Rethinking the Law and Economics Paradigm

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As a step toward that ideal it seems to me that every lawyer ought to seek an understanding of economics. The present divorce between the schools of political economy and law seems to me an evidence of how much progress in philosophical study still remains to be made. In the present state of political economy indeed, we come again upon history on a larger scale, but there we are called on to consider and weight the ends of legislation, the means of attaining them, and the cost.’ (Oliver Wendell Holmes; 1897) [1]

The World Bank’s policy focus shifted in the 1990s from a market-oriented paradigm to other issues such as social justice, poverty reduction and “market failures”, where institutions had to play a greater role [2]. Known as the Post-Washington Consensus or the Third Moment in Law and Development, this new paradigm emphasizes the importance of “good governance”, the implementation of property rights for economic growth, and makes the following proposition: well-defined and formalized property rights lead to market efficiency, economic growth and development. Hence, since then the establishment of the “rule of law” has become the new goal to reach for developing countries.

However, this Law and Economics paradigm relies on a narrow set of theoretical assumptions and is heavily influenced by neoclassical views of the state, the market and overall competition. But this framework raises some questions: (a) are these assumptions empirically valid, namely is the implementation of property rights a necessary condition for economic growth and development? And (b) are “perfect competition” and “market failures” reliable concepts one should start from to cope with development – if by such term we mean a social and economic process that will ultimately increase human well being?

The role of institutions in New Institutional Economics

Classical political economists stressed the importance of institutions in human affairs – particularly in the economic sphere – from the very beginning. On the one hand, there was a tradition that tried to draw economists’ attention on the determinant role of social and cultural norms and how they shape/influence the individuals’ decision-making process (for instance, in the findings of Weber, Durkheim and Veblen). On the other hand, another tradition paid more attention to the mode of subsistence of society and how physical institutions reflect and regulate class struggle (as illustrated by the Scottish Historical School – which included Adam Smith, John Millar, Adam Ferguson and William Robertson – and the Historical Materialist tradition initiated by Karl Marx. In that regard Malthus and Ricardo were close to both movements despite their divergent theories).

However, the modern overlap between institutional economics and development took a different path and started with Douglas North’s early work [3]. In this case, by institutional economics one should understand neoclassical institutional economics. The policy ramifications of this new paradigm differ form the classical tradition.

North’s institutional approach ultimately supports the efficient market hypothesis: markets can and do fail if the underlying institutional arrangements do not provide a solid ground for private transactions. It follows that a legal system in which property rights (or the rule of law) are clearly defined and strongly protected will correct these market failures and achieve the market clearing process.

There are two elements than can explain such a narrow departure: (a) the Coase Theorem as a basis for the legal reforms [4] and (b) Hayek’s political influence on neoclassical economics [5]. On the one hand, the Coase Theorem concludes that “the legal environment could impose effects and costs on market actors that would become variables determining economic output” [6]; on the other hand, Hayek’s theory of the state included “minimal government, the rule of law, and strong property rights” [7]. From this perspective, one can anticipate the conceptual tour de force the New Institutional Economics (NIE) would come up with: (i) given that economic output is dependent on the legal environment, (ii) and given the minimum role the state should have to allow market clearance, (iii) the state’s sole intervention is to limit transaction costs by implementing strong and clear property rights to achieve economic growth. This latter proposition is perfectly described by De Soto: “Property is… the legal expression of an economically meaningful consensus about assets. Law is the instrument that fixes and realizes capital” [8]. The immediate political translation was fostered by the New Political Economy (NPE) and its focus on international trade law policy: the world is a global efficient market if each state implements the rule of law domestically and free trade (the law of comparative advantage). The circle is now complete: the world economy reaches economic growth and by extension development. This approach is not a fundamental critique of the perfect competition paradigm but represents rather a mere departure from it by adopting an imperfect competition framework – namely, perfect competition would be closely reached if the imperfections were removed (a radical critique could be found in the theory of real competition that is a “dynamic disequilibrium process or a violent life-and-death struggle rather than the static equilibrium set of conditions underpinning conventional theories” [9]).

The World Bank “religiously” implemented the principles of the Third Moment in Law and Development. Some economists, such as Rodrik [10] and Sen [11], criticized some propositions of the theory by incorporating a human rights approach (in the case of Sen) or by giving a greater role to state intervention in industrial policy (in the case of Rodrik). Yet, these critiques did not question the core premises of NIE: (a) protecting property rights (strongly or formally, since Rodrik makes this distinction) increases economic output and (b) if market failures are corrected perfect competition is achieved. Hence, the question is whether a radical critique is necessary if one wants to (a) understand the process of economic development and (b) propose a policy solution to make such a process sustainable.

Property as a “bundle of rights”

There is no doubt that the arrangement of legal entitlements affects economic and social development in general (and such a framework is not monolithic). Yet, one needs to have a deeper understanding of property to realize how the ““clear and strong” property rights is a misleading recipe” [12]. Hence, a thorough analysis of the concept of property should expose the limits of the Law and Economics policy implications as highlighted by David Kennedy, a scholar in the Critical Legal Studies tradition.

As David Kennedy puts it: “From a development perspective, what matters is not the “strength” or “clarity” of property rights, but the relationship between legal entitlements and the distribution and use of resources in a particular time and place” [13]. We can extract from Kennedy’s remark two ingenious theses: (i) property is allocated through a power struggle and this allocation does not happen in a vacuum; (ii) property is not sui generis but represents a bundle of rights – namely, a relationship between individuals in relation to an object, which render the notions of “strong’ and “clear” very problematic. One can notice how these two propositions directly challenge the core premise of the World Bank Third Moment paradigm.

Kennedy illustrates the first thesis by stating that: “Development specialists must understand that in a market economy, “property” has no ideal form separate from social and economic struggle in that society. (…) Before “property rights” can be strong or weak, they must be allocated. In every Western society, the process of allocation has been inseparable from political and social struggle and debate” [14]. In other words, a system of secure property rights is not an a priori framework, but is determined by social interactions and conflict. This view can find an echo in Polanyi’s concept of embeddedness – namely, the economic sphere is embedded in human and social institutions (Polanyi : 1944). In fact, even within the Marxian tradition little attention has been paid to this a priori determination (rather than a mere parameter) of property rights (despite Marx’s analysis of “bloody legislation” and primitive accumulation in Capital Vol.I). Therefore, if property is determined by a social struggle it also gives power to the winners of such a struggle to maintain its domination and structure the rule of the game to shape the income distribution to their advantage. Moreover, the state is primordial in this process as it is the authority that enforces and allocates entitlements: the state is a locus of constant struggles from the very beginning of any market formation. As a consequence, since property rights and social struggles are intertwined, it follows that this process cannot be unique, uniform and homogenous as assumed in modernization theory and NIE. This process can only be peculiar and specific to each society (it does not exclude similarities). Property rights are not a “system” but a human institution historically constructed and contingent on time and geography.

The elaboration of the first thesis automatically leads one to question the very definition of property: if property is not a legal system per se but rather a historical process, what shape does its legal implementation take?

According to Kennedy, the notion “that property rights concern the relationship between an individual and “his property”” is false. On the contrary, one should understand property as “the relationship between people with respect to a thing” and “the difference is crucial”[15]. This distinction is of first importance because it directly refutes the notion of “market failures” for the following reasons. I have explained in the first section how NIE consider the rule of law as a remedy to market failures. In that sense market failures are understood as ill defined and weakly protected property rights. In this view property is defined as a relationship between an individual and his/her object. Suppose, we replace this conception of property by Kennedy’s – namely, property is a relationship between individuals in relation to a thing – what becomes of the notion “strong” and “clear” and more important, what becomes of market failures? Three implications follow from this conceptual shift:

(a) The state has its say on the private settlements and agreements, as it defines and enforces “the rights of one against the other” [16]

(b) Since property constitutes a bundle of rights that could vary in substance due to political and social struggles, it can never be “clear” and “strongly formalized” as it will damage other individuals’ opportunities.

(c) Since it is a relationship with other agents, its process of entitlements “routinely fail” therefore “transaction costs are ubiquitous” [17]. Transaction costs being market failures, if market failures are ubiquitous they become the market itself.

This set of propositions demonstrates the deep conceptual change operated by the legal realist approach. Jamee Moudud remarkably illustrates the proposition (c): “But if externalities are ubiquitous then they are the inevitable outcomes of normal market behavior. But if “market failures” are ubiquitous then they are not “market failures” anymore” [18]. Consequently, the entire theoretical legal corpus of NIE and NPE falls apart: (1) property is not a spontaneous pre-established framework; (2) property cannot be clearly and strongly defined in a singular way; therefore (3) property cannot be the cause (with the epistemological implications of the term) of economic growth.

I would like to thank Professors Sanjay Reddy and Jamee K. Moudud, and Ingrid Harvold Kvangraven for their helpful and enlightening feedback.

This is part 1 of a 2-part series on law, institutions and economics. In Part 2, Prof. Jamee Moudud offers new insights from Legal Political Economy.

Mohamed Obaidy is an MS student in Economics at The New School

Sources

[1] Holmes, Wendell Oliver, “The Path of Law”, Harvard Law Review, 457, 1897
[2] K. Moudud, Jamee, “Beyond the Third Moment in Law and Development: Insights from Critical Legal Studies and Critical Political Economy” (2016). Law and Economics: Contemporary Approaches.
[3] Lance E. Davis and Douglass C. North (with the assistance of Calla Smorodin), Institutional Change and American Economic Growth. Cambridge: Cambridge University Press, 1971; And North, Douglass C. and Robert Paul Thomas, The Rise of the Western World: A New Economic History. New York: Cambridge University Press, 1973.
[4] Coase, R.H, “The problem of Social Cost”, Journal of Law and Economics, Vol.3, Oct.1960.
[5] Hayek, Friedrich, The Constitution of Liberty, Chicago, IL: University of Chicago Press. 1960.
[6] Thomas, Chantal, “Law and Neoclassical Economic Development in Theory and Practice: Toward an Institutionalist Critique of Institutionalism” (2011). Cornell Law Faculty Publications. Paper 608. at 979.
[7] Id. at 976.
[8] Id. at 999.
[9] Moudud, J.K., Bina, C., and Mason, P. (2012). “Introduction: the Search for an Alternative.” In Alternative Theories of Competition: Challenges to the Orthodoxy”, eds. J.K. Moudud, C. Bina & P.L. Mason, Routledge Press. P.5.
[10] Rodrik Dani, One Economics, Many Recipes: Globalization, Institutions, And Economic Growth. P. 99-100 (2007).
[11] Sen, Amartya, Development as Freedom. P.3-4 (1999).
[12] Kennedy, David (2011) “Some Caution about Property Rights as a Recipe for Economic Development,” Accounting, Economics, and Law: vol.1 : Iss. 1, Article 3. P. 53.
[13] Id. at 5.
[14] Id. at 10.
[15] Id. at 26.
[16] Id. at 40.
[17] Id. at 40.
[18] K. Moudud, Jamee, “Beyond the Third Moment in Law and Development: Insights from Critical Legal Studies and Critical Political Economy” (2016). Law and Economics: Contemporary Approaches. P. 20.

3 thoughts on “Rethinking the Law and Economics Paradigm

  1. […] ‘As a step toward that ideal it seems to me that every lawyer ought to seek an understanding of economics. The present divorce between the schools of political economy and law seems to me an evidence of how much progress in philosophical study still remains to be made. In the present state of political economy indeed, we come again upon history on a larger scale, but there we are called on to consider and weight the ends of legislation, the means of attaining them, and the cost.’ (Oliver Wendell Holmes; 1897) [1] […]

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