctively different perspective on this issue. Coming from the Carnegie tradition (Williamson, 1996, chap. 1), for which firms matter, he has consistently emphasized the existence and role of discrete mechanisms of governance, with distinct forms of contracts for the different modes of governance. Referring to Macneil (1978), he has put at the forefront the specificity of the “classical contract law” that would characterize market contracts. “The emphasis [is] on legal rules, formal documents, and self-liquidating transactions” (1985, p. 69). As a result “. . . the specific identity of the parties is of negligible importance; substantive content is determined by reference to formal terms of the contract, and legal rules apply. Market alternatives are mainly what protect each party against opportunism by his opposite. Litigation is strictly for settling claims; concentrated efforts to sustain the relation are not made, because the relation is not independently valued” (id. p. 74). This characterization contrasts nicely markets contracts with arrangements prevailing in firms or in hybrids, and it is the view I have adopted in this chapter.

One important consequence of market contracts as arrangements in which the identity of parties does not matter, concerns the role of safeguards for protecting parties and of credible commitments for markets to operate efficiently. At least two different mechanisms are involved. One is market pressure: the existence of substitutes, which is essential to the existence of markets, disciplines parties. But

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because markets are not perfect, this is usually not enough to procure adequate safeguards. Hence the role of specific contractual clauses developed for protecting traders. “Hostage” clauses intend to reinforce credibility (Williamson, 1985, chaps. 7 and 8 [1983]). Third parties such as courts (Schwartz, 1992) and arbitrators (Rubin, this book, chap. 9), and informal mechanisms such as reputation or trust contribute to the respect of market contracts, suspending a sword over the head of undisciplined parties.32 Once more we are back to the necessity of looking at institutions needed for markets to operate.

To summarize, the main lesson learned from the extensive new institutional literature on markets is that they are all but “black boxes”. (1) Markets can take many different forms, a neglected issue that requires further investigation.

(2) They share fundamental characteristics only partially summarized by the price system.33 (3) They are costly to use. (4) They require a dense web of institutions in order to develop. In that respect, and like the other modes of organization, they have flaws of their own, which makes them part of the continuous tradeoff among institutional arrangements that characterize a complex market economy.

6. SOME UNSOLVED PROBLEMS

The previous sections summarize a fraction of the contributions of NIE to the analysis of the different modes of organization supporting transactions in a market economy. Notwithstanding its limitations, this survey illustrates how substantial these contributions are. Progress made has also exhibited grey areas and domains of divergence that are likely to generate new research. I conclude this chapter by a short review of some of these issues.

The Contractual Divide

The role of contracts in the analysis of organization emerges as a central theme in recent literature, and new institutionalists have played a pioneering role here (Brousseau and Glachant, 2002). However, and without overemphasizing the divergences, several problems persist regarding the nature and status of contracts. First, the question of their importance with respect to other devices remains open. The answer may be partially semantic depending on how extensively one defines contracts.34 However, it has also a crucial analytical implication: Do contracts tell us the essentials of what we need to know about organizations? Alchian,

32The role of trust remains controversial. For two opposite views, see Zucker, 1986 and Williamson, 1993.

33As firmly stated by Demsetz (1988a, p. 159): “What parades as perfect competition is a model that has much to say about the price system, but little to say about competition or the organization of firms. [ . . . ] What is modeled is not competition, but extreme decentralization”.

34Personally, I endorse the definition provided by Macaulay (1963, p. 31): “Contract, . . . , involves two distinct elements: (a) rational planning of the transaction with careful provision for as many future contingencies as can be foreseen; and (b) the existence or use of actual or potential sanctions to induce performance of the exchange or to compensate for non-performance.”

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Demsetz, Klein, among others, argue that contracts provide the fundamental characteristic of all trading activities in a market economy, with firms or hybrids viewed as subsumed markets. The concept of the firm as a nexus-of-contract illustrates, with no role for authority. Williamson has adopted a more nuanced position, more in line with the organization theory perspective: contracts permeate all forms of organizations, but they tell only part of the story. I have clearly endorsed this position here, emphasizing the incompleteness of contracts and the existence of complementary devices. But the question remains open.

Second, there is the problem of determining if contracts differ across modes of organization. This chapter adopted the view that there exist discrete organizational structures, with properties of their own. If so, one expects contracts to exhibit substantial differences according to the type of arrangement in which they are embedded. Several neo-institutionalists (as well as mainstream economists) disagree. Once more, the contrast in the initial positions adopted by Alchian and Demsetz (1972) and Williamson (1979) is illustrative: the former defended the idea that all contracts share the same fundamental properties,35 while the later endorsed the typology proposed by Macneil (1974), differentiating contracts along modes of organization. Further developments, in theory and in empirical studies, are needed, to make the decision.

Third, the question of the incompleteness of contracts remains controversial. This issue particularly concerns the relationship between new institutionalists and mainstream economists. The former share quite unanimously the view that contracts are “unavoidably incomplete”, with non-contractible decisions both ex-ante and ex-post (Williamson, 1993, section 5). This question is crucial. If complete contracts provide the adequate unit of analysis, all relevant actions concentrate in the ex-ante incentive alignment, making ex-post governance largely irrelevant. Therefore, the study of contracts would be what matters while studying the “structural properties” of different modes of organization would at best be a minor issue. In a NIE perspective, the challenge is to model behavioral assumptions in order to provide microfoundations to incompleteness.

The Role of Specific Assets

Another controversial issue concerns the attributes of transactions that determine their costs and the weight of these attributes in the choice and/or fitness of a mode of organization. A series of papers on the paradigmatic case of the relationship between Fisher Body and General Motors in the 1920s recently reignited the debate. I do not intend to summarize this controversy.36 I simply want to point out its importance for the analysis of organizations.

35Hence the provocative statement by B. Klein (1983, p. 373): “The question what is the essential characteristic of a firm now appears to be unimportant. Thinking of all organizations as group of explicit and implicit contracts among owners of factors of production represents a fundamental advance.”

36The main elements of the debate are exposed in the April 2001 issue of the Journal of Law and Economics. Several chapters in this Handbook refer to the GM-FB case (e.g., Joskow, chap. 13; Klein, chap. 17)

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In his 1937 paper, Coase linked the decision to integrate and the effort to economize on costs that the price system may impose on transactions. When the idea caught up, in the 1970s, two interpretations developed. Williamson (1975; 1979) established the well-known model identifying the three major attributes that would determine transaction costs: asset specificity, uncertainty, and frequency (see my section 2). At about the same time, Klein et al. (1978) argued that the main explanation to vertical integration was the risk of hold up from opportunistic partners once specific investments have been made. They illustrated with the decision of General Motors to integrate Fisher Body in 1926, which ended a long contractual relationship. This example has become a paradigmatic case, referenced in innumerable papers (Bolton and Scharfstein, 1998). The view developed in Klein et al. converged with Williamson’s emphasis on the role played by contractual hazards in the tradeoffs among modes of organization, and with the development of empirical studies and econometric tests that largely focused on specific assets as the main source of these hazards.37 This is what Coase has repeatedly challenged, since 1988 (1991, chap. 5), using the Fisher Body-General Motors case to defend the role of uncertainties and, above all, of human assets (in this case, the Fisher brothers) for explaining the decision to integrate.

This debate raises important issues for the theory of organization. One points the need for more extensive analyses and more sophisticated models of the determinants of transaction costs, and how they affect the choice and performance of different modes of organizations. Uncertainty and the role of human assets deserve particular attention in that respect. Second, we need more empirical studies, identifying and measuring relevant proxies in order to assess the role of these variables and their impact. As noted by Masten et al. (1991) and Joskow (Chap. 13, this book), most tests so far have focused on the role of specific investments, at the sector level. Looking at other variables and digging into data at the firm level or at the level of inter-firm agreements involve difficulties that need to be dealt with.

Digging Deeper in Organizational Arrangements

The initial research program in the micro-analytical branch of NIE focused on the tradeoff between markets and hierarchies. History explains this agenda: in arguing that there are situations in which firms may efficiently prevail over markets in organizing transactions, Coase challenged the conventional wisdom about the superiority of markets. For those convinced by the argument, making it operational and testing it was a legitimate priority. However, it has become increasingly clear that a satisfying explanation of why and under what circumstance one mode of organization overcomes another one requires investigating the internal characteristics of these arrangements. Some key issues are summarized hereafter.

37 Beside theoretical problems, practical factors explain these developments, e.g., available data, easiness in defining proxies, etc. Joskow (chap. 13) discusses some of these issues.

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First, we need more studies on how the internal organization of labor within a firm might affect “administrative costs” in comparison to the costs of taking advantage of specialization through markets. Although Williamson (1975, chap. 4 and 5; 1985, chap. 9) raised the issue, few studies followed that would use transaction costs lenses.38

Second, with the exception of Williamson and Demsetz, few new institutionalists have paid attention to the classical problem of the separation of ownership and management.39 However, the varied institutions of corporate governance likely have an impact on the internal costs of organizing transactions. Demsetz (1995, commentaries 2,3 and 6) suggested that if operating in properly designed institutions, managers may save on transaction costs by their capacity to combine and develop dispersed knowledge. Further studies are needed here.

Third, a transaction cost approach to financial issues within firms and among hybrids remains to be developed. Alchian and Woodward (1987) briefly discussed the trade-off between debt and equity, noting that when risks of hold-up are high, users will have an incentive to own rather than to rent more exposed resources and will rather finance through equity than debt. Williamson (1988a; 1988 b) proposed a similar analysis, linking the choice between debt and equity to the redeployability of assets to be financed. However, few developments have followed these intuitions.

A fourth dimension that requires further exploration involves how transaction costs affect the selection of incentive mechanisms. Empirical evidences suggest that contracts for aligning interests of agents and principals are relatively simple and complemented by other motivational devices. Most new institutionalists share with mainstream economists the view that formal organizations have lower incentives than markets, since on markets agents can cash directly the results of their efforts (Williamson, 1996, p. 105). However, if the replication of market incentives (“selective intervention” in Williamson’s terminology) is not possible, what factors allow firms to overcome costs of control and perform better than markets under some circumstances? The answer likely lies in the combination of organizational incentives, e.g., bonuses, job design, work rules, tasks assignments, strategic plans, delegation of power, information channels, corporate culture, and so on (Aoki, 1988, chap. 3 and 8; Holmstrom, 1999). Clearly, an institutional approach can improve our understanding of these issues.

One last problem, which attracted the attention in NIE earlier but has been neglected later on, concerns the emergence of new organizational forms, the evolution of existing ones, and their interaction with institutional changes. As early as 1975 (chap. 8), Williamson reinterpreted Chandler’s view on large

38For example the suggestion (Williamson, 1988; Alchian and Woodward, 1987, p. 120; Aoki, 1988, chap. 5; and M´enard, 1997, pp. 40 sq.) that highly specific human assets are more exposed to contractual hazards so that they are likely to look for safeguards such as representation on the Board presumably have a significant impact on the internal organization and its costs. But we know almost nothing about this.

39The classic reference for this problem is Berle and Means (1934). This relative disinterest is particularly surprising if one notes a comment by Demsetz, according to which “. . . ownership of even the largest U.S. corporations is more concentrated than Berle and Means’ discussion of the separation issue would lead one to believe” (1995, p. 63).

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