The Legal Environment, Banks, and Long-Run Economic Growth

Abstract

This paper examines the relationship between the legal system and banlding development and traces this connection through to long-run rates of per capita GDP growth, capital stock growth, and productivity growth. The data indicate that countries where the legal system (1) emphasizes creditor rights and (2) rigorously enforces contracts have better-developed banks than countries where laws do not give a high priority to creditors and where enforcement is lax. Furtherrnore, the exogenous component of banking development-the component defined by the legal environment-is positively and robustly associated with per capita growth, physical capital accumulation, and productivity growth. THIS PAPER ADDRESSES TWO QUESTIONS. First, do crosscountry differences in the legal rights of creditors, the efficiency of contract enforcement, and the origin of the legal system explain cross-country differences in the level of banking development? Second, do better-developed banks cause faster economic development; that is, is the component of banking development defined by the legal environment positively associated with long-run rates of economic growth, capital accumulation, and productivity growth? Examining the relationship between the legal system and banking development is valuable irrespective of issues associated with long-run growth. First, banks may influence the level of income per capita and the magnitude of cyclical fluctuations (Bernanke and Gertler 1989, 1990). Second, many economists stress that understanding the evolution of legal and financial systems is essential for understanding economic development (North 1981; Engerman and Sokoloff 1996). Consequently, quantitative information on the relationship between the legal environment and banks will improve our understanding of business cycles and the process of economic development. Furthermore, examining the causal links between banks and economic growth has both conceptual and policy implications. On the conceptual front, a long literature debates the importance of banks in economic development. Starting as early as Bagehot (1873), economists have argued that better banks banks that are better at identifying creditworthy firms, mobilizing savings, pooling risks, and facilitating transactions