(This essay was published in Hong Kong Economic Journal on 9 December 2015.)
Recent economic research into legal origin has found overwhelming evidence that different legal traditions approach the control of economic and social problems very differently. Most countries have adopted one of a relatively few number of legal traditions from mother countries that were transplanted largely through conquest or colonization and only in a few cases by voluntary adoption.
A survey of 150 countries in the world today shows 42 have a common law legal system and 108 have a civil law legal system. Within the civil law tradition, there are sub-traditions: 84 are French, 19 German, and 5 are Scandinavian. China, Japan and Korea adopted the German system voluntarily.
Following the transplantation of legal infrastructure, such as legal codes, legal principles and ideologies, a great deal of legal and regulatory change to national laws occurs as they evolve and adapt to local circumstances. For this reason, the legal and regulatory systems of no two countries are identical. But still, many of the basic transplanted legal institutions have remained and the differences in style between legal traditions in addressing economic and social problems have persisted.
What is most remarkable is that legal origin continues to exert powerful influence for very long periods, even after national independence and the departure of the former colonial power. The effects of legal origin are pronounced and persistent regardless of whether the country is politically democratic or autocratic, and they can be seen in all aspects of the economy and society despite the huge variations in history and culture of these countries.
Legal origin can help us comprehend Hong Kong’s present difficult predicament in the transition from British colonial rule to “one-country, two-systems” under Chinese sovereignty. It also offers hope for developing a new narrative that could reorient our future development under “one-country, two-systems” and our participation in China’s “one-belt, one-road” overseas strategy.
But before suggesting what this new narrative might be, let me first discuss some of the economic outcomes and social behaviors that are shaped by legal origin.
First, in common law countries, financial and capital markets are deeper and more developed than in civil law countries because of more efficient financial institutions.
Civil law is generally associated with lower shareholder and creditor protection, less efficient debt enforcement, and higher government ownership of banks.
Compared to common law countries, French legal origin countries have fewer anti-self-dealing regulations against abuse by corporate insiders and less prospectus disclosure of critical information in the offerings of new issues.
Bankruptcy laws in civil law countries are also less protective of creditor rights, resulting in less efficient enforcement of debt collection through the courts. It is a longer, more difficult process to collect a bounced check or arrears from a nonpaying tenant in civil law courts.
Government ownership of banks is significantly higher in civil law countries. As a consequence, interest rate spreads between lending and borrowing rates are wider than in common law countries, where there is greater competition in the banking industry with less market concentration.
In contrast to civil law countries, common law countries have a higher stock market capitalization to GDP ratio, a higher number of firms per population, less overall market concentration, and a lower control premium (i.e., the amount a buyer has to pay above the market price to acquire a controlling share in the company). In debt markets, they have a higher private credit to GDP ratio, greater efficiency of debt collection, and lower interest rate spreads between lending and borrowing rates compared to civil law countries.
A second area in which legal origin shapes behavior is in government regulation, or even ownership, of a wide range of business and non-business activities beyond finance. Compared to common law countries, French legal origin countries have more entry and labor regulations, higher state ownership of the media, and heavier reliance on conscription.
The number of steps required to open a new business is significantly higher in civil law countries. This can lead to a worsening of corruption and an increase of employment in the unofficial economy. An increase in government regulation of labor reduces the labor force participation rate and increases the unemployment rate, especially of young persons.
Third, legal origin has a pronounced effect on judiciary and government institutions. Compared to common law countries, civil law countries generally have more legal formalism and less judicial independence. The latter is reflected in lower judiciary tenure, and sharply lower constitutional acceptance of appellate court rulings as a source of law.
Judicial institutions matter for both the efficiency of contract enforcement and the security of property rights. The differences are very large. Increases in legal formalism are associated, for example, with a longer time needed to evict a nonpaying tenant or to collect a bounced check in civil law countries. Judicial independence significantly improves the quality of contract enforcement and the security of property rights.
Fourth, legal origin has large and persistent effects on all of the above-discussed financial, economic and social outcomes even across societies of widely different cultures and very different political arrangements (or power configurations).
As mentioned, the effects of legal origin are significant regardless of whether a government is autocratic or democratic. Their effects prevail in societies with strong left-wing political movements and powerful labor unions that are alleged to have tamed capitalism, particularly financial capitalism. They also prevail in democratic societies with proportional representation electoral systems that have produced power configurations characterized by political divisiveness and deadlock dominated by intransigent minority interests (of which Continental Europe is the prime example, which also happens to be dominated by the civil law tradition). Research has found that legal origin effects are so prominent across different power arrangements that they can eclipse political influence.
Legal origin effects are autonomous and independent because they work primarily (but not necessarily exclusively) through legal rules and regulations impacting a broad range of areas of society and the economy, with large, substantive, and long-term consequences. Differences in legal rules and regulations then lead to the differences in economic outcomes and social behavior.
Moreover, the influence of legal origin effects persists over decades and even centuries because the transplantation involves not just specific legal rules (many of which actually change over time), but also legal institutions (of which judicial independence might be the most important), human capital of the participants in the legal system and, critically important, the strategic approach in how to use the law to deal with new problems. Successive generations of judges, lawyers, and politicians all learn the same broad ideas of how the law and the state should work.
One can think of the two legal traditions as trying to simultaneously address the twin problems of social disorder or market failure, on the one hand, and dictatorship or state abuse, on the other. There is a tradeoff involved.
As the state becomes more assertive in dealing with disorder, it may also become more abusive. The civil law tradition can be thought of as a system that is relatively more concerned with disorder than with dictatorship in finding solutions to social and economic problems. In contrast, the common law tradition is relatively more concerned with dictatorship than with disorder. One can think of the two legal traditions as conditioning a style of social control over economic life as well as some aspects of social and political life.
Both systems seek a balance between private disorder and public abuse of power. But they seek it in different ways. Common law approaches the problem by buttressing markets and resolving disputes, and civil law by restricting markets or even replacing them with state commands. As a consequence, freedom and prosperity have made bigger strides in common law countries.
The opening of China in 1979 coincided with the march of economic globalization. Hong Kong would subsequently experience a period of economic boom followed by the most severe post-war bust since the Great Depression. Also lurking in the background is the gradual onset of the worst demographic ageing in the world, second perhaps only to Japan. The economic and social shocks that have swept through Hong Kong in this period have been enormous and unprecedented. The conditions for disorder have begun to ferment.
When the manufacturing industry expanded and disappeared across the border, it created enormous prosperity in Hong Kong. Property prices shot through the roof and vast numbers of peoples became new millionaires. But there has also been a downside to property-driven wealth because it has left half the population behind, especially after property prices were temporarily punctured by the Asian financial and economic crisis.
Family breakdowns have also become common, with rising divorce rates fuelled by growing cross-border marriages among low-income households. Nearly one-fifth of all children are now brought up in single-parent households. Hong Kong’s divorce rate is now among the top 10 in the world.
The lion’s share of Hong Kong’s social and economic problems has external origins. Hong Kong has been adapting to these shocks and adjusting to rapidly emerging opportunities and challenges. The response has been uneven, quick in areas where markets dominate but slow in administrative areas. But given the overwhelming scale and suddenness of the shocks, the response has to be judged inadequate.
A major policy failure has been the inability to respond to the growing crisis of economic and social inequality, especially of housing wealth. In retrospect, to focus on settling political issues first rather than tackling social and economic problems was the greatest political failure. But this is characteristic of those used to the common law tradition.
The common law fear of state abuse of power trumps its fear of disorder. And this has led political actors on the ground to prematurely test the nascent “one country, two systems” compromise political arrangement, before it is ready. This was probably a bad strategic move, but it is the instinctive style of those with a firm common law bent.
Unfortunately, in choosing to insulate Hong Kong from Beijing’s political reach out of fear of its interventionist and control instincts, the democratic movement has had to directly confront Beijing. The search for absolute security has ended up creating greater insecurity.
Alas, the philosopher Hegel would have said it was the cunning of history. Did Hong Kong really have no choice!
Yet embedded in the common law tradition lays the strength of Hong Kong’s financial, economic, and social institutions. These are the sources of soft power, the skills necessary and important for building and forging contractual relationships that are the foundations of lasting prosperity and friendship. Their strength lies with the individual people of Hong Kong, whose tolerance, trustworthiness, and openness towards different cultures in foreign communities prepare them to be natural ambassadors to reach out to the peoples and places along “one belt, one road” without having to be given a purpose by the state.
Such is the strength of Hong Kong’s common law-inspired institutions and people. They are deep and many; and are somewhat in short supply in the civil law tradition on the Mainland.