Legal Institutions, Credit Markets, and Economic Activity

Abstract

This paper provides novel evidence on the causal connections between legal institutions, credit markets, and real economic activity. Our analysis exploits an unexplored within-country setting—Native American reservations—together with quasi-experimental variation in legal contract enforcement wherein the US Congress externally assigned state courts to adjudicate contracts on a subset of reservations. According to area-specific data on small business credit, reservations assigned to state courts, which enforce contracts more predictably than tribal courts, have stronger credit markets. Moreover, the law-driven component of credit market development is associated with significantly higher levels of per capita income, with stronger effects in sectors that depend more on external financing. By using exogenous variation in legal institutions across relatively similar sovereign entities, our study offers compelling evidence that stronger contract enforcement and better-developed credit markets lead to significant improvements in broad economic outcomes.