Twenty years of ‘Law and Finance’ – Time to take law seriously

Twenty years ago, the first of a series of tremendously influential papers on 'Law and Finance' was published by Rafael La Porta and his colleagues. By putting legal institutions at the centre of their investigation into the determinants of financial and economic development, La Porta et al. added to an ongoing refocussing of economic research towards institutional determinants. This trend gathered pace in the 1990s with Douglas North’s New Institutional Economics approach and his interest in formal institutions.

In parallel, international development agencies and financial institutions realised the limitations of macro-economic reform policies. Increasingly after the Asian Financial Crisis of 1997, they started to turn towards institutional reform as their prime tool for economic development. This created a window of opportunity for the Law & Finance School (LFS), which largely explains its extensive influence over developmental policies promoted by the World Bank, IMF, and OECD since the late 1990s.

The impact of law on economic development and the promise of legal reform as a development tool have since been hotly debated and the key claims of the Law & Finance school have been critically investigated. Surprisingly, however, no previous study has questioned the underlying theory of law on which the LFS’s confident claims about law’s role in the economy are based.

Our brand new paper (SSRN version here; early-view version in Socio-Economic Review) constitutes the first study analysing in detail the legal theoretical assumptions underlying the LFS. We confront twenty years of LFS literature with the most influential Western legal theories to assess the coherence and plausibility of the LFS’s theoretical conceptualisation of the link between law and the economy.

Surprisingly, we find that the LFS has very little to say about what law is and how it affects economic actors and outcomes. Indeed, the LFS mostly applies economic theory and econometric methods to legal phenomena rather than the other way around. Moreover, over the past twenty years – presumably due to heavy criticism of the initial studies on the ‘quality of law’ – the LFS has increasingly moved away from the focus on substantial features of the law towards much vaguer claims about ‘legal origins’ as the underlying construct of interest. This trend has led the LFS to dodge the question of ‘how law matters’ and instead amalgamate legal factors with an increasingly large number of alternative explanatory factors – including religion, culture, and politics.

We argue that these are non-negligible shortcomings, because the theoretical weakness of the LFS leads to questionable empirical strategies and research designs, which may affect the results of empirical investigations into the question whether law matters for economic outcomes.

Thus, we suggest that the LFS should start taking law more seriously by theoretically answering the question ‘how does law matter?’ in order to design more robust empirical strategies.

Gerhard Schnyder is a Reader in International Management at Loughborough University London.

Mathias Siems is a Professor of Commercial Law at Durham University.

Ruth V Aguilera is a Distinguished Professor of International Business and Strategy at the D'Amore-McKim School of Business and a Visiting Professor at ESADE Business School.