[Paleopsych] Legal Affairs: Common Denominator By Nicholas Thompson

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Common Denominator By Nicholas Thompson

     Using sophisticated mathematical models, a group of four economists
    has proven that a country's legal history greatly affects its economy.
     At least they think they've proven it. How their sweeping theory has
                          roiled the legal academy.
                                        By Nicholas Thompson

    called siblings. The adjacent Southeast Asian nations possess similar
       natural resources and their citizens speak similar languages and
    follow similar strains of Islam. But Malaysia's economy is prospering
    while Indonesia's is floundering. Malaysia's stock market is far more
     vibrant than its neighbor's, and its average resident is three times
      Economists might explain these divergent paths by pointing to the
     countries' different responses to the Asian financial crisis of the
       mid-1990s. Sociologists might find a cultural explanation in the
     close-knit community of Chinese immigrants who are the most powerful
      force in Malaysia's business community. Historians might point out
     that Malaysia's struggle for independence was much less bloody than
      Another explanation lies in the countries' legal systems, however.
      Malaysia was a British colony and its legal system is based on the
     common law: the set of rules, norms, and procedures that has guided
      the legal system of England and the British Empire for about nine
     centuries. Indonesia was a Dutch colony and its legal system derives
    from French civil law, a set of statutes and principles written under
       Napoleon in the early 19th century and imposed upon the lands he
                    conquered, including the Netherlands.
     According to research published by a group of scholars beginning in
     1998, countries that come from a French civil law tradition struggle
    to create effective financial markets, while countries with a British
     common law tradition succeed far more frequently. While the scholars
      conducting the research are economists rather than lawyers, their
    theory has jolted the legal academy, leading to the creation of a new
    academic specialty called "law and finance" and turning the authors of
     the theory into the most cited economists in the world over the past
    The evidence supporting their theory is hardly absolute. For starters,
    some civil law countries handily outperform common law ones. Although
    it may not stack up well against Malaysia, Indonesia looks positively
    affluent when compared with common law countries like Ghana or Sierra
      Leone. The logic underlying the theory isn't universally accepted
     either. Legal and economic scholars alike have attacked nearly every
     premise and conclusion, though the frequency and fury of the attacks
      seem to be evidence as much of its importance as of its flaws. If
    true, the theory provides more than just a new way of looking at legal
    historyit also gives Indonesians gazing across the South China Sea at
       their far richer neighbor insight into how they might catch up.
     comes from four economists who are referred to in their field by the
    acronym LLSV: Rafael La Porta of Dartmouth's Tuck School of Business,
     Florencio Lopez-de-Silanes of the Yale School of Management, Andrei
     Shleifer of Harvard's economics department, and Robert Vishny of the
      University of Chicago's business school. Though the law is at the
      heart of their theory, none of the scholars has a J.D. "We're all
              lawyer wannabes," Lopez-de-Silanes said recently.
    Shleifer organized the group, and he's the best known of the four. In
     1975, at age 15, he immigrated to the United States from Russia and
      soon entered Harvard, claiming to have learned English by watching
      Charlie's Angels on television. He earned tenure at Harvard before
     turning 30. In 1999, Shleifer won the John Bates Clark medal as the
    most accomplished economist under 40, an award second in prestige only
       to the Nobel Prize in the profession. He's also recently gained
        notoriety for a scandal over whether it was illegal for him to
      personally invest money into the same Russian markets that he was
       helping to design in the mid-1990s, while funded by a government
    Shleifer and Vishny were graduate students together at the University
       of Chicago, and in 1994 they founded an investment firm that now
    manages about $25 billion. Shleifer later met Lopez-de-Silanes and La
    Porta when they were his students at Harvard. Asked how much the group
       knew about common law and civil law when the project commenced,
      Shleifer said, "Nothing, literally." But the scholars did have an
      instinct that the nature of laws could explain important national
     differences. Three of the group's four members grew up in countries
     whose economies collapsed in their adult lives in large part due to
        corruption that legal systems failed to stop: La Porta is from
       Argentina, Lopez-de-Silanes is from Mexico, and Shleifer is from
       LLSV's initial work examined why some government regulations of
       markets succeed in creating and maintaining an environment where
    people want to invest, and others don't. Intrigued by what seemed like
    patterns related to legal history, LLSV built a database that included
      every country with a stock market in the world and then classified
    each country's legal origins. The group then ran mathematical tests to
     determine correlations between legal origin and other variables like
      measures of corruption and indices of shareholder rights. In 1998,
       their first major paper, "Law and Finance," set off a firestorm.
     theocratic law, for examplemost countries' legal systems derive from
     either French civil law or English common law. Legal scholars had of
     course already cataloged the differences between the two, but until
     "Law and Finance," no one had tried to link these differences to the
         success or failure of financial markets. Nor had anyone ever
       mathematically examined the differences between the two systems.
    LLSV's main tool was regression analysis, a mathematical technique in
     which many variables are plugged into a program that sorts out which
    ones are correlated and which ones are not. Using regression analysis,
    for example, you could plug in the heights, weights, and eye colors of
        100 people. The results would show that height and weight are
     correlated (the taller you are, the more you're likely to weigh) but
                      that weight and eye color are not.
     Using this tool, "Law and Finance" showed that common law countries
        protect both shareholders and creditors better than civil law
    countries do, and they also tend to be less corrupt. LLSV took dozens
    of specific financial indicatorsranging from key gauges, like the odds
     that a company's assets will be confiscated by the state, to smaller
     measures, like whether shareholders can vote at company meetingsand
     regressed them all against legal origin. The regressions showed that
     the measures that indicate high investor and creditor protection or
     low corruption connect to common law origin, just as height connects
        to weight. The measures that represent low protection and high
                   corruption connect to civil law origin.
     The regression didn't show that common law necessarily makes people
     richer, but it did represent a crucial link in a chain of logic that
    could connect legal origin to prosperity. When shareholders have more
    rights, people are more likely to invest in markets, because they have
      more protections against dishonest executives. When creditors have
     more rights, they are more likely to lend money, which spurs markets
     to grow. And when countries are free from corruption, investors put
    more money into them. The LLSV scholars weren't the first to recognize
      that shareholder and creditor rights spur economic growth, or that
        corruption stunts it, but they were the first to connect these
     conditions to a country's legal system and to do so using cold, hard
     THERE'S NOTHING IN THE COMMON LAW PER SE that significantly protects
       shareholderscommon law doesn't come with a shareholder's bill of
     rights. Nor is there a mandate for corruption embedded in civil law.
       "Law and Finance," then, raised as big a question as the one it
       claimed to answer: Why is a country's legal system so powerful a
               factor in determining its economic development?
    In subsequent papers, LLSV has set out to solve that mystery. The most
      compelling theory they've developed has to do with the power both
     systems afford their judiciaries. Common law judges are, on balance,
      far more powerful than their counterparts in civil law countries.
     Since judges tend to be a country's most reliable check on the other
      parts of its government, common law countries grant less power to
       their executives than civil law countries do. And in developing
          nations, corruption is generally perpetuated from the top.
    The difference in the power that the two systems grant their judges is
     rooted in their respective histories. French civil law derives from
      the Napoleonic code, published in 1804 by scholars eager to wrest
     power from the judiciary. Before the country's revolution, France's
     courts had earned reputations for elitism and corruption. Influenced
     by popular discontent with much of the judiciary, Napoleon attempted
      to write a statutory code that was essentially judge-proof. Judges
     draw their influence from their power to interpret laws. Napoleon's
     code stripped them of this prerogative; his code favored the writing
          of a new law over a judge's interpretation of an old one.
     Consequently, compared to common law countries, civil law countries
                 have weak judiciariesand long statute books.
       Common law was similarly influenced by a violent revolution that
     pitted the people against the crown. But in the years leading up to
    England's Glorious Revolution in the late 17th century, the judiciary
    tended to side with the people and against the Stuarts, who had tried
     to eliminate an independent judiciary. When the revolution came, the
      new government gave the judiciary far more power than France did a
       century later. Courts could interpret laws and even overrule the
                              executive branch.
      Legal historians didn't need LLSV to tell them all this. They knew
    that common and civil law countries differ fundamentally in the roles
    that judiciaries play. But LLSV was hardly content just to recite the
    old histories and anecdotes. They went back to their calculators and,
         in a 2003 paper titled "Judicial Checks and Balances," they
    demonstrated mathematically that common law countries give judges more
        independence, which in turn correlates with the sound economic
     policies they had examined in "Law and Finance." The paper compared
     factors like whether judges in a country's highest court system have
      life tenure against measures of what LLSV called economic freedom,
    such as whether people have secure property rights. The numbers showed
     that judicial independence closely correlates with common law legal
        origins. It also correlates strongly with economic freedom and
                             investor protection.
      Again, the idea that judicial independence was related to economic
      freedom wasn't revolutionary. You can find arguments for judicial
     independence in The Federalist Papers. But James Madison didn't back
                  up his theories with regression analysis.
     built on it, as co-authors publishing close to a dozen papers since.
      According to Essential Science Indicators, a research service that
     tracks publications, over the past 10 years, Shleifer's papers have
       been cited more frequently than any other academic writing about
         business or economics topics. Vishny is a close second, with
          Lopez-de-Silanes in seventh place, and La Porta in eighth.
       From their first publication, the quartet had clearly uncovered
       something deeply original and surprising, and the legal academy
      reacted with a combination of fascination and disdain. Lawyers are
          generally trained to answer narrow questions with detailed
      intellectual or historical analysis. LLSV had ventured to answer a
     far-reaching question with sweeping mathematical analysis, and they
      had done so in a decidedly pro-market framework. ("We use the term
     'good' in this paper to stand for good-for-capitalist-development,"
     they wrote in one paper.) Their approach pricked up the ears of the
     legal academyand raised its hackles. Soon after the first drafts of
    "Law and Finance" began circulating, LLSV was presenting the paper at
    conferences around the world and, according to La Porta, receiving "a
                              lot of hate mail."
     "The first time that I saw LLSV's work I had two thoughts. The first
     was, Why didn't I think of this? It's such a simple, brilliant thing
       to do," said Mark West, a professor of law at the University of
    Michigan. "The second thought was: This is just way too simple. . . .
    I can't run regressions [analyzing] the houses in my subdivision. They
                    are running regressions on countries."
      West has published a widely read paper mocking LLSV's work. "LLSV
      controlled for GDP growth and the logarithm of real GNP," he notes
       dryly. "In this model, I control for a potentially more relevant
    development-related factor in this context: the number of professional
     soccer players per capita." With bravado no doubt inspired by LLSV's
     work, West then takes the parody a step further, attempting to prove
         that civil law countries fare better than common law ones in
     international soccer tournaments. The paper is the most widely read
        comment on LLSV's work on the Social Science Research Network.
    But West has launched substantive attacks on LLSV's actual findings as
    well, believing that they have relied heavily on oversimplification in
      order to make their analyses work. He points to Japan, which LLSV
      codes simply as a German civil law country. But the foundation of
    Japan's legal code comes from China. Some of it did come from Germany
       during the late 19th century, but still other sections came from
      elsewhere. The laws covering corporate conduct, for example, were
    imported from Illinois state law by professors from the University of
      Chicago during Japan's postwar reconstruction. "You can't code an
    entire legal system with all of its societal baggage into one entry on
               a spreadsheet," said West. "That's just wrong."
    Other scholars don't question the data so much as the hypotheses LLSV
         draws from it. They point out the thinness of the quartet's
      explanation that common law correlates with judicial independence,
      which in turn correlates with economic liberalism. "The puzzle was
         less the econometric results than their explanation for the
       differences. I think it's fair to say that most lawyers, whether
    trained in common or civil law countries, thought the explanation was
           naïve," said Ronald Gilson, a law professor at Stanford.
    The LLSV scholars admit that this latter point is a weakness that they
     have yet to fully resolve. Not all the links in their chain of logic
      are steel. Though they've shown that having a strong tradition of
     judicial review does correlate with sound economic regulations, for
     instance, it's a weak enough correlation that the authors know other
      factors are in play. Think again of height and weight: The two are
    related, but there are other variablesa fondness for exercise, a taste
         for chocolate crullersthat can determine how much you weigh.
    have little patience, however, for most of their critics in the legal
     academy, who they believe look through microscopes, not telescopes.
     According to Lopez-de-Silanes, you can't come up with a theory about
      the way the world works if you're fretting over whether Canada has
    been miscategorized as a common law country because Quebec uses civil
     law. Lawyers worry about such issues, Lopez-de-Silanes said, so they
    don't have to come up with grand theories. "Lawyers don't do empirical
           work," said Shleifer. "They just argue with each other."
    Yet strong criticisms of LLSV's work have also been leveled by members
    of their own discipline. One of the most compelling critiques of their
       theory comes from economists Luigi Zingales of the University of
    Chicago and Raghuram G. Rajan of the International Monetary Fund. They
      argue that even if you accept that there are distinctions between
        countries with common law and civil law origins, that doesn't
          necessarily mean that legal origins are the cause of those
      distinctions. According to a paper Zingales and Rajan published in
     2003, France had a much more developed stock market than Britain or
        the U.S. in the early 20th century. It lagged for much of the
      remainder of the century, but is now catching up. If civil law is
        fundamentally flawed, you would expect that France would have
                   continued to lag at about the same rate.
      To Zingales, the differences that LLSV has shown may not come from
     something intrinsic to common law or civil law, but rather from some
        other correlated factor. Correlation is not the same thing as
       causation, especially when you are looking at complicated global
      trends. It is said that in the decades between the two world wars,
     German intelligence agencies divided the world into countries where
     people tucked in their shirts and countries where they didn't. That
       classification made some sense because people in industrialized
     countries feared that loose shirttails could get stuck in machinery.
    But it didn't mean that a country could mandate that its citizens tuck
     in their shirts and vault its way into the league of industrialized
    Similarly, common law may be linked to strong markets without causing
     them. Common law countries tend to speak English (a big advantage in
         the latter half of the 20th century, given American economic
      dominance) and tend to be Protestant (scholars dating back to Max
     Weber have connected Protestantism with hard work). Many historians
    also believe that the British did a much better job than the French of
     finding economically viable locations to set up colonies. "What LLSV
     has done is a very clever relabeling of things," said Zingales. "We
    all know that Anglo-American countries are different. You can call it
     the English language, the English tradition, and you can code it in
                             all sorts of ways."
    The LLSV scholars counter that they have built their regression models
    to try to take all of these variables into account. In one paper, they
    compared religious affiliation with legal origin and found that civil
      law origin has much more of an impact on markets than Catholicism
    does, just as height has more of an impact on weight than bone density
     does. It's not possible, however, to control a regression for every
    factor. Until they can come up with a clear and convincing explanation
    for what precisely it is about common law that causes the differences
        they've found, scholars will continue to assail their theory.
    THE POLICY IMPLICATIONS OF THE DEBATE over what factors spur economic
     success make it more than a shouting match echoing inside the ivory
    tower; they are what lured LLSV into the scrum. "I am from Mexico, and
       the first goal I have in my life is to make it look nice," said
     Lopez-de-Silanes. La Porta added that the quartet deliberately chose
      to look at variables that could lead to solutions. They wanted to
    avoid focusing on religion, for example, because converting a country
     from Catholicism to Protestantism isn't possible, at least not for a
     group of economists. Altering shareholder regulations, on the other
    hand, isn't out of the question. "[We] look at things that the policy
                      maker can change," said La Porta.
    It's not clear, however, that LLSV's work can translate into practical
        policy changein part because their work is so sweeping. Their
    contention is that civil law leads to profoundly flawed outcomesthat's
    not something a policy maker can easily fix. LLSV hasn't discovered a
    disease in the soil that, once identified, can be eradicated. They've
     discovered a more fundamental problem: There's something wrong with
         the region's climate. Consequently, LLSV can't offer an easy
      prescription. Civil law countries can't just switch over to common
     law, asking all their judges to throw out their code books. "If you
     fly into the Côte d'Ivoire, where the new government is just holding
     on by its fingertips, is the first thing out of your mouth going to
    be, 'Junk your legal system and adopt the British's'? Not even close,"
             said Roger Noll, an economics professor at Stanford.
      Though they may wish otherwise, LLSV has not produced a recipe for
    success that government ministers in developing countries can follow.
    What they have done is provide a giant statistical brief in support of
     the ideas of John Locke and James Madison, and they've updated those
    ideas for a world that's as interested in economic success as liberty.
       Creating a judicial branch that can check the executive and the
      legislature doesn't just protect individual rights and prevent the
    persecution of the government's political opponents. It improves your
                                stock market.
     If 18th-century reasoning can't convince modern constitution writers
       and lawmakers of the utility of protecting private property and
         putting judicial checks on other government branches, maybe
    21st-century statisticsand economic enticementscan. Indonesia's market
       won't improve if the new finance minister comes into office this
        winter with a list of regulations culled from LLSV papers. But
     Indonesia's stock market might improve over time if the minister has
    read LLSV's papers and thought about the larger principles of judicial
                independence and judicial review they espouse.
    This, at least, is the path being taken by the French government, for
    obvious reasons the most elegant and persistent defender of civil law.
      Initially, the French government ignored LLSV's findings. Then it
       dismissed them. Starting last summer, it began funding research
     through its Ministry of Rights and Justice into what the country can
                               learn from LLSV.

            Nicholas Thompson is a senior editor at Legal Affairs.
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