The Legal System and the Economy

The author is associate professor at the Department of Economics, School of Social Sciences, Ateneo de Manila University, Quezon City.  This article was published in the Opinion Section, Yellow Pad Column of BusinessWorld, September 3, 2007 edition, page S1/4.

Many often blame the country’s judicial branch for the many woes that beset the economy.

If the judicial branch were faster in deciding cases, especially the commercial ones, there would be far less “wait –and-see” mode among investors.  They would decide and move faster in their dealings. If the judicial branch were more consistent in its decisions, market players would have a better idea of the rules governing competition, and investors would be able to make the necessary adjustments. If it had been more “market-friendly” in the interpretation of the Constitution, foreign investments would have easily increased.

These are the classic arguments of mainstream economists.

Something not classic is the debate pertaining to the “legal system” as opposed to the “judicial branch.” Textbooks in the field of “Law and Economics” such as those of Robert Cooter and Thomas Ulen (1999) provide a detailed distinction between the two.

In the interest of simplicity, consider a simplified version of the Butterfield versus Forrester [11 East 60 (K.B., 1809)] case. Suppose that the only existing traffic rule in the country is to drive and park on the right side. Suppose that Juan is driving safely on the right side. Unfortunately, his car’s steering wheel loses control, which forces him to step on the brakes and incidentally makes the vehicle stop on the left side. Suppose that a few minutes after the incident, Maria comes driving at excessive speed from the opposite direction, say 150 kilometers per hour. As a result, Maria is not able to avoid colliding with Juan’s car. Suppose that Juan and Maria go to court to claim damages from each other.

Under extreme civil law systems, judgment will favor Maria. The justification is that the law clearly states that Juan should park on the right side. Even if Maria drives at excessive speed, no existing laws prohibit her from doing so. Under a common law system, the judgment will favor Juan. The justification is that the law was written to establish traffic order and protect citizens, implicitly under the condition that everyone acts normally. If Maria had been driving at normal speed and was still not able to avoid the collision, the law guarantees judgment in favor of Maria. But since Maria was driving at a speed that is “commonly” described as excessive, the law does not guarantee judgment in her favor.  The not-so-common speed of driving, not the illegal parking, caused the collision.

In corporate governance, Klaus Gugler et al (2003) find that common law systems or English-origin systems are much better at aligning managers’and shareholders’interests than are civil law systems. Specifically, they find that a €1 invested in a common law country creates assets with a value of roughly €1. On the other hand, a €1 invested in a civil law country creates assets with a value of €0.68. More so, no developed country with an English -origin legal system has weak accounting standards, and no developing country with a civil law system has strong contract enforceability. These differences underscore the importance of institutions like the legal system for economic performance.

The economics behind this follows. Common law systems penalize those who violate common ethical standards even in the absence of a formal law.

The case filed by smokers and families against tobacco companies in the US is a good example. The plaintiff argued that the companies should pay them for compensation for the emotional, physical and financial distress that “victims” encounter as result of years of smoking, and that the defendants were responsible for selling goods that they knew could harm consumers. On the other hand, the defendants argued that there was no law requiring them to warn consumers, and they had not enough knowledge of the harm that smoking could induce. But the federal courts decided against the tobacco companies, citing that they had the obligation, with or without law, to warn consumers of probable side effects. And even if there was not enough knowledge, the companies should have been more proactive in avoiding harm. Therefore they should have done more research and have their research published even if it was still limited. The system holds managers more accountable into doing what is ethical as opposed to what is legal.

Civil law systems penalize only those who violate the formal law. Lack of a formal law on specific decisions and course of action protects economic agents from litigation even if they choose to practice obviously unethical ways. This is literally the same as saying that lack of law against money laundering protects money launderers from getting punished. The only way one can induce leaders and corporate managers to choose ethical ways is to create new laws, for example an Anti-money Laundering Act. But since it is impossible to make a perfectly written law against each specific kind of unethical action, the system cannot protect the economy one hundred percent from culprits with unethical ways.

Common law systems structurally force agents to adopt ethical ways proactively. On the other hand, civil law systems structurally allow agents to adopt ethical ways reactively to the law (emphasis added). To the extent that common law systems force private sector managers to conduct their business and behavior more for what is ethically good for its investors, workers, customers and the country, the economy improves. And to the extent that common law systems force government leaders to proactively run their offices in a way that is good for the country, the economy improves.

The reader probably instinctively thinks that the Philippines should shift to the common law system. However, one has to keep in mind that one of the reasons that the country has civil law is the lack of trust in the judicial branch. Even if there was doubt about corporate governance, the doubt against the integrity of the judges was even greater. For this reason, the proper system to have was the system that gave less discretion to judges.

But that was then. The present scenario might be different. For example, one can argue that the Supreme Court these days is the most respected government authority, compared to, say, the Office of the President and Congress. This is an argument that would have been harder to believe 30 years ago. It is therefore recommended that updated research be done whether the integrity of the judicial system has improved to the point that it is already practical to shift to a common law system. If so, we should seriously accommodate a system that is more ethics-friendly.

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