from governments’ inability to address institutional shortcomings or lack of understanding of the institutional foundations of a sound financial system that lead to badly sequenced reforms.18 The second group of literature specifically examines the links between law and finance, and identifies a more fundamental problem: some legal systems are simply not well suited to creating the preconditions for financial systems and institutions to successfully develop.19 This explanation has a static and a dynamic perspective on why financial development, particularly arms’ length finance, depends on how outsiders’ property rights are enforced. Under the “static” view of law and finance, the focus is on the difference in legal traditions regarding the comparative rights of individual investors vis-à-vis the state—that is, common law versus civil law. Common law systems were designed to protect investor property against the Crown, thus creating an environment in which individuals could transact confidently. On the other hand, the state is set above the courts under civil law, and consequently interests of politically connected heads of firms above individual investors. According to this literature, countries that adopted British Common Law have larger financial systems compared to countries that adopted the French Civil Code due to the better protection given to investors under the former system. In this body of literature, either politics and political institutions do not matter (La Porta et al. 1998), or they matter but are less important than legal origin (Beck, Demirgüç-Kunt, and Levine, 2003) (in Haber, 2006). The “dynamic” view of law and finance focuses on the adaptability of the law to changing conditions, with flexible legal systems deemed as better suited to fostering financial development. Because common law emerges on a case-by-case basis, it can more quickly close the gap between an economy’s needs and the law. This is in stark contrast to the seemingly immutable legal code of French civil law. The more difficult it is to undertake legal reform, the less investor protection there is at the cutting edge of financial innovation, thus tending to slow down financial development (Girma and Shortland, 2004). However, Tavares (2002) notes that country experiences do not entirely accord with this dichotomy—all countries, regardless of legal tradition, adapt to a greater or lesser extent to new economic and contractual realities. Beck et al. (2001a, 2001b; in Tavares, 2002) empirically show that legal tradition does affect the level of overall financial development. But critiques of this literature also argue that there are some civil law countries that performed very well in terms of financial development in the early 20th century. And even within legal origins, a large discrepancy in terms of financial development exists (Tavares, 2002). Thus, other studies focus on the quality of legal systems, rather than legal origins per se. Results show that the level to which firms are financially constrained is higher when there is a high risk of expropriation, inefficient legal systems and high associated corruption. Modigliani and Perotti (1999; in Tavares, 2002) also argue that, in the absence of a strong legal system that can protect external investors, financial intermediaries with sufficient bargaining power to enforce their rights privately come forward and extract rents. The third group of studies identified by Girma and Shortland (2004) focuses on the political economy of financial development, and presents a dissenting argument that legal origin has little effect on financial development or on economic growth more broadly. Instead, financial development is an outcome of specific laws and regulations, which in turn are the result of politics and political institutions (Haber, 2006). 20 This view also provides another way of 18
E.g., Demirguec-Kunt and Detragiache (1998), Kaufmann et al. (1999), Hellmann et al. (2000), Andrianova et al. (2002). 19 La Porta et al. (1997, 1998); see Beck et al. (2001a, 2001b) for a review of the literature. 20 E.g., Rajan and Zingales (2003), Acemoglu, Johnson, and Robinson (2005), Lamoreaux and Rosenthal (2005). 31