Frank A. Schmid

Jason Higbee

English

Research Papers in Economics

August 2004 InternationalEconomicTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Rule of Law and
Economic Growth
G
ross domestic product per capita, adjusted for
differences in purchasing power, varies widely
among countries. In fact, a United Nations report
shows that in 2001, real (that is, purchasing-power
adjusted) GDP per capita ranged between a high of 53,780
(Luxembourg) and a low of 470 (Sierra Leone), as meas-
ured in U.S. dollars.1 What explains these cross-country
differences in real GDP per capita? Why are some countries
wealthier than others?
Admittedly, there are large differences in countries’
endowments with natural resources; however, an abundance
of natural resources (or lack thereof) cannot fully explain
the state of a country’s economic development. Japan, for
instance, has few natural resources. Yet, it is one of the
richest countries in the world. A country’s ability to accu-
mulate physical and human capital, and the efficiency with
which it turns its capital and natural resources into goods
and services, seems to be a key factor. But what explains
these cross-country differences in economic activity?
In an influential article, La Porta et al.2 argue that coun-
tries adhering to common law generally have the strongest
legal protection for investors, followed by countries adher-
ing to civil law adopted from the German and Scandinavian
legal traditions; countries rooted in French civil law offer
the weakest legal protection. A notable difference between
these two legal systems is that common law, which is of
English origin, gives priority to jurisprudence over codified
doctrine, while the opposite holds for civil law, which
originates from ancient Rome. Legal systems that provide
strong legal protection for investors have permitted the
development of sophisticated financial markets, which
enhances the economy’s ability to bear risk. This ability
to spread risk over a multitude of investors is critical for
entrepreneurship and economic growth.
But differences in the legal system are only part of the
story. Actual enforcement of the law is also important.
Corruption renders codified law ineffective. By weakening
property rights, corruption deprives investors of compen-
sation for risk taking and increases uncertainty about
potential investment payoffs. This decreases the incentive
to invest, which in turn dampens economic growth.
There are also unwritten rules that allow economic
agents to trust one another. Trust is critical where matters
are too complex to be written into law or where enforcing
these laws is too costly. In fact, many contracts in the
business world are implicit (and, hence, not enforceable)
rather than explicit. Yet, the contracting parties abide by
these implied agreements because reputation is valuable.
In a recent speech about corporate governance and finan-
cial market malfeasance, Federal Reserve Chairman Alan
Greenspan argued that trust and reputation were so valuable
to 19th century bankers and companies that the penalties
for breaking this trust were severe enough to make econ-
omic commerce, to a large extent, self-regulating.3
The chart shows that countries with less corruption
(that is, a higher value on the corruption perception index)
tend to have higher levels of GDP per capita. The correla-
tion between the two variables is 0.87, which is statistically
significant. Of course, while correlation is not evidence of
causation, there is little doubt that corruption depresses
economic activity.
—Jason Higbee and Frank A. Schmid
1 United Nations Human Development Report 2003,
http://hdr.undp.org/reports/global/2003.
2 La Porta, Rafael; Lopez-de-Silanes, Florencio; Shleifer, Andrei; Vishny,
Robert W. “Law and Finance.” Journal of Political Economy, December 1988,
106(6), pp. 1113-55.
3 Alan Greenspan (2004) “Capitalizing Reputation,” 
http://www.federalreserve.gov/boarddocs/speeches/2004/20040416/default.htm.
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0
10,000
20,000
30,000
40,000
50,000
60,000
0123456789 1 0
2001 Corruption Perception Index
2001 Per Capita GDP (PPP $US)
Nigeria
Russia
Chile
USA
Luxembourg
SOURCES: United Nations Human Development Report 2003,
http://hdr.undp.org/reports/global/2003. Global Corruption Report 2001,
http://www.globalcorruptionreport.org. 

Rule of law and economic growth

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Rule of law and economic growth

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