The Economics of Legal Certainty

In the paper ‘The Economics of Legal Uncertainty’, we study how legal uncertainty affects economic activity. Theoretically, we show that legal uncertainty can be classified as idiosyncratic (ie diversifiable) or systematic (ie nondiversifiable). For example, variation in judges’ preferences affects the outcomes of individual cases in an idiosyncratic way. If a firm is subject to many legal cases, then the firm is diversified and cares only about the average outcome of all cases but not the idiosyncratic variation across individual cases. In contrast, changes in the law or important legal decisions that establish legal precedent may affect the outcomes of a broader set of legal cases in a systematic way.

In the empirical part of the paper, we test the predictions of the model in the context of bankruptcy law and credit markets in Korea. We develop three empirical measures of legal uncertainty based on differences in bankruptcy judges’ debtor-friendliness and the intuitional features of the bankruptcy court system in Korea. Specifically, because judges are randomly assigned to bankruptcy cases, we can measure idiosyncratic legal uncertainty as the standard deviation of bankruptcy judges’ debtor-friendliness within a given court. Further, because firms learn about judges from their decision making and because this information is lost once the judges are replaced at the end of their term, we measure systematic legal uncertainty as the average number of decisions observed for judges in a given court, and the time until bankruptcy judges are scheduled to be replaced.

As predicted by the model, we find that all measures of legal uncertainty are associated with a reduction in the size of credit markets. Those effects are driven by the riskiest firms in the economy, consistent with their higher exposure to legal risk in the bankruptcy system. Finally, on examining differences in interest rates, we show that credit supply is relatively more sensitive to systematic sources of legal uncertainty, since banks are involved in multiple bankruptcy cases allowing them to diversify idiosyncratic sources of legal uncertainty.

Our analysis suggests that legal uncertainty is detrimental to economic activity, which has important implications for the design of bankruptcy law and legal systems more generally as well as for firm policies and market structure. For example, our findings imply that frequent changes in laws and regulations or replacements of judges depress economic activity by generating systematic legal uncertainty. In addition, random judge assignment, which is a feature of many legal systems, generates idiosyncratic legal uncertainty that is detrimental to economic activity. Further, transparency about judges’ past decisions allows market participants to learn about judges’ preferences and reduces legal uncertainty. Firms can reduce their exposure to idiosyncratic sources of legal uncertainty by growing larger, for example through mergers, which allows them to diversify idiosyncratic legal uncertainty through exposure to more legal cases. The same line of argument provides a role for intermediaries like banks or insurance companies that can take on and diversify legal uncertainty from smaller market participants. Which type of legal uncertainty is more important for a given market depends on how systematic it is and how well market participants can diversify legal uncertainty.

David Schoenherr is an Assistant Professor of Economics at Princeton University.