LEGAL DNA (WALL STREET JOURNAL 2002)

THE WORLD ECONOMY is putting modern capitalism through another stress test. Like tests that physicians do for people with heart disease, this one highlights the system’s weaknesses and brings forth various prescriptions for treating symptoms. But, just as with heart disease, the stress test raises intriguing questions about genetic advantages: Do some economies have institutions, laws and commonly accepted business norms that produce a stronger strain of capitalism, one better adapted to withstand shocks and improve its people’s prosperity?

Specifically, why do the U.S. and Britain have bigger stock markets and more shareholding citizens than Germany and France, and does that make their economies more flexible? Why do more companies go public in India than in Brazil? Why do American businesses use private arbitration more than others to resolve corporate disputes? Why are U.S. governments more comfortable settling trade disputes one case at a time than their Continental counterparts?

To a remarkable degree, the answers can be traced to the different legal traditions that emerged in England and France in the 12th century and spread through their colonies. Nine hundred years later, these traditions still influence business, investors and government. And as globalization steadily erodes national boundaries, the differences are causing unavoidable strains. WESTERN COMMERCIAL LAW comes from two traditions: the common law, with roots in England, and the civil law, rooted in ancient Rome and refined later by continental Europeans. Common-law countries, including the U.S. and other former British colonies, rely on independent judges and juries and legal principles supplemented by precedent-setting case law. In civil-law countries, which include much of Latin America, judges often are lifelong civil servants who administer legal codes packed with specific rules. Case law matters less. Civil-law countries distrust judges and arbitrators; common-law countries venerate and empower them. Rule-laden civil-law countries aren’t well-adapted to cope with change; the case-law approach makes common-law countries inherently more flexible. All this has long fascinated law professors. After the early failures at building capitalism in Russia following communism’s collapse, the issue also attracted a band of economists, led by Harvard’s Andrei Shleifer. They sought to identify conditions essential for functioning markets and private property. Whatever they were, Russia didn’t have them.

Examining 49 countries from Argentina to Zimbabwe, the economists discerned a distinct pattern in both rich and poor countries: “Civil-law countries exhibit heavier regulation, weaker property-right protection, more-corrupt and less-efficient governments and less political freedom than do common-law countries,” Mr. Shleifer puts it. As France well illustrates, civil law “more easily accommodates the expansion of government intervention in economic and social life.” Investors in civil-law countries, Mr. Shleifer and colleagues argue, are less certain that their property rights will be enforced. One symptomatic example: Civil-law countries more frequently require shareholders to attend meetings to vote instead of voting by mail. In these countries, few people own stock, bond and stock markets are smaller and more companies are controlled by a few big holders. In the past decade, this has proved a significant constraint on investment and economic growth. The law matters—and it matters a lot. AS FINANCIAL MARKETS outgrow national borders, economies built on different legal foundations are being forced to reconcile their differences. When shares of a French company are traded on the New York Stock Exchange by a Japanese brokerage house, there is pressure to agree on consistent accounting standards and a shared understanding of investor-protection rules. The trend is toward the U.S.-British approach, but the deep roots of the alternative explain the resistance in other countries.

Similar tensions appear in world trade disputes. The U.S. tends to be more willing to allow World Trade Organization arbitrators to make case law (particularly when decisions favor the U.S.) than Europe, which prefers clear rules. The old differences also inform some international environmental disputes: Civil-law countries, accustomed to well-articulated and rigid rules, are uneasy relying less on rules and more on tradable pollution permits. There remains a chicken-and-egg dispute about which came first: The law, as Mr. Shleifer and allies argue, or the rise of an independent business-investor class that demanded legal protection, as Columbia law professor John Coffee Jr. sees it. In either case, the lesson of history is sharp: Markets and the prosperity they can provide do not exist independent of the law and the institutions of government but are intertwined with them. Well-functioning financial markets, in particular, rest on clear and enforced protections for investors. And when a changing economy requires new rules—for auctioning radio spectrum, modernizing stock markets, regulating new financial products, enforcing intellectual property rights—it’s wise to remember that the economic impact is long-lived.