Robust US Innovation Is Rooted in Legal History

In the past few years, there has been more attention paid to issues including corporate consolidation, executive pay, and inequality. People have been asking some big questions about democratic capitalism and free markets, including whether we need more regulation. What’s your view?

Twenty-five years ago, Dartmouth’s Rafael La Porta, SKEMA’s Florencio Lopez-de-Silanes, Harvard’s Andrei Shleifer, and I published “Law and Finance” in the Journal of Political Economy. The paper looks across dozens of countries to see the impact of a country’s legal system on the development of its financial institutions and the size of its stock market.

If you compare the common-law tradition, brought through British colonization, with the Roman/French civil-law system, you see an enormous difference. Common-law countries, including the United States, have better-developed financial systems.

One reason is that common-law tradition more effectively protects investors and property rights, leading to more developed financial markets. More generally, private contracts are respected and actively enforced by the courts, in contrast to the more regulatory approach of civil law, where government often retains the ultimate authority to set the rules. In the UK and US, the legal tradition goes back hundreds of years and offers protection against the government sticking its hands in everything. Most economists think that’s positive.

Today, the US seems to be the center of innovation, and a piece of that probably has something to do with its financial system being so fluid. Is it any coincidence that it has the most innovative companies on the planet? We owe some of that to the institutional tradition here. For example, our legal system allows venture capitalists to seed people the money they need to grow their companies and to easily go public. You don’t see that same degree of development of the financial system in a lot of places around the world. For example, continental Europe lags behind, and obviously other places including China have issues with the rule of law.

One outgrowth of our initial research is that some other areas beyond financial markets are related to the same institutional structure. Studies have found that it’s easier to start a business in common-law countries. There’s less regulation and more of a flexible relationship between employees and employers.

The benefits of a robust legal tradition can be eroded if, for example, you get an administration and congress that want to regulate business to a large degree. But a certain amount is baked into the system, and it’s hard to get rid of. The politics of the day are constrained by the institutional system. Politicians can’t rewrite everything. It’s not so easy to do overnight.

Robert W. Vishny is the Myron S. Scholes Distinguished Service Professor of Finance and Neubauer Faculty Director of the Davis Center at Chicago Booth.