For a well-functioning economy, the rule of law matters

AUSTIN, Texas — Countries in which courts more easily enforce contracts see less economic volatility overall than countries that don’t adhere as well to the rule of law. This is the conclusion of a study by a finance researcher at the University of Texas at Austin.

Research suggests that when contract execution is poor, employee morale suffers, which ultimately triggers churn, leading to greater economic volatility and greater differences in productivity between companies. Countries that adhere less to the rule of law as measured by the World Bank have greater volatility in their growth rates and the economy in general.

“In countries where the rule of law is worse, if I’m an employer, I have more incentive to break my promises to you when a bad shock hits,” said the co-author of the study. Guillaume Fuchs, professor of finance at the McCombs School of Business. “Without the ability for affected employees to seek help, you work less, become less productive, and that amplifies the shock to the economy.”

The findings appear in the Monetary Economics Journal.

Fuchs, along with Martin Dumav from Carlos III University in Madrid and Jangwoo Lee from the Chinese University of Hong Kong, used game theory – the study of how people make strategic decisions – to create a model in which two entities, such as a boss and an employee, interact over time.

The model includes two building blocks. The first is the concept that firms are hit by shocks that make them more or less profitable. The second is that contracts are not perfectly enforceable, depending on the legal environment. This lack of contract enforcement can cause someone to backtrack on a promise, and when it’s the boss, there’s a cost. The business relationship is damaged.

The team compared two theoretical economic environments, one with strong rule of law or contract enforcement, and the other marked by poor enforcement. Next, they studied the effects of economy-wide and firm-specific shocks.

The researchers found that a 1-point decrease (on a scale of 1 to 5) in the rule of law measure is associated with a reduction in overall volatility of 1.2 percentage points. In countries with weaker legal systems, workers in less productive companies are quicker to stop trying during tough economic times.

India and China, for example, which rely more on relational contracts based primarily on trust between the parties, could potentially reduce the productivity ratio of the most productive to the least productive firms by around 60% if they could strengthen their legal systems at the level of that in the USA

The findings have implications for relations between employers and employees, businesses and governments around the world. Building trust is particularly important for businesses in countries where the rule of law is weak and relational contracts are the norm. Organizations can work to build trust long before a major shock hits, and empowering employees to challenge broken promises can also help companies gain credibility.

“The economic cycle could be smoother if you had better rule of law,” Fuchs said. “Anything companies can do to build trust and commit to delivering on promises is a very valuable thing.”

For more details on this research, read McCombs Big Ideas Reportage.