chapter  6
27 Pages

Comparing legal and alternative institutions in finance and commerce

ByFRANKLIN ALLEN AND JUN “QJ” QIAN

Transiting from a central-planning to a market-based economy, China’s economic achievements in the past three decades have been remarkable. Its economic growth, lifting hundreds of millions of people out of poverty in the process, represents one of the greatest economic transformations in history. India is also successful in terms of economic growth during the past two decades. At the end of 2007, China and India together accounted for 40 percent of the world population and about 20 percent of the world GDP in Purchasing Power Parity terms. With growth rates among the highest of all countries, these two countries will play an increasingly important role in the world economy for years to come. The conventional wisdom is that to be successful in terms of long-run eco-

nomic growth a country needs good institutions. In particular, it needs a good legal system that enforces contracts and resolves disputes and a good financial system including financial markets and a banking sector to fund firm growth. In earlier work (Allen, Qian, and Qian (AQQ) 2005, 2008; Allen, Chakrabarti, De, Qian, and Qian (ACDQQ) 2008), we have documented that China and India do not have these. In fact, the governments of these countries are notoriously corrupt, the legal systems are ineffective, and the financial markets and banks are small relative to their economies and inefficient. Most observers would characterize the economic performance in China as

“successful despite the lack of Western-style institutions.” By contrast, we argue in this chapter that China has done well because of this lack of Westernstyle institutions – in that conducting business outside the legal system in fastgrowing economies, such as China and India, can actually be superior to using the law as the basis for business transactions. We develop our main theses by comparing and contrasting two different sets of systems, with the focus on dispute-resolution and contract-enforcement mechanisms. In one system, observed in developed and democratic countries such as the US, there is a commitment to use the law as the basis for finance and commerce, with legal institutions serving as the ultimate source for resolving disputes and enforcing

contracts. Moreover, any fundamental changes to the law must be approved by the legislature and electorate. In the other system, with China providing the primary example, there is no clear definition of private property rights at the highest level and, in place of the law, nonlegal mechanisms based on reputation, relationships, and trust rather are the norm for conducting business.3