CHICAGO JOHN M OLIN LAW ECONOMICS WORKING PAPER NO 271 2D SERIES Institutions History and Economic Development Kenneth W Dam THE LAW SCHOOL THE UNIVERSITY OF CHICAGO January 2006 This paper can be downloaded without charge at The Chicago Working Paper Series Index http www law uchicago edu Lawecon index html and at the Social Science Research Network Electronic Paper Collection http ssrn com abstract id 875026 INSTITUTIONS HISTORY AND ECONOMIC DEVELOPMENT Kenneth W Dam Max Pam Professor Emeritus of American and Foreign Law and Senior Lecturer The University of Chicago Law School Senior Fellow The Brookings Institution If one wants insight into how the developing world can attain the Rule of Law one good place to start would be to ask how countries in today s developed world did it Though the developed world now stretches well beyond the countries of Western Europe where the Rule of Law first arose developed countries such as the United States Canada and Australia and in a less direct fashion Japan were blessed with a successful transplant of Western European legal institutions Perhaps the Western European experience can provide insights into how this process of legal institutional development can succeed in developing countries where the transplant remedy is obstructed by historical societal or other differences from Western European nations Western Europe after all was not blessed with a Rule of Law in the Middle Ages but successfully achieved it over a number of centuries The first step in this analysis is to recognize that Rule of Law institutions are not essential for economic activity though they are relevant to economic growth In every country goods and services are exchanged usually against money In fact in some of the poorest countries the level of economic activity in local marketplaces is intense truly something to be marveled at And yet this exchange takes place without law playing a significant role The author would like to thank for their assistance and insight Richard Helmholz of the University of Chicago Law School and Maria Dakolias of the United Kingdom Department of Constitutional Affairs as well as his research assistant at the Law School Wonbin Kang This working paper was written in preparation for a forthcoming book length study of the rule of law in economic development Let us consider the public market or bazaar the primary economic institution of the medieval world and even today a common sight in the developing world After verbal agreement between seller and buyer is reached the seller hands over the goods and the buyer hands over the money The quid and the quo are exchanged simultaneously But as Greif put it suppose the quid and the quo are separated 1 They can be separated in time as when the buyer promises to pay later but wants to take the goods with him What will then give the seller confidence that he will be paid as promised In the absence of law or as we shall see some ongoing relationship between seller and buyer the seller is likely to simply refuse to sell except against money pressed into his hand The same problem arises where goods are to be made to order with the seller requiring advance payment These problems were compounded in the medieval world when the buyer and the seller were geographically separated True seller and buyer could negotiate in writing or through a traveling agent But the separation in place meant that the goods would have to be produced and delivered before payment could be expected the seller thereby taking what he might well consider an unreasonable risk that the buyer would change his mind Or payment could be made before the goods were produced in which case it is the buyer who took the risk In these cases the quid and the quo were separated in both space and time Of course most goods were simply taken physically to distant bazaars where they were offered for sale The problem for the seller in that situation was twofold If he was cheated in the bazaar he had to trust the local authorities to protect him and not to discriminate against him as a foreigner And second he would normally have to choose some kind of agent to act for him If the agent absconded with his goods or with the payment received in exchange the producer s remedies might be limited These kinds of problems were acute in the Middle Ages not so much within the city states that were the dominant economies of the time in Europe but whenever long distance trade had to be carried on 2 The city states had domestic legal systems3 but they could not easily enforce contracts in which their citizens were cheated when selling or buying goods in distant city states And so inter city trade was limited These kinds of problems extended beyond trade and its financing to purely financial contracts and insurance contracts both of which necessarily had the same separation between the quid and the quo as the trade examples 1 Greif 2004a Greif 2004b 3 Smith 1928 p 213 216 2 2 Even where the parties were bargaining in good faith the separation of the quid and the quo created the possibility that one party however well intentioned ex ante would find it to his advantage ex post to reopen the bargaining or simply welsh on the deal This incentive to renegotiate agreements after one party had performed a common occurrence even today can be referred to as ex post opportunism it creates severe economic inefficiencies whenever an adequate legal system is not in place In other words the enforcement of contracts is important to assure that contracts will be performed voluntarily As we will see throughout this book these kinds of problems exist across the entire spectrum of economic activities whenever a system of law is not in place or does not work effectively to give parties confidence that contracts will be carried out This is the essence of the Rule of Law problem in many developing countries where the legal system does not for whatever reason work effectively Nevertheless some trade can take place even though the quid and quo are separated if the party at risk has confidence in the performance of the other party That confidence may come from the reputation of the other party though that statement begs the question of how the requisite reputation can be created Of course if the parties have repeated transactions confidence may be created because each party knows that a failure to perform will end the business opportunities between the two Readers familiar with the theory of games
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