metadata: authors: 0: author: Djankov, Simeon
1: author: Glaeser, Edward
2: author: La Porta, Rafael
docna: 0: docna: The new comparative economics
docty: Policy Research Working Paper
subtopic: Social Policy,Legal Products,Judicial System Reform,Private Sector Economics,Common Property Resource Development,Private Sector Development Law,Legal Reform,Marketing,Legislation,Regulatory Regimes,Financial Structures
teratopic: Finance and Financial Sector Development
abstracts: cdata!: In recent years, comparative economics
            experienced a revival, with a new focus on comparing
            capitalist economies. The theme of the new research is that
            institutions exert a profound influence on economic
            development. The authors argue that, to understand
            capitalist institutions, one needs to understand the basic
            tradeoff between the costs of disorder and those of
            dictatorship. They then apply this logic to study the
            structure of efficient institutions, the consequences of
            colonial transplantation, and the politics of institutional choice.
repnme: repnme: The new comparative economics
display_title: The new comparative economics
listing_relative_url: /research/2003/05/2386464/new-comparative-economics
topicv3: Private Sector Development m1326060 1921,Common Law m1326145 2071,Personal Property Rights m1326571 1907,Market Discipline m1326726 1248,Civil Law m1327064 1044
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: PSICS
no_of_pages: 36
model_extractions: I POLICY RESEARCH WORKING PAPER 3054

# Abstract

In recent years, comparative economics experienced a revival, with a new focus on comparing capitalist economies. The theme of the new research is that institutions exert a profound influence on economic development. The authors argue that, to understand capitalist institutions, one needs to understand the basic tradeoff between the costs of disorder and those of dictatorship. They then apply this logic to study the structure of efficient institutions, the consequences of colonial transplantation, and the politics of institutional choice.

This paper-a product of the Private Sector Advisory Department, Private<sup>SectorDevelopmentVicePresidency-ispart</sup> of a larger effort to understand institutional differences in the regulation of<sup>business.Copies of the paper are available free</sup> from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact<sup>Gracia Sorensen,room 19-206, telephone</sup> 202-473-7088, fax 202-522-3480, email address gsorensen@worldbank.org.<sup>PolicyResearchWorkingPapersarealso</sup> posted on the Web at http://econ.worldbank.org. Simeon Djankov may<sup>becontactedat sdiankov@worldbank.org.May</sup> 2003. (27 pages) _The Policy Research Working Paper Series disseminates the findings of_<sup>_workin progress to encourage the exchangeof ideas about_</sup> _development issues. An objective of the series is to get the findings out_<sup>_quickly, even if the presentations are less than fully polished. The_</sup> _papers carry the names of the authors and should be cited accordingly. The findings,_<sup>_interpretations, and conclusions expressed in this_</sup> _paper are entirely those of the authors. They do not necessarily represent the_<sup>_view_</sup> _of_<sup>_the World Bank,its Executive Directors, or the_</sup> _countries they represent._ Produced by the Research Advisory Staff
# The New Comparative Economics

Simeon Djankov, The World Bank Edward Glaeser, Harvard University Rafael La Porta, Harvard University Florencio Lopez-de-Silanes, Yale University Andrei Shleifer, Harvard University

* We are grateful to Daron Acemoglu, Olivier Blanchard,<sup>Rafael DiTella, Simon Johnson,Peter</sup> Murrell, Katharina Pistor, Richard Posner, Dani Rodrik,<sup>GerardRoland, Lawrence Summers, and</sup> Daniel Treisman for helpful comments
# The New Comparative Economics

## TABLE OF CONTENTS

|**I.**|**Introduction.............................**<br>**I**<br>|
|---|---|
|**II.**|**BasicFramework.............................**<br>**3**<br>|
|**m.**|**Applications..............................**<br>**.9**<br>|
|**IV.**|**Transplantation............................**<br>13<br>|
|V.|**Politics............................**<br>**1**7<br>|
|**VI.**|**Conclusion:AppropriateInstitutions**<sup>**............................**</sup><br>19|

List **of Figures** Figure 1: Institutional Possibilities Figure 2: Legal Origins Figure 3: Progressive Reforms Figure 4: Transition Figure _5:_ Transplantation of Laws

**Table:** Correlations Between Regulation<sup>Measures</sup>
# **I. Introduction**

The traditional field of comparative economics<sup>deals mostly with the comparisonof socialismand</sup> capitalism'. Under socialism, the principal<sup>mechanismof resource allocationis central planning.Under</sup> capitalism, this mechanism is the market.<sup>Comparativeeconomics,which dates backat least to the</sup> discussions of market socialism in the<sup>193 Os,asks under what circumstances either the planor the market</sup> delivers greater economic efficiency<sup>and equality.</sup> By the time socialism collapsed in Eastem<sup>Europe and theSoviet Union,this questionlost much</sup> of its appeal. It was clear that socialism<sup>produced misery and inefficiency -not to mentionmass murder</sup> by the communist dictators who practiced<sup>it.Capitalism,in contrast,producedgrowthand wealth.With</sup> capitalism triumphant, is comparative<sup>economicsdead?</sup> The answer, we argue in this paper,<sup>is NO.Traditionalcomparativeeconomics has evolvedinto a</sup> new field. This field shares with its<sup>predecessor the notion that by comparingalternativeeconomic</sup> systems, we can understand better what<sup>makes eachof them work.But it sees the key comparisonsas</sup> being those of alternative capitalist models<sup>that prevailindifferent countries.Eachcapitalist economy has</sup> many public and private institutions.<sup>These institutions functionto choosepolitical leaders,to secure</sup> property rights, to redistribute wealth,<sup>to resolve disputes, to governfirms, to allocate credit, andso on.</sup> Political economy over the last two<sup>centuries, as wellas recentempirical research,demonstratethat these</sup> institutions differ tremendously and systematically<sup>among countries,withsignificant consequencesfor</sup> economic performance. The analysis of<sup>these differencesis the subject of the new comparative economics.</sup> In thinking about these issues, it is<sup>best to startfrom first principles.Since the days of the</sup> Enlightenment, economists agreed<sup>that good economicinstitutionsmust secureproperty rights,enabling</sup> people to keep the returns on their<sup>investment,make contracts,and resolve disputes. Such security</sup> encourages people to invest in themselves<sup>andinphysical capital, andthereby fosters economicgrowth.</sup> As Smith [1776] wrote, "in all countries<sup>wherethereis tolerablesecurity[of property], every manof</sup> common understanding will endeavor<sup>to employ whatever[capital]stockhe cancommand...In those</sup> unfortunate countries... where men are<sup>continuallyafraid of the violence of their superiors, they frequently</sup> bury and conceal a great part of their<sup>[capital]stock ... in case of theirbeing threatened with any of those</sup> disasters to which they consider themselves<sup>as at all times exposed."</sup> But there are two sides to the security of<sup>property rights.On the one hand,investment must be</sup> secured - typically by the government<sup>-from the expropriation by one's neighbors:thieves,competitors,</sup> or tort-feasors. Hobbes (1651) considered<sup>controlling privatedisorder -the war of all againstall -to be</sup> the central concern of the state. The<sup>problemsof disorder -crime, ethnic violence,squattertakings,</sup> bribery, investor expropriation, and so<sup>on -'continueto plague modemdeveloping countries.On the other</sup> hand, a government capable of protecting<sup>property againstprivateinfringementcanitself become the</sup> violator and thief. Smith refers to the<sup>violence from"superiors;"Montesquieu (1748)is even more</sup> explicit: "Great enterprises in commerce<sup>are not foundinmonarchical,but republican governments...An</sup> opinion of greater certainty as to the possession<sup>of property in these[republican] states makes[merchants]</sup> undertake everything... Thinking themselves<sup>sure of what they have already acquired,they boldly expose</sup> it in order to acquire more... A general<sup>rule:A nationin slavery laborsmore to preserve than toacquire;a</sup> free nation, more to acquire than to preserve."<sup>InEnlightenment thinking, a crucialaspect of securing</sup> property rights is the control of dictatorship.

> 1This field has its own category in the _Journal of Economic Literature,_ called Economic Systems. The subcategories are capitalist systems, socialist systems, socialist<sup>institutions,other economicsystemsand comparativeeconomic</sup> systems.
_The New Comparative Economics_ _2_ A fundamental problem of institutional design is the conflict between the twin goals of controlling disorder and dictatorship. Hobbes, most fearful of disorder, favored absolutism, but subsequent writers recognized that extreme solutions are generally suboptimal. The framers of the U.S. constitution realized that dealing with disorder and localism through a more powerful central government directly conflicts with the objective of restraining the sovereign (Hamilton, Madison, and Jay 1788). This concern with institutional design continues in modern writing, most importantly in institutional economics (Hayek 1960, Olson 1965, 2000, Demsetz 1967, North 1981, 1990, North and Weingast 1989) and public choice (Buchanan and Tullock 1962). In addition, empirical studies confirm the close relationship between good institutions and economic development (De Soto 1989, De Long and Shleifer 1993, Besley 1995, Easterly and Levine 1997, 2003, Knack and Keefer 1995, Acemoglu et al. 2001, Rodrik et al. 2002).

The interest in institutions revived with the collapse of socialism, and the transition of the economies in Eastern Europe, the former Soviet Union, and China to capitalism. The transition experience has been diverse. Many countries of Eastern and Central Europe, especially Poland, Slovenia, Hungary, and the Czech Republic, successfully established both secure democracies and many of the legal and regulatory institutions of capitalism during the 1990s. They grew rapidly, and are expected to fully integrate into Europe over the next several years. Countries further East, such as Romania and Russia, also moved to establish democracies and market institutions, but their experience has been more complex. Some of the Asian countries, from Kazakhstan to China, did not embrace democracy, but undertook significant economic reforms and grew, in China's case spectacularly. Finally, several transition economies, including Cuba, Belarus and many countries of Central Asia, did not reform and stagnated.

> Early discussions of the transition experiences focused on the speed of reforms - big bang versus gradualism - as a crucial determinant of performnance. Although it is now clear that the absence of reform - as in Belarus and Cuba - is associated with both economic and political stagnation, the emphasis on speed turned out to be excessive. The important differences among countries had more to do with the

> effectiveness of the newly created institutions (Murrell 1995). The countries of Central Europe succeeded

> in creating successful institutions of both democracy and a market economy. Russia - having moved as fast or faster on many of its reforms - also established a successful democratic government, but faced

> greater problems of corruption and capture, and began growing only recently.

These divergent experiences raised many questions. Some of them dealt with controlling disorder. How much government ownership is desirable? Poland, the Czech Republic, and Russia privatized extensively; China retained large state industries, yet grew the fastest. How much should governments regulate? Transition saw both successful regulation and degeneration of regulation into corruption and selective abuse of new business (Frye and Shleifer 1997, Hellman, Jones, and Kaufmann 2003, McKinsey 1999). How much should the government fight disorder at all? Many writers saw public institutions as having limited use, and stressed private orderings as the means of securing property and contract (McMillan and Woodruff 1999, Johnson, McMillan, and Woodruff 2002, Allen, Qian, and Qian 2003, Murrell 2003).

Other questions focused on dictatorship. For starters, is democracy the best political system for economic reform or is dictatorship efficient when radical change is required? China's economic success under communism, contrasted with the difficulties of Yeltsin's democracy in Russia, animated the advocates of one party rule; the successes of democracies of Central Europe pointed in the opposite direction. Within democracies, do reforms proceed better under divided or consolidated governments? Many economists assumed that consolidated government is better for reforms, yet here again, the deeply divided governments of Central Europe had the most success (Hellman 1998). Is a federal structure desirable from the viewpoint of economic transformation? Scholars of China credited its federalism and resulting competition among regions with the success of reforms (Jin and Qian 1998, Roland 2000); scholars of Russia saw its federalism and the resulting conflict between the regions and the center as a key obstacle to stability (Shleifer and Treisman 2000, Blanchard and Shleifer 2001, Zhuravskaya 2000).
_3_ _The New Comparative Economics_ What can one make of these questions? First,<sup>the standard economicquestions of market failure,</sup> and inefficiencies associated with<sup>it, have playedvirtually no rolein the centraldebatesof transition.</sup> Rather, the central issues have all dealt<sup>withproperty rights:how these rights can best be securedagainst</sup> both public and private expropriation?<sup>Second,wesee inall these questions a common tradeoff.On the</sup> one hand, there is the objective of controlling<sup>disorder,thatpushes toward greaterstateintervention.On</sup> the other hand, there is the goal of controlling<sup>dictatorship,that pushesagainst statepower.In the rest of</sup> the paper, we explore this tradeoff.

To this end, we present a framework describing<sup>thetradeoff betweendictatorshipanddisorder,and</sup> apply it to the problem of social control of<sup>business.We argue that the four common strategies of such</sup> control: private orderings, private litigation,<sup>regulation,andstate ownership,canbe thought of as pointson</sup> the institutional possibility frontier, ranked<sup>interms of increasing powers of thestate.Thesestrategiesare</sup> associated with progressively diminishing<sup>social costsof disorder,and progressively risingsocial costsof</sup> dictatorship. We use this framework to<sup>analyzeefficientinstitutionalchoice, andto argue thatit provides</sup> useful empirical predictions as well<sup>as guidancefor reform.</sup> But the efficiency perspective is not the only<sup>way to think about institutionalchoice.A key reason</sup> for institutional inefficiency is the transplantation<sup>of institutionsthroughconquest andcolonization. Many</sup> countries have inherited their legal systems.<sup>Aninstitution which intheorigin country respectsthe delicate</sup> tradeoff between dictatorship and disorder<sup>may not, once transplanted, remainefficient.This view of</sup> colonial transplantation may shed light<sup>onthe amazing consistency with whicha givencountry regulates</sup> different activities, as well as on some<sup>institutional pathologies.In addition,as boththe Marxist andthe</sup> public choice literature have long recognized,<sup>governmentschoosepolicies andinstitutions to benefits</sup> themselves - to stay in power and to get rich.<sup>The politicsof institutional choicemay also explain the</sup> inefficiencies.

We describe our framework in Section II<sup>andillustrate it in SectionHI.SectionIV focuses on</sup> transplantation, and Section V on<sup>politics. SectionVIconcludes.</sup>

# **IIL** Basic Framework

The two central dangers that any society faces<sup>are disorderand dictatorship.By disorder we mean</sup> the risk to individuals and their property<sup>of privateexpropriationin theform of murder,theft,violationof</sup> agreements, torts, monopoly pricing,<sup>and so on.Disorder,in this framework,is alsoreflectedinprivate</sup> subversion of public institutions, such as courts,<sup>through bribes and threats, whichallowsprivate violators</sup> to escape penalties. By dictatorship we mean<sup>the risk to individualsandtheir property of expropriationby</sup> the state and its agents in the form of murder,<sup>taxation, violationof property,andso on.Dictatorship,in</sup> this framework, is also reflected in<sup>expropriationthrough -rather than just by -the state,as withtheuse</sup> of regulators to eliminate entry by competitors.<sup>Somephenomena,suchascorruption,are reflectionsof</sup> both disorder and dictatorship: in so far as individuals<sup>pay bribes to avoid penaltiesfor harmfulconduct,</sup> corruption is a reflection of disorder, but<sup>inso far as officials createharmfulrules to collect bribesfrom</sup> individuals seeking to get around them,<sup>corruptionis a cost of dictatorship.2</sup> Institutions function to control the twin<sup>dangersof dictatorshipand disorder.Wefocuson a</sup> fundamental tradeoff inherent in such control:<sup>a statethat has enoughpowers to controldisorder alsohas</sup> enough for dictatorial abuse.

> 2Our discussion of dictatorship and disorder is related to the literature on rent-seeking and corruption (Tullock 1967, Posner 1974, Shleifer and Vishny 1993, Ades and<sup>DiTella1997).</sup>
_4_ _The New Comparative Economics_ Figure I - the basic building block of our analysis - depicts what we call the Institutional Possibility Frontier (IPF) for a society or a sector within it. On the x-axis are the social losses from a higher level of dictatorship (as opposed to gross amounts of such activities as taxation and government expropriation), measured relative to a world with perfect property rights. On the y-axis are the social losses from a higher level of disorder, again measured relative to a perfect property rights benchmark. We measure the costs of dictatorship and disorder in the same units of "social losses" to think about the tradeoff. The IPF reflects the institutional possibilities of the society: how much disorder can be reduced with an incremental increase in the power of the state. As in all standard neoclassical theory, the IPF is convex to the origin. In our framework, an institution - such as a legal or a regulatory system - is a point on the IPF.

**Figure 1: Institutional possibilities**

<!-- Start of picture text --> Social losses due<br>to private<br>expropriation<br>(Disorder)<br>Private orderings<br>Independent judges<br>Total loss<br>minim ization<br>Reguulatory state<br>45n {<br>Social losses due to state<br>expropriation<br>(Dictatorship)<br><!-- End of picture text --> In thinking about institutions, economists usually distinguish between written rules and their enforcement. In our framework, this separation disappears: a rule comes with its own enforcement properties, reflected in the equilibrium degree of dictatorship and disorder arising when this rule is used. If Russia regulates its monopolies through an anti-trust agency, there will be a certain residual amount of market failure, the equilibrium disorder, given by the waste from actual monopolists escaping the law and exercising their market power, as well as from their bribing the regulators to let them do so. There will also be a certain amount of public abuse of the private sector, the equilibrium dictatorship, associated with monopolists using the regulator to restrict entry by competitors, as well as from the agency's officials charging non-monopolists bribes in exchange for agreeing not to harass them.

The downward sloping 45 degree line in Figure I holds constant the total social costs of dictatorship and disorder. Its point of tangency with the IPF is the efficient institutional choice for a given society or a sector within a society. In much of our discussion, we focus on the efficient institutional choice for a given IPF. Efficient institutions could evolve from democratic pressures (Wittman 1989), from the influence of growth-seeking interest groups such as merchants (DeLong and Shleifer 1993), from a Coasian negotiation among the members of the elite, such as the Magna Carta or the American Constitutional bargain (Becker 1983), or from a long term evolutionary process described by Hayek (1960). Moreover, looking at efficient institutional choices does not mean that, in equilibrium, the society eliminates the problems of dictatorship and disorder. It does not. Consistent with Coase (1960), even the most efficient institutional structure retains residual levels of both dictatorship and disorder.
_5_ _The New Comparative Economics_ The shape and the location of the IPF --<sup>andhence the efficient choice -- varies acrossactivities</sup> within a society, as well as across societies.3<sup>An activity that involves repeated interactionsamong</sup> participants of roughly similar resources,<sup>and withlittletechnological change,such as diamond trading,</sup> can achieve order with little dictatorship<sup>(Bernstein1992). In contrast,anactivity likesecurity issuance,</sup> involving players with few repeated interactions<sup>and massive inequalities of power,is vulnerableto much</sup> more disorder for a given level of police.

Looking across societies, the differences<sup>loomevenlarger.The institutionalpossibilitiesof</sup> modem Sweden, or even China, are far superior<sup>to thoseof Albaniaor Congo.Swedencanpursueeither</sup> extreme laissez-faire policies or toy with<sup>socialism andstill achievedecent outcomes,Albaniacan choose a</sup> perfect balance of dictatorship and disorder<sup>for itsIPF, but property rightswould remaininsecure.For</sup> lack of a better term, we refer to location of<sup>the IPF as "civic capital," with theidea thatsocietieswith</sup> more such capital, and an IPF closer to<sup>the origin,arebetter capableof achievingcooperationamong their</sup> members. We use the term "civic capital"<sup>rather thansocial capitalbecausewe have something similar but</sup> broader in mind. We stick with the idea of<sup>capitalbecause investmentsin civiccapitalpay off in the</sup> medium run.

Recent historical research has made progress<sup>in understandingthe determinantsof civic capital.</sup> Landes (1998) continues the great tradition<sup>of stressingthe influenceof culture.Easterly andLevine</sup> (1997) and Alesina, Baqir and Easterly<sup>(1999) showhow ethnicheterogeneity,and the resulting ethnic</sup> strife, reduce institutional quality. Diamond<sup>(1997) and EngermanandSokoloff (1997,2002) stress the</sup> role of factor endowments and the physical<sup>environmentin shaping-and limiting -the institutional</sup> opportunities of a society. For instance,<sup>the environmentof LatinAmerica, unlike that of North America,</sup> was most hospitable to large scale agricultural<sup>technologies that bredsignificant economicand social</sup> inequalities, causing a long-lasting damage<sup>to the regions'sinstitutions. Acemoglu, Johnson,and</sup> Robinson (2001) argue that the mortality of<sup>Europeansettlersshaped settlement patternsandinstitutional</sup> outcomes. Putnam (1993) maintains that<sup>thelong run history of cooperationin a community -- its social</sup> capital -- determines the ability of its<sup>members to cooperatein theproductionof publicgoods.</sup> But there are some other, more prosaic,<sup>determinantsof civic capital. Technologyof production</sup> matters. When the scale of production<sup>and the paceof interactionamongindividuals rise, the opportunities</sup> for private expropriation expand, moving<sup>the IPF out. The technology of govemmentrepression -the</sup> efficiency of tax extraction and the monopoly<sup>onpower -influenceboth thelocationand the shapeof the</sup> IPF, because they determine how much<sup>dictatorshipis needed to reduce disorder both on averageand at</sup> the margin. Last but not least, the level<sup>of human capitalinthe societyis itself likely to determinethe</sup> location of the IPF, as better educated<sup>andinformed people maybe morelikely to solveproblemswithout</sup> violence.

Admittedly, civic capital is a somewhat<sup>vagueconcept,but manyaspects of it have been measured.</sup> We have already referred to the measurement<sup>of historical influences, whichare predeterminedfor many</sup> policy choices. Other aspects of civic<sup>capital,such ashuman capital,technology,or inequality, canbe</sup> changed in the medium run through public<sup>investmentsor largeinterventions,suchas land reform.For</sup> many reformns that economists focus on,<sup>however,includingsocialcontrolof business,thelocationof the</sup>

> 3Empirical growth studies generally confound the location of the IPF and the choice of a point on it under the rubric of "institutions," but for us it is important<sup>todraw thedistinction.In these empiricalstudies,"institutions"are</sup> measured with a variety of objective<sup>andsubjective assessmentsof institutional quality of a country, suchas law and</sup> order, risk of government expropriation, rule<sup>of law,corruption,efficiencyof the judiciary,or some combinationof</sup> these variables (Easterly and Levine 1997, 2003,<sup>Halland Jones1999,Kaufmann,Kraay,and Zoido-Lobaton2002).</sup> These variables are highly correlated with each<sup>other,and have proven to be strong predictorsof per capita income,</sup> economic growth, and many other "good"<sup>outcomes,but it is not entirely clearwhat they measure conceptually.</sup>
_6_ _The New Comparative Economics_ IPF is fixed in the short run. For the analysis of such reforns, civic capital is a constraint rather than a choice.

To think about the IPF and institutional choices in more concrete terms, consider the problem of social control of business. Suppose that "the society" wishes to reduce disorder from monopoly pricing, torts, predatory tactics, etc. There are four distinct strategies of such control, involving ever growing powers of the officials vis-a-vis private individuals: market discipline, private legal action through courts, public enforcement through regulation, and state ownership. They are shown as points on the IPF in Figure 1. These four strategies are not mutually exclusive: competition and regulation often operate in the same market, as do private litigation and public regulation. Moreover, intermediate strategies of social control of business, such as private litigation to enforce public rules, are available. Nonetheless, these four categories provide a useful analytical classification. I To illustrate these categories, take the example of social control of securities issues. Suppose that the society - through its institutions - has an interest in having broad and liquid securities markets and, to this end, deems it desirable that firms issuing equity disclose accurate information about their circumstances. The society has four choices.

First, it can rely on the incentives of issuers themselves, or of their underwriters, to disclose the truth about the securities because, to raise funds in the future, they need to establish a reputation for credibility. This is the market discipline solution.

Second, the society can rely on private suits by buyers of securities who feel that they have been cheated by the issuers, under the general doctrines of contract or tort. For this, the society needs a court and a judge. The question for the court is whether the issuer disclosed inaccurate information or, alternatively, negligently failed to provide material information.

Third, the society can designate a public regulatory agency, which mandates what should be disclosed by security issuers, inspects their books and disclosures, and penalizes issuers and underwriters who break the regulations. Between private litigation and full-scale regulation, the regulatory agency can establish the rules for security issuance, but leave the enforcement of these rules to private litigation by the wronged investors.

Fourth, the society can nationalize security issuance. A company wishing to raise capital would turn over the inspection, disclosure, and sale of securities to the state. These are the four basic institutional strategies for the enforcement of good conduct.

These four basic strategies differ in the degree of public control. With competition and private orderings, there is basically no public involvement. With courts, there is a role for impartial judges enforcing the rules of good behavior. These rules do not even need to come from legislation, but may instead derive from custom or from judge-made common law. Even so, there is a public agent - the judge - who has at least some decision-making authority. With regulators, control by the state rises sharply. The state now writes the rules, inspects the product before it is sold, and possibly penalizes sellers for delivering a bad product. Both the scope of government activity, and its centralization, are greatly increased relative to the judges. Finally, with state ownership, government takes complete control over an activity.

From the perspective of the tradeoff between dictatorship and disorder, the principal strength of market discipline as a method of enforcing good conduct is that it is free of public enforcers. There is no possibility of politicization of rules of conduct, of corruption, of costly and delayed enforcement of rules, of random or compromised choice of one competitor over another. But market discipline often fails to control disorder. Market participants use their economic, political, or social resources to damage their customers and rivals, relying on methods ranging from deception to predatory pricing to monopoly pricing to social exclusion to outright theft or violence. One man's peaceful private orderings become another
7 _The New Comparative Economics_ man's death in the hands of<sup>the mafia.Whenmarket disciplinecansuccessfully controldisorderandavoid</sup> Hobbesian anarchy, it works<sup>best becauseit minimizesthe socialcosts of dictatorship.As a corollary, any</sup> case for public intervention relies<sup>crucially on the presumptivefailure of market discipline to control</sup> disorder.

This case for the effectiveness of<sup>private orderings andmarketdisciplineis oftencompelling.</sup> Neighbors resolve disputes among<sup>themselves,without any governmentintervention,becausethey needto</sup> get along with each other over long<sup>stretchesof time(Ellickson1991).Industriesformassociationsthat</sup> assure quality for consumers,<sup>and penalizecheatersamong themselvesto assurethat consumers continueto</sup> patronize the industry (Greif 1989,<sup>1993,1994,Bernstein1992).Families,cities,and ethnic groups</sup> establish reputations in the marketplace,<sup>and penalizereputation-threateningmisconduct by their</sup> members. To the extent that market<sup>disciplinecancontrol disorder, regulation,orevencourts,are</sup> unnecessary.

But this is far from always being<sup>the case.Marketpressuresmaynot get ridof allmonopolies.</sup> Employers may under-invest<sup>in safety and thenblame accidentson an injuredworker's owncarelessness</sup> (Fishback and Kantor 2000).<sup>A fraudulentstock issue canseparate investorsfromtheirmoney very</sup> quickly, undermine confidence<sup>inmarkets, and runoff withthe cash.In theseinstances,tocontrol</sup> disorder, societies may efficiently<sup>accept ahigherlevelof governmentinterventionanddictatorship.</sup> The traditional libertarian response<sup>to these problemsis to move onenotchtowardmore</sup> dictatorship by turning to the enforcement<sup>of goodconduct throughprivatelitigationovercontractsand</sup> torts. Injured employees can<sup>sue their employersfor harm.Investorscan sueissuers andunderwritersfor</sup> damages when they believe that<sup>representationsabout securities were falseor incomplete.Ideally,a judge</sup> would recognize quickly whether<sup>investors havebeenmisled, andcompeltheissuer tocompensate</sup> investors for their losses. Such<sup>judicial enforcementof contractsand torts is seenby libertariansas a</sup> sufficient guarantee of security<sup>of property.</sup> Private litigation has many advantages.<sup>Inprinciple,suchlitigationis of no special interest to the</sup> government, and hence disputes<sup>canbe resolved apolitically,with no favors to influentialparties.Judges</sup> may also develop expertise in contract<sup>enforcement(as wellas inhandlingtort cases),andhence address</sup> problems efficiently and expeditiously.<sup>Thisis what Coase(1960), Nozick (1974),andPosner(1985)</sup> have in mind in making the<sup>casefor courts.</sup> The reality of litigation is, unfortunately,<sup>notso perfect, andthe tradeoff between dictatorshipand</sup> disorder is helpful for thinking<sup>about courtsas well.As with privateorderings,the powerfulandnot the</sup> just often get their way in court<sup>(Galanter1974).Somemechanisms of influencing courts,suchas hiring</sup> good lawyers, delaying proceedings,<sup>and(insomeinstances)seeking political help,are entirelylegal.But</sup> judges are also bribed with cash,<sup>benefits,or promisesof promotion,aswellas threatenedwith violenceif</sup> they do not favor the strong (Dal<sup>B6, DalB6,andDiTella 2002).When the rich and the politically</sup> connected influence the path<sup>ofjustice,litigationover contractsand torts cannot be countedonfor</sup> enforcing socially desirable<sup>conduct(Glaeser,Scheinkman,and Shleifer 2003).</sup> A common way of protecting judges<sup>frominfluenceis to formalizelawsandproceduresthrough</sup> codes, so as to minimize judicial<sup>discretionand thepotentialfor subversion.Such strategiescanbe</sup> thought of as a move along the<sup>IPF, as they reducedisorderbut alsooffer the statemore controlover the</sup> outcomes of litigation. A related<sup>mechanism for controllingprivatesubversionof courtsis to make judges</sup> employees of the state, whose<sup>careerconcernsprotectthem fromsuccumbing to outsideinfluence.But as</sup> judges become more dependent<sup>on thestate,the riskof politicizationof theirdecisionsrises,and so do the</sup> social losses from dictatorship.

This brings us to the third strategy<sup>of enforcing good conduct, governmentregulation.Regulation</sup> has been an anathema to libertarians<sup>such as Nozick (1974), whosee a sharpcontrastbetweenthe</sup> enforcement of rules by judges<sup>and thatbyregulators.Butinfact,the changetoa higherlevelof</sup>
_8_ _The New Comparative Economics_ dictatorship is incremental, and there is no profound conceptual distinction between litigation and regulation. The libertarian distinctions miss Coase's (1960) realization that the costs of enforcement shape the optimal institutional choice.

To make this continuity clear, note that a step short of full-fledged public enforcement, there is an important intermediate strategy, namely private enforcement of public rules. The government can create rules governing private conduct and then leave their enforcement to private litigation. Private enforcement of such specific statutes through litigation is often considerably cheaper than that of contracts or torts. It may be efficient, for example, for the government to specify appropriate safety standards but to let workers or consumers sue when they feel the standards are violated. Likewise, the government can mandate specific disclosures by a company issuing shares, but then leave litigation to investors. It may be cheaper for investors to establish in a trial that the company has failed to reveal specific information whose disclosure was mandated by law, than to prove the issuer's negligence in the absence of a statute.

Private enforcement of public statutes addresses a number of problems of disorder inherent in pure litigation. First, the burdens on the courts and the plaintiffs of proving liability (or the lack thereof) fall considerably when the statutes describe precisely what facts need to be established to do so. Second, subversion of judges becomes more difficult when they lose discretion. It may be relatively easy to convince a judge - by persuasion or bribery - that a security issuer who concealed important information from investors is not liable when there are no specific rules as to what needs to be disclosed. It is much harder to convince the same judge when the law states specifically what must be disclosed. Perhaps for these reasons, private enforcement of public rules is a highly efficient strategy of enforcing good conduct in some situations (Black and Kraakman 1996, Hay and Shleifer 1996, Hay, Shleifer and Vishny 1998).4 At the same time, the creation of public rules - even rules that are enforced privately - raises the risks of dictatorship. Such rules can be used to expropriate politically weak and to favor the politically strong. Mandatory safety precautions in factories, mines, and meat-packing plants during the progressive era in the U.S. at the beginning of the 20t century are sometimes interpreted as an attempt by large established firms to restrict entry by smaller rivals by raising these rivals' costs of regulatory compliance (Libecap 1992, Coppin and High 1999).

Compared to the enforcement strategies described above, public regulation has a number of advantages in controlling disorder. First, unlike judges, public regulators can be expert and motivated to pursue social objectives in specific areas. This, indeed, has been the principal argument for public regulation of securities markets (Landis 1938, Johnson, Glaeser, and Shleifer 2001). A regulator can become expert, for example, in what constitutes material omission from a prospectus, present market participants with specific rules, and then enforce them by imposing its own sanctions or by convincing courts to adopt its rules. Second, to the extent that regulators are empowered to complete the law, they may have an enforcement advantage relative to judges by acting preemptively (Pistor and Xu 2002). Third, because regulators can be incentivized by the sovereign to enforce social policy, they can in principle be much more difficult to subvert than the disinterested judges with either persuasion or bribes (Glaeser and Shleifer 2003). These differences render public enforcement more efficient than private enforcement in some cases.

> 4La Porta, Lopez-de-Silanes, and Shleifer (2002b) show that this is a key strategy for enforcing good conduct in security issuance in many countries. Barth, Caprio, and Levine (2003) show that private enforcement of public disclosure rules is a key strategy of bank supervision.
_9_ _The New Comparative Economics_ Alas, public regulation obviously<sup>has problems,the key one being public abuseof market</sup> participants by the officials<sup>whoare eitherpursuing their ownpoliticalinterestsorare capturedby a</sup> particular group, including<sup>the regulated industryitself (Stigler1971).Although motivated regulators</sup> might be more difficult to<sup>subvert than judges,regulated industrieshave developeda rangeof techniques</sup> to turn regulation into a mechanism<sup>of protectingindustry rents rather than public welfare.Therisks from</sup> dictatorship clearly rise as those<sup>fromdisorder decline.</sup> The basic implication of<sup>our theoryis thatregulationis onlynecessarywhen the levelof disorder</sup> is too high for private orderings<sup>and even courtsto dealwith successfully.The casefor regulationismost</sup> compelling when the problem<sup>of inequality of weapons betweenprivateparties involvedin a transactionis</sup> severe. Securities issuance<sup>isoneinstance; workplacesafetyis perhaps another.In contrast,entry of new</sup> firms into competitive markets<sup>isunlikely to require regulatory control(De Soto 1989, Djankovet al.</sup> 2002). Most regulations of<sup>competitivelabor marketsare likewisedifficultto justify onefficiency</sup> grounds (Botero et al. 2003).

Finally, in some situations,<sup>nothing short of government ownership caneliminatedisorder.If</sup> monopolies cannot be tamed<sup>by competitionor regulation,if qualityis essentialbut cannot be assured</sup> except with full state control, if<sup>public safetyis jeopardized-thentherecan bea plausiblecase for state</sup> ownership. Hart, Shleifer and<sup>Vishny (1997) arguethatprisons might be properlypublicly- rather than</sup> privately-owned because<sup>therisk thatprivate jailers mistreatinmatesis too high.Thisis so because</sup> inmates have few legal rights<sup>andcannot count on the market, the courts,or eventhe regulators to protect</sup> them. Likewise, the military<sup>andthe police tendto bestate-controlledbecause the likelihoodof disorder</sup> from private control is too high.<sup>The casefor the "statemonopolyon arms"is justa reflectionof a</sup> particular area where the<sup>tensionbetweendictatorshipanddisorderisresolvedby goingto anextreme.</sup> Although in some instances<sup>the casefor governmentownershipas ameans of dealingwith</sup> disorder is compelling, state<sup>ownershiphas the obviousproblems of dictatorship,illustrated by the</sup> miserable performance record<sup>of publicenterprisesandthe benefitsof privatization(Lopez-de-Silanes</sup> 1997, La Porta and Lopez-de-Silanes<sup>1999,Megginson and Netter2001,Djankov and Murrell2002).</sup> The failure of state socialism<sup>asaneconomicsystemrevealsmost dramaticallytheconsequencesof</sup> dictatorship taken to an extreme,<sup>in whichall economicproblemsaresolvedto maintainpoliticalcontrol</sup> by the communist party (Kornai<sup>1992).</sup> In summary, the framework<sup>presentedin FigureIenables us to discuss systematicallythe</sup> alternative forms of social control<sup>of business. As a consequence,it may providesomeusefulinputinto</sup> thinking about efficient institutional<sup>choices.In the next section,we put the model to work and examine</sup> three episodes of institutional<sup>design.In thefollowingtwo sections, wemove away theassumptionof</sup> efficiency, and examine alternative<sup>views of institutional choice.</sup>

# m. **Applications**

We examine three applications<sup>of the basic framework:thedivergencebetween Franceand</sup> England in the 12'h and 13<sup>th centuriesin their choicesof legalsystems, the rise of the regulatorystate in the</sup> progressive era U.S., and post-communist<sup>transition.In allthreeinstances,we focusonefficient</sup> institutional choice given the<sup>institutionalpossibilities of a country.</sup>

## _Legal Origins_

In the 12th and 13th centuries,<sup>EnglandandFrance establishedthe foundationsof their modern</sup> legal systems. These systems<sup>took ratherdifferent forms.Englanddevelopeda systemof commonlaw,</sup> characterized by fact finding<sup>by juries,relatively independent judges,infrequentappeals,and the reliance</sup> on precedents and judge-made<sup>law rather thanstrict codesin reaching judicialdecisions. France,</sup>
> _The New Comparative Economics_

_10_

> following the Roman tradition, adopted a system of civil law, characterized by fact finding by state-

> employed judges, automatic superior review of decisions, and later the reliance on procedural and substantive codes rather than judicial discretion. Over the centuries, some of these differences have been

> emasculated, others reinforced, but the basic differences among the two legal systems survive to this day.

Why did the two systems diverge? Glaeser and Shleifer (2002) argue that a crucial feature of any legal system is its vulnerability to subversion by the powerful (disorder). The greater are the pressures on courts to rule for the strong rather than the just, the more centralization (dictatorship) is needed to counter these pressures. On the other hand, greater centralization raises the cost of dictatorship: sovereigns rule according to their personal preferences and biases rather than the community standards or laws that the jurors follow.

> In the 1 2'h and **13 th** centuries, France was relatively decentralized and disorderly, with local notables successfully able to subvert all local institutions to their own advantage. England, in contrast, was relatively peaceful and the king maintained control over the entire country. To counter disorder, it was efficient for France to adopt a legal system with higher dictatorship than England, even at the cost of

> greater scope for sovereign abuse of the law.

Figure 2 illustrates the relevant choices, where we think of the French IPF as a shift out of the English IPF, but also as a tilt that made marginal increases in dictatorship highly productive in reducing disorder. The efficient choice for France was a legal system with a higher level of dictatorship. In equilibrium, France had a higher level of disorder as well, consistent with the notion that its institutional possibilities were less attractive. Glaeser and Shleifer (2002) further show that state employed judges, reluctance to rely on independent jurors, codification of rules and procedures, and nearly-automatic appeals are all complementary aspects of this choice of greater centralization and dictatorship to counter the problems of disorder.

**Figure 2: Legal origins**

<!-- Start of picture text --> Disorder<br>France<br>Civil law<br>Englan<br>Dicta to rsh ip<br><!-- End of picture text --> _The Rise of the Regulatory State_ Before 1900, significant commercial disputes in the United States were generally resolved through private litigation over contracts and torts. Courts ruled on corporate liability in industrial accidents, on anti-competitive practices such as railroad rebates, on safety of foods and medicines, and even on the constitutionality of the income tax. Between 1887, when Congress passed the Interstate Commerce Act, and 1917, when participation in the war put an end to the progressive movement, this situation changed radically. Over thirty years, reformers eroded I **9 th** century belief that private litigation was the sole
_11_ _The New Comparative Economics_ appropriate response to social<sup>wrongs.Duringthe progressiveera,regulatory agenciesat both the state and</sup> the federal level took over<sup>the social controlof competition, anti-trust policy,railroadpricing, foodand</sup> drug safety, workplace safety,<sup>and many other areas.The regulatory state was bornin the UnitedStates.</sup> Glaeser and Shleifer (2003)<sup>interpret this experience usinga modelintimately related to the</sup> framework of this paper. They<sup>arguethat the pre-Civil-WarUnitedStates was a relatively stablecountry,</sup> without great inequality among<sup>the potential litigants,so privatelitigation wasanefficientstrategyof</sup> social control of business (see<sup>Figure 3).But massive industrializationand commercializationof the</sup> American economy after the<sup>Civil War severelyunderminedcourtsas the sole institutionsecuringproperty</sup> rights. The rise of railroads<sup>andlargefirms greatly increaseddisorder:these firmsmaimedpassengersand</sup> workers, destroyed their competitors<sup>throughaggressiveandpossibly wasteful tactics,occasionally</sup> poisoned and deceived customers,<sup>andso on.The growthin disorder resulting fromthe greaterscaleof</sup> enterprise and rising inequality<sup>of wealthshifted the IPF of the economy out, renderingthe existingsystem</sup> of private dispute resolution inefficient.<sup>The robber barons commanded economicandpolitical resources</sup> that overwhelmed consumers,<sup>workers,or competitorswho complainedin court.They did so bothlegally</sup> -<sup>by bribing judges and legislators.Figure3 illustratesthe</sup> by hiring superior lawyers,<sup>and illegally -</sup> changes in the U.S. economy<sup>duringthepost-civil-warera, as wellas theregulatory reform.Technological</sup> change shifted the IPF out, but<sup>also twistedit so that thereductionindisorder froma marginalrisein</sup> dictatorship increased. When<sup>courtsweresubvertedbut regulationswere new andrelatively benign,</sup> marginal regulation was highly<sup>productive.As Figure 3shows, the efficientinstitutional choicein the</sup> American economy in response<sup>to this shiftin the IPF called for moreregulationto provide the</sup> countervailing power to big business.

**Figure 3: Progressive reforms**

<!-- Start of picture text --> Disorder<br>Post-gilded age<br>Pre-gilde age<br>Dictatorship<br><!-- End of picture text --> Glaeser and Shleifer (2003) interpret<sup>the rise of regulation,of litigationover statutes rather than</sup> contracts and torts, as well<sup>as manyother reformsin the U.S. economy during the progressiveera,as</sup> precisely such a shift toward the<sup>newly-efficientsystem of socialcontrolof business.</sup> In equilibrium, disorder may well have increased<sup>relativeto the mid- 19th century-this by itself does not imply that the</sup> progressive reforrns were ineffective.<sup>Dictatorship,asnoted by Stigler (1971)andhis followers, increased</sup> as well. The greater power of the<sup>state has led to greater benefits of state capture, and more such capturein</sup> equilibrium. Still, the reforms<sup>havemovedthe U.S.economy to a better pointthanit wasat in1880,as</sup> much of the evidence on economic<sup>and socialprogressduring the refornperiodindicates.</sup>
_The New Comparative Economics_ _12_

# _Institutions in Transition_

At least some aspects of the transition of Eastem Europe and the Former Soviet Union from socialism to capitalism can be interpreted using our framework. The crucial - though often insufficiently emphasized - aspect of the transition is the collapse of communism, and therefore a sharp decline in dictatorship through most of the region. Figure 4 presents our view of Russia, East European countries, and the FSU non-reformers (with Belarus taken as an example), in the first few years of transition. Two crucial factors separate Russia from FSU non-reformers on the one hand, and from East European reformers on the other. First, Russia has experienced a much more dramatic decline in dictatorship and, consistent with our model, a rise in disorder, than countries like Belarus and Uzbekistan. Second, Russia's <!-- Start of picture text --> Figure 4: Transition<br>Disorder<br>Russia, 1995<br>Russia, 1990<br>B\larus, 1990-95<br>Eastern Europe, 1995<br>Eastern Euroe, 1990<br>Dictatorship<br><!-- End of picture text --> IPF is probably less attractive than that of the East European countries and, at the same time, its shift along the IPF was probably greater.

According to Komai (1992), the communist party is the critical mechanism of keeping economic, political, and social order in socialist countries. Such police order comes at the expense of personal, economic, and political freedom, and as such has enormous human costs, but it is order nonetheless. As the communist control of the Russian economy and society was eliminated by Gorbachev and Yeltsin, so were the mechanisms of keeping order. The immediate benefits of disorder - the free press, the growth of entrepreneurship, the tremendous rise of ties to the rest of the world - were apparent, but so were the costs. The initial impact of the fall of economic dictatorship was extreme economic disorganization (Murrell 1992, Murphy, Shleifer and Vishny 1992, Blanchard and Kremer 1997), but even as markets began to work, the lack of law and order was manifest. The unofficial economy reached perhaps as much as 40% of the total (Johnson, Kaufmann, and Shleifer 1997). The nascent public institutions were subverted by the powerful through crime, corruption and political influence (Shleifer 1997, Hellman, Jones, and Kaufmnann 2003, Sonin 2003). Most importantly, the U.S.S.R. disintegrated and Russia itself- like the U.S. prior to the adoption of its constitution and Argentina today - experienced severe problems of localism, with regional governments undermining both national finances and law and order (Shleifer and Treisman 2000, Zhuravskaya 2000). Russia's transition can be plausibly described as a sharp move up along its IPF.

This experience can be usefully contrasted with that of non-reforming states, such as Belarus and Uzbekistan, where communist dictatorship was replaced by personal dictatorship, but many of the controlling institutions of the communist state remained intact. These countries still utterly lack freedom,
_13_ _The New Comparative Economics_ but they also did not suffer as sharp a rise in disorder. Tellingly, Belarus and Uzbekistan<sup>retained</sup> extremely small unofficial economies, a clear indicator of pervasive state control<sup>(Johnson, Kaufmann,and</sup> Shleifer 1997). They also did not experience as large a decline in officially measured<sup>output,again</sup> consistent with preserving order. On the other hand, these countries failed to reap the<sup>benefitsof</sup> economic transition from communism, and over the decade performed very poorly.

Compared to Russia, Eastern Europe had a more attractive IPF. East European countries<sup>lived</sup> through a shorter spell of communism, and have, in the cases of the Czech Republic,<sup>Hungary,andPoland,</sup> rebelled against their Soviet occupiers and local dictators. They had many more independent organizations and, in the case of Poland, an independent Church. They<sup>were alsomore integratedinto</sup> Western Europe, and from the beginning anxious to join the European community,<sup>whichimposedrulesof</sup> cooperation restricting dictatorship and disorder. Compared to Russia (or Yugoslavia),<sup>East European</sup> countries also did not move as far up along their IPFs, perhaps because they did not face<sup>assevere</sup> problems of decentralization and localism.

A plausible case can be made that Russia in the 1990s stayed on its institutional possibility frontier. It has moved away from the communist dictatorship, but arguably overshot initially<sup>inits</sup> institutional change toward too much disorder. Under the Putin presidency, Russia<sup>has moved downalong</sup> its IPF toward reducing disorder, even at the cost of some growth in dictatorship.<sup>Themoregeneral point</sup> suggested by this reasoning is that economic and social change in each country<sup>should be consideredin</sup> light of its own institutional possibilities, rather than some idealized view of perfect law and<sup>order.</sup>

# **IV. Transplantation**

Although one can explain at least some institutional diversity by focusing on efficient<sup>choices,</sup> these are clearly not the whole story. One dramatic deviation from the assumption of<sup>indigenousformation</sup> of institutions is transplantation. As European powers conquered much of the<sup>worldin theI gth century,</sup> they brought with them their institutions, including their laws. A significant portion of<sup>institutional</sup> variation among countries, especially in legal systems, is accounted for by transplantation<sup>(Watson1974,</sup> La Porta et al 1997, 1998, Berkowitz et al 2002).

When the English, the French, the Spaniards, the Dutch, the Germans, and the Portuguese colonized the world, they brought with them many institutions, including language and sports.<sup>As we</sup> discussed above, there is systematic variation among these institutions in origin countries,<sup>shaped by their</sup> political economy over the last millennium. England developed a common law<sup>tradition, characterizedby</sup> the independent judges and juries, relatively weaker reliance on statutes, and<sup>the preferencefor contracts</sup> and private litigation as a means of dealing with social harms. France, in contrast,<sup>developedacivillaw</sup> tradition, characterized by state-employed judges, great reliance on legal and procedural<sup>codes, and a</sup> preference for state regulation over private litigation. Germany developed its own<sup>civillaw tradition,also</sup> based in Roman law. There is also a distinctive legal tradition of Scandinavian<sup>countries.Finally,and</sup> crucially for the **20 th** century, the U.S.S.R. developed a system of socialist law.

Napoleon exported the French legal system during his conquests to Spain, Portugal, and<sup>Holland,</sup> and through his and their colonial conquests, it was transplanted to all of Latin America,<sup>large parts of</sup> Europe, North and West Africa, parts of the Carribean, and parts of Asia. The common<sup>law traditionwas</sup> transplanted by England to the U.S., Canada, Australia, New Zealand, East Africa, large<sup>parts</sup> of<sup>Asia</sup> (including India), and parts of the Carribean. The German legal system was voluntarily<sup>adoptedby</sup> Switzerland, Austria-Hungary, and later Japan, and through Japan it influenced<sup>legalsystems ofKorea,</sup> Taiwan, and China. The U.S.S.R. transplanted its legal system to socialist<sup>countries. These channelsof</sup> both voluntary and colonial transplantation suggest that there might be systematic variation<sup>in legal</sup> systems among countries.
_14_ _The New Comparative Economics_ Some of the initial evidence on transplantation<sup>of legalsystems,assembled by La Porta et al.</sup> (1997, 1998), strongly supports this hypothesis.<sup>Theauthorslook at thelaws governingthe protection of</sup> investors - shareholders and creditors<sup>-fromexpropriationby corporateinsiders usinga sampleof 49</sup> countries around the world. They find<sup>that, generally speaking,commonlaw countriesprotect</sup> shareholders better than do civil law countries,<sup>and especially Frenchcivil law countries.They also find</sup> that common and German civil law<sup>countries protect creditorsbetter than do the Frenchcivil lawcountries.</sup> La Porta et al. (1997, 1998) and subsequent<sup>studies alsoshow that bothlegalorigin andinvestor</sup> protection are strongly correlated with<sup>various aspects of financialdevelopment (Demirguc-Kuntand</sup> Levine 2001, Johnson et al. 2000, Wurgler<sup>2000, Beck et al.2003a,b, Friedman,Johnson,andMitton</sup> 2003, La Porta et al. 2000, 2002).

Djankov, La Porta, Lopez-de-Silanes,<sup>and Shleifer(2002, 2003)and Botero et al.(2003)take</sup> these cross-country comparisons further<sup>by examining variousdomainsof government regulation,</sup> including entry by new firms, judicial<sup>proceduresin courts,and labor markets.Although the data for each</sup> of these studies were collected using different<sup>proceduresand theycover somewhat different samples of</sup> countries, some systematic patterns emerge.<sup>Countries appear to have pronouncedstylesof socialcontrol</sup> of business intimately related to the legal<sup>origin of their laws.Inall three areas -entry,courts,and labor -</sup> socialist and French legal origin countries<sup>regulate much more heavily than do the commonlaw countries.</sup> On average, the very same countries that<sup>regulateentry,also regulatecourts and labor markets,and that</sup> these correlations are at least in part<sup>drivenby legalorigin(see Table1).</sup>

# **Table I**

# **Correlations between regulation measures**

The table shows the pairwise correlations<sup>of regulationindices across 63countries.No forrner or current communist</sup> countries are included to avoid spurious correlation.<sup>Themeasures of regulationare:(1) "Employmentlawsindex"</sup> which measures the level of protection of labor<sup>andemploymentlaws and is formed by thenormalized sumof:(i)</sup> subindex: alternative employment contracts.<sup>(ii)subindex:conditions of employment.(iii) subindex: job security; (2)</sup> "Number of procedures to start a business;"<sup>whichis defined as the number of different procedures thata start-up has</sup> to comply with in order to obtain a legal status,<sup>i.e.,tostart operatingas alegalentity; and (3)"Court formalism</sup> index for the collection of.a bounced check"<sup>whichmeasuressubstantive and proceduralstatutory interventionin</sup> judicial cases at lower-level civil trial courts,<sup>andis formed by variouscharacteristicsin the process such as the need</sup> for lawyers and legal justifications<sup>in</sup> the<sup>process, writtenvs. oral elements,statutory regulationof evidence,control</sup> of superior review, engagement formalities<sup>for the parties,and thenumber of independentproceduralactions.</sup>

|Employmentlawsindex|Numberofproceduresto<br>startabusiness|
|---|---|
|Numberofprocedurestostarta||
|business<br>0.6168a|1|
|Courtformalism indexforthe||
|collectionofbouncedcheck<br>0.6083a|0.5944a|

a=significant at I percent level; b=significant<sup>at 5 percentlevel; c=significantat10 percentlevel.</sup> Sources: "The Regulation of Labor," Harvard<sup>Universitymanuscript,November2002(Botero,Djankov, LaPorta, Lopez-de-Silanesand Shicifer);</sup> "The Regulation of Entry," Quarterly<sup>Joumalof EconomicsCXVII,February2002,1-37(Djankov,La Porta, Lopez-de-Silanesand Shleifer);</sup> "Courts," Quarterly Joumal of Economics,<sup>forthcoming 2003,(Djankov,LaPorta,Lopez-de-SilanesandShicifer).</sup>
_The New Comparative Economics_ _15_ The same rankings appear when we look at state ownership. Socialist and French legal origin countries have more government ownership of banks (La Porta, Lopez-de-Silanes, and Shleifer 2002a) and a greater role of state-owned enterprises in the economy (La Porta et al. 1999) than do common law countries. This evidence suggests that transplantation, rather than local conditions, exerts a profound effect on national modes of social control of business, including both state ownership and regulation. This evidence poses a sharp challenge to standard theories of regulation, which emphasize local industry conditions and the power of interest groups, as opposed to broad national tendencies, to explain regulatory practice.

The fact that colonial transplantation is such a significant deterninant of institutional design suggests that the observed institutional choices may well be inefficient. A legal and regulatory system perfectly suitable for France might yield inefficiently high levels of regulation and state ownership when transplanted to countries with lower civic capital. Likewise, a system of independent courts that works in Australia or the U.S. might fail in Malaysia or Zimbabwe. Can we understand how colonial transplantation can go awry?

Figure 5 applies our theoretical framework to transplantation. We think of a legal system as (roughly) limiting dictatorship and disorder in fixed proportions. For a given country, its legal system is the intersection of the ray emanating from the origin defining these proportions with its own IPF. The common law ray has a higher proportion of disorder to dictatorship than the civil law ray. Finally, as the IPFs shift out from developed to developing countries, the marginal amount of dictatorship required to reduce disorder rises: less developed countries (unlike the U.S. in 1900) cannot buy much order with regulation. As a consequence, less developed countries need _relatively_ less dictatorship in equilibrium, i.e., less regulation.

Figure 5 describes the transplantation of common and civil law into a country with an IPF further from the origin. Whichever system is transplanted, the equilibrium amounts of dictatorship and disorder rise simply because the institutional possibilities are less attractive. Also, relative to efficiency, the transplantation of both civil and common law will lead to excessive intervention and regulation in lower civic capital countries. Finally, transplantation leads to higher levels of over-regulation in civil than in common law countries. Because of the enormous risks of public abuse of business, countries at lower levels of civic capital efficiently need less regulation. But when legal systems are transplanted, they end with as much relatively speaking, and more in absolute terms, than do the origin countries. This problem is most severe in civil law countries, which end up being especially over-regulated relative to efficiency.

Figure 5 is consistent with the findings of Djankov et al. (2002, 2003) and Botero et al. (2003) that levels of regulation are higher in poorer than in richer countries, and in civil law than in common law countries. Moreover, consistent with Figure 5, the evidence shows that, in poor countries, the levels of regulation are often excessive. Higher levels of regulation of entry are associated with larger unofficial economies and no measurable benefits for product quality (Djankov et al. 2002). Higher level of regulation ofjudicial procedure are associated with higher costs and longer delays, without offsetting benefits in terms of perceived justice (Djankov et al. 2003). Heavier regulation of labor is associated with larger unofficial economies, higher unemployment, and lower labor force participation (Botero et al. 2003). In all these cases, the transplanted regulatory systems appear excessive for the countries that use them.
_16_ _The New Comparative Economics_ The evidence on the role of legal origin points<sup>to some tangible waysin whichthe existing</sup> institutions fall short of their potential, as well as to some<sup>possible directionsfor reform.The evidence</sup> suggests that deregulation - particularly in<sup>areassuch asentry and labormarkets, where theforces of</sup> competition are potentially so effective - is a high level priority<sup>for poor countries.In thesecountries,</sup> regulation is nearly universally associated with<sup>poor outcomesbecausepublic officialsabusetheir powers</sup> over private agents. Deregulation is likely to diminish<sup>the problemsof dictatorshipwithouta significant</sup> increase in disorder.

**Figure 5: Transplantation of laws**

<!-- Start of picture text --> Disorder<br>Common law<br>country<br>Dictatorship<br><!-- End of picture text --> But the evidence also identifies some pitfalls of reform.<sup>One cannot assume,for example,that</sup> highly formalized general jurisdiction courts could<sup>efficientlyresolvedisputesindevelopingcivillaw</sup> countries. The most attractive areas for deregulation<sup>indevelopingeconomiesare those where one can</sup> count on competition and market discipline,<sup>rather thanon courts,to controldisorder.Incontrast,in the</sup> developed countries, courts - especially specialized<sup>courts -arebecominganincreasinglyattractive</sup> alternative to regulation.

So far, we have focused on the content of transplantation,<sup>and morespecificallyon the</sup> transplantation of the legal/regulatory regimes.<sup>But obviously,other institutionsaretransplantedas well.</sup> Moreover, how they are transplanted may also matter.<sup>Berkowitz,Pistor,and Richard(2003)andPistor et</sup> al. (2002, 2003) stress the importance of "receptivity"<sup>for the success of transplantationof legalsystems.</sup> Acemoglu, Johnson, and Robinson (2001 ) argue<sup>that the quality of institutionaltransplantationdependson</sup> whether the colonizers themselves settled in the<sup>occupiedland,as they didin the U.S.or New Zealand,or</sup> just set up trading posts and exploited the<sup>colonies, as they didin most Africanstates.</sup> All the evidence points to extraordinary importance<sup>of institutionaltransplantation.Legalorigin</sup> as we discussed it proxies for the transplantation of<sup>institutions of socialcontrolof business:it captures the</sup> location of the transplanted institutions on the<sup>IPF,rather than the locationof the IPFitself.Assuch, we</sup> expect legal origin to only affect growth indirectly,<sup>in so far as the specificmechanismsof socialcontrol</sup> affect markets for capital, labor, and entrepreneurs,<sup>therebyinfluence factor accumulationand productivity</sup> growth. Other aspects of colonization and transplantation<sup>may influence growth directly,by influencing</sup> the civic capital of the society, i.e., the location of the IPF. Of<sup>these,humancapitalof thepeople</sup> operating the institutions is probably most important.<sup>Understandingthe diverseconsequenceof</sup> transplantation is a crucial challenge for the new comparative<sup>economics.</sup>
_17_ _The New Comparative Economics_

# V. **Politics**

Politics has a bad name in economics. From Marx (1872), to the Austrians (von Mises 1949, Hayek 1960), to institutional economists (Olson 1965, 1982, North 1990), to public choice scholars (Buchanan and Tullock 1962), to regulation economists (Stigler 1971), to political historians (Finer 1997), writers on institutions have maintained that political choice is often responsible for institutional inefficiency. Generals, dictators, ascendant social classes, democratic majorities, and favored interest groups all choose institutions that entrench them in power, so that they can collect political and economic rents. Constitutions, voting rules, federalist arrangements, organization of army and police are selected by incumbents to keep themselves in power. Olson (1993), Rajan and Zingales (2000), Acemoglu and Robinson (2000, 2002), Aghion, Alesina, and Trebbi (2002), Glaeser and Shleifer (2002b), are some of the recent models examining these phenomena. In these models, there is no reason that the equilibrium institutional choice would end up on the IPF, let alone minimize total social losses, because Coasian negotiations between various players fail (Olson 2000, Acemoglu 2003).5 The political perspective predicts that equilibrium institutions can be either excessively disorderly or excessively dictatorial. Recent research on Yelstin's Russia argues, for example, that the oligarchs who came to strongly influence the government (like the robber barons in the pre-progressive-era U.S.) preferred institutional disorder as a strategy of maximizing their rents (Black and Tarassova 2003, Sonin 2003). More typically, as those in power attempt to stay in power, they help themselves and their supporters through excessive dictatorship. State ownership becomes a mechanism of dispensing patronage and maintaining political support for the incumbent politicians (Shleifer and Vishny 1994). Regulations with ostensibly benign goals end up protecting incumbent firms from competition, and offering extensive corruption and political support opportunities to their enforcers (Stigler 1971, De Soto 1989, Djankov et al. 2002, Bertrand and Kramarz 2002, Besley and Burgess 2002, Rajan and Zingales 2003). At the most basic level, the political perspective explains socialism itself- the system that concentrates all political power and economic decision making in the hands of a small elite, thereby providing this elite with the most powerful lever for perpetuating itself- making the whole population of a country dependent on it economically.

Despite the value of the political angle, it is premature to blame all institutional failure on politics. Politics is often a stronger force toward institutional efficiency than away from it. After all, even communist dictatorships collapsed and turned into capitalist democracies. There are at least four significant ways in which the political process moves institutions toward efficiency. First, some institutions evolve over time toward more efficient forms as they confront new circumstances. This, fundamentally, is Hayek's (1960) view of the evolution of common law. Second, the reigns of government are often captured by interest groups favoring efficiency. De Long and Shleifer (1993), for example, show that, over the last millennium, the regions of Europe that were governed by merchants established good institutions and experienced rapid urban growth, whereas regions governed by absolutist princes did not do as well. Third, even when some interest groups oppose change, Coasian bargaining often does lead to efficient institutional choice (Becker 1983). The adoption of Magna Carta in England, and of the U.S. Constitution, are only the most famous examples of such bargaining. Last but not least, despite wellrecognized problems with democratic voting (Buchanan and Tullock 1962), it is often a powerful force toward more efficient institutions (Wittman 1989). We have already discussed progressive reforms. On a broader scale, the enormous rise in the world's wealth during the 20'h - democratic - century is the best evidence of the virtues of democratic politics.

> 5We do not discuss here a large literature on comparative political institutions. See, for example, Laffont (2000) and Persson and Tabellini (2000).
_18_ _The New Comparative Economics_ The tendency of democratic states to seek<sup>efficiencyis well illustratedby the adoptionof that great</sup> American invention for balancing dictatorship<sup>and disorder -a rigidconstitution with checksand balances</sup> (Brennan and Buchanan 1980). The<sup>clearestembodimentof such rigidityis the ideathat courts</sup> themselves have the power to check laws<sup>passedby the legislatureagainst the constitution.The American</sup> idea of constitutional review has spread<sup>to countriesinfluencedby the U.S. Constitution, especially those</sup> in Latin America, but after World War II<sup>to many other partsof the world,includingContinental Europe,</sup> as constitutional courts became common.<sup>La Porta, Lopez-de-Silanes,Pop-Eleches,andShleifer (2002)</sup> examine recent constitutions of 71 countries,<sup>identify the countries that have adopted judicialreviewin</sup> their constitutions, and find that constitutional<sup>reviewisindeedassociatedwithgreater politicalfreedom.6</sup> Not all efficiency-enhancing bargains<sup>have the sweet smell of the Magna Carta or the U.S.</sup> Constitution, but they may still improve<sup>welfare.During the1 990s,Russia's President Yeltsinfought the</sup> possible return of the communist dictatorship<sup>andextremedisorder arising fromdecentralizedfederalism</sup> and economic disorganization. Yelstin's<sup>political, economic, andlegal reforms generally requiredCoasian</sup> bargains with significant stakeholders,<sup>bargains thatto uninformedobservers appearedas failures of</sup> democratic rule. Privatization, for example,<sup>requireddeep concessionsto enterpriseinsiders,the defeatof</sup> communists at the polls in 1996 called<sup>fora purchaseof politicalsupport from the oligarchs, and the</sup> preservation of the federation demanded<sup>massivegiveawaysto independentregions(Boycko, Shleifer,and</sup> Vishny 1995, Shleifer and Treisman 2000).<sup>By the endof the decade,Russia emerged asa democratic,</sup> capitalist economy, with much stronger<sup>institutions thanit had at the beginning of the decade,enabling</sup> Yelstin's successor to continue his program<sup>and reapconsiderable benefitsof stability and economic</sup> growth. In retrospect, many of Yelstin's<sup>policiesandinstitutional reformslook like welfare-improving</sup> strategies of combating dictatorship<sup>anddisorder.</sup> To take this point still further, consider<sup>the even more extremeexampleof Peru's President</sup> Fujimori and his director of Central Intelligence<sup>Agency, Vladimiro Montesinos. Montesinoswas</sup> Fujimori's right hand man, managing<sup>the President's relationswithother politicians, judges,business</sup> people, the media, foreign govemments,<sup>and civil society.A principaltool of Montesinos'management</sup> was corruption: he routinely exchanged<sup>favorsandbribeswithkey members of the elite.Unfortunatelyfor</sup> Montesinos, he taped his conversations<sup>andexchanges.When Fujimori eventually escapedthe country,</sup> the tapes became public. Ocampo (2003)<sup>reviewssome of the tapes anddocuments the corruptdeals</sup> between Montesinos and over 100 members<sup>of the Peruvianelite.Whatdo we makeof thishorrifying</sup> evidence?

On the one hand, this is a story of<sup>obscene dictatorshipandcorruption.But on the other,these</sup> deals were part of restoring order in Peru.<sup>Before Fujimoriwas elected,Peru wasa countryin the state of</sup> anarchy, with negative growth rate, continuous<sup>-and murderous-threat from theleft-wing guerillas,the</sup> Shining Path, and incessant political<sup>battlesamong the elite.Fujimorirestoredorder,destroyedthe</sup> Shining Path, and attained significant economic<sup>growthduringhis rule.He didso,in part,by reducing</sup> conflict among the elites and entrenching<sup>himself in power through Montensinos'corrupt deals.From the</sup> perspective of Peruvian institutions, these<sup>deals reflecta move to eliminatedisorder and increase</sup> dictatorship, which was probably efficient.<sup>The moveisnot attractive,but neitheris theinstitutional</sup> possibility frontier that Peru faced.<sup>Eventually,as Fujimoriattemptedto consolidatehis dictatorship,the</sup> political process worked and he was driven<sup>out of the country.Notsurprisingly,disorderincreasedas</sup> well.

The often benign influence of politics<sup>issubject to animportant caveat.Politicsis fundamentallya</sup> negotiation between different interests,<sup>andthe success of political negotiationitself reliescrucially on the</sup> 6In transition economies and in West European<sup>constitutional deliberations,thecreationof checksand balanceshas</sup> become a central issue of institutional design<sup>(Berglof et al.2003).</sup>
_19_ _The New Comparative Economics_ civic capital in the society - the ability to cooperate. Countries with higher civic capital, and the more attractive IPFs, are more likely to have successful political negotiations and to choose an efficient point on the IPF. In this very important way, the location of the IPF, and the political choice of a point on it, are not independent. Even so, it is incorrect to blame all poor institutional outcomes on politics, since the failures of political negotiation are rooted in many of the same factors that undermine institutional opportunities in the first place.

# **VI.** Conclusion: **Appropriate Institutions**

At least since the 18 th century, economists have recognized that good institutions - those that secure property rights - are conducive to good economic performance. The appreciation of the benefits of good institutions has grown recently, in light of both the challenges of transition and development and the significant growth of empirical knowledge. But now economics can move further, and recognize that different institutions are appropriate in different circumstances. This, we believe, is the goal of the new comparative economics.

In this paper, we tried to put some flesh on this bare bones agenda. We argued that institutional diversity can in part be understood in terms of the fundanental tradeoff between controlling dictatorship and disorder. Many features of successful and unsuccessful institutions can be understood from this perspective. Moreover, this perspective sheds light on a range of historical experiences, including colonial transplantation, the rise of the regulatory state, and the transition from socialism. This perspective also maintains most forcefully that reforms in any country should be evaluated relative to its own institutional opportunities, rather than some idealized benchmark free of dictatorship and disorder.

The field of comparative economics has entered a fascinating new stage. The extraordinary turbulence in the world during the last decade - from post-communist transition, to Asian and Latin American financial crises, to economic and social devastation of Africa - has flagged the centrality of institutional reforms, but also the many pitfalls along the way. We are all humbler and wiser now. But we are also keenly aware that the comparative perspective, which identifies both the possibilities and the limitations of individual societies, can serve as a useful framework for future progress.