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«1 Introduction Understanding the causes of financial development and economic growth is central to re- search agendas in many fields of economics, ...»

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Law and Finance “at the Origin”

Ulrike Malmendier*

December 2008


What are the key determinants of financial development and growth? A large literature

debates the relative importance of countries’ legal and political environment. In this pa-

per, I present evidence from ancient Rome, where an early form of shareholder company,

the societas publicanorum, developed. I show that the societas publicanorum flourished

in a legally underdeveloped but politically supportive environment (Roman Republic) and disappeared when Roman law reached its height of legal sophistication but the politi- cal environment grew less supportive (Roman Empire). In the Roman case, legal devel- opment appears to have mattered little as long as the law as practiced was flexible and adapted to economic needs. The ‘law as practiced,’ in turn, reflected prevalent political interests. After discussing parallels in more recent history, I provide a brief overview of the literature on law and finance and on politics and finance. The historical evidence sug- gests that legal systems may be less of a technological constraint for growth than previ- ously thought—at least “at the origin.” 1 Introduction Understanding the causes of financial development and economic growth is central to re- search agendas in many fields of economics, ranging from macroeconomics and micro- economics to finance. The law and finance literature suggests a causal impact of coun- tries’ legal systems.1 Another strand of the literature emphasizes the role of the political environment and argues that the effectiveness of institutions varies considerably with the political support they receive.2 * I would like to dedicate this article to the late John McMillan, without whose encouragement and interest, I would never have written it. I would also like to thank Daron Acemoglu, Thorsten Beck, Stijn Claessens, Stefano DellaVigna, Peter Howitt, Simon Johnson, Marco Pagano, Enrico Perotti, Paola Sapienza, Walter Scheidel, Andrei Shleifer, Mark Weinstein, Jeff Wurgler, Luigi Zingales as well as the participants at the 2006 Conference on the Formation and Evolution of Institutions at Brown University, UC Berkeley, UCLA, and Yale University for helpful comments and discussions. The article also benefited significantly from the detailed comments of four anonymous referees and Roger Gordon, the editor. Yelena Bakman, Aisling Cleary, Kimberly Fong, Xing Huang, Zhenyu Lai, William Leung, and especially Prasad Krishna- murthy provided excellent research assistance.

1 La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997) and (1998).

2 Rajan and Zingales (2003); Acemoglu and Johnson (2005); Pagano and Volpin (2005).

-1- Definitive empirical evidence for either of those approaches is hard to come by.

Given the scarcity of perfect natural experiments, careful and detailed analyses of individual cases are a valuable part of the literature, even if they stop short of proving causality. In fact, much of the literature revolves around specific historical examples, mostly taken from the last two centuries.3 This paper expands the current body of evidence to a much earlier time period, two thousand years ago in ancient Rome. I focus on a specific cornerstone of financial and economic development: the emergence of the business corporation. I propose that, contrary to widespread belief, the earliest predecessor of the modern business corporation was not the English East India Company nor the medieval commenda,4 but the Roman societas publicanorum, i.e. the “society of government leaseholders.” While this claim alone may be of independent historical interest, I use the Roman case to shed light on the “law and finance” versus “politics and finance” debate. The Roman evidence illustrates the limitations of the existing law and finance theories. In the case discussed here, legal restrictions (or the lack of legal development) per se appear to matter little as long as the law as practiced is flexible and adapts to economic needs. In fact, one of the most important periods of legal development, “classical Roman law,” appears to be negatively correlated with financial and economic development. I also show that ‘the law as practiced’ reflects prevalent political interests.

In addition, the historical evolution of the Roman societas publicanorum allows us to better understand the political and economic preconditions for the development of the business corporation in modern history, an organizational format that has been essential for economic development. The Roman case illustrates the balance of power between the political elites and the business elites that determines whether this organizational form can survive and expand.

I first provide a historical introduction to Rome’s economy and legal system. This brief overview helps to explain how an ancient economy could arrive at a surprisingly sophisticated level of financial structure. I emphasize the flexibility in the creation and interpretation of legal rules, which allowed new business forms to be invented through modifying preexisting commercial and social institutions (Section 2.1). I then describe the role and business activities of the publicans, from the 5th century BC until their demise under the Roman emperors (Section 2.2). I argue that, at the height of its developExamples are Engerman and Sokoloff, (1997) and (2002); Berkowitz, Pistor, and Richard (2003); Lamoreaux and Rosenthal (2005); and Haber, Razo and Maurer (2003).

4 Ekelund and Tollison (1980) and Gower (1969), p. 22. Kindleberger (1984) characterizes, more generally, alterations of the “true” partnership as the earliest forms of business organization but views the medieval commenda as the starting point (p. 195). Baskin and Miranti (1997) explicitly assess the development of the business organization under Greco-Roman law as restricted to partnerships.

-2ment, the societas publicanorum resembled the modern shareholder company along several core dimensions: its existence was not affected by the departure of partners (differently from the regular societas, i.e. the Roman partnership), and it could issue traded, limited-liability shares (Section 2.3). I then discuss the causes of the corporation’s demise under the Roman Empire (Section 2.4). In particular, I point out how a change in political interests triggered its demise at a time when the general legal framework had substantially evolved and was, if anything, better able to support the institutional format of the corporation. That is, I evaluate the demise of the societas publicanorum in the light of a drastically changing political environment, the shift from Republic to Empire. In Section 2.5, I summarize the insights from this historical evidence and point to parallels in the later development of the East India Company and other parallel cases from modern history.

I link the historical evidence to the modern debate on the causes of financial development and growth. In Section 3, I first provide a brief overview of the literature on law and finance and on politics and finance. While the law and finance literature emphasizes the importance of a growth-fostering legal environment, the politics and finance literature argues for the predominance of political interests in determining the growth path of an economy. The overview emphasizes research on the role of different business formats (such as the shareholder company) and their characteristics (such as limited liability, agency, and representation), which has found less attention in previous reviews. These historical papers highlight that smooth access to financing requires more than investor and creditor protection. Restrictive business formats impose transaction costs on managers and may impede the funding of promising enterprises.

I discuss the implications of the rise and fall of Roman corporations for the current debate on law versus politics, focusing on two aspects. First, the fundamental assumption underlying the law and finance approach is that the legal environment causally affects economic development. The literature attributes better financial development in common-law than in civil-law countries to the legal flexibility inherent to common-law systems and the lack thereof in civil-law systems, often using Roman legal origin as a proxy for a rigid and growth-hostile legal environment. The historical evidence (from the time period that spawned Roman law) suggests that legal systems may be less of a technological constraint for growth than previously thought—at least “at the origin.” Roman law provided a flexible and nurturing legal environment for financial development during the Republic, accommodating fundamental advancements such as a corporate business format. In fact, the case-based evolution of Roman law closely resembles today’s common-law systems.

In the same vein, the case of the societas publicanorum illustrates that the functioning of an organization may develop independently of formal laws regulating company

-3formats. Business formats affect firms’ access to external financing, stability (or “longevity”), ease of representation by individual managers, and the rights and obligations they can assume. An advanced (corporate) format facilitates its operation. However, analyses focusing on the formal law rather than the ‘law as practiced’ risk misconstruing the actual state of organizational development and its implications for finance and growth.

Second, if it is the ‘law as practiced’ that matters, the next question is what affects the practice of law and its responsiveness to economic needs. Here, the historical evidence points to the role of political pressure. The law as practiced appears to serve economic needs if and only if aligned with the dominant political interests. Differently from the view put forward in some of the politics and finance literature (e.g., Perotti and van Thadden, 2006), the Roman case does not provide evidence that the influence of politics acts via its influence on law, i.e., the view that the law matters, but that the choice of the law is endogenous to political forces. What we see in the Roman case is that formal contract and business law develop orthogonally to political changes. Formal law has little influence on economic outcomes because it is trumped by political forces.

While this dominance of politics over law is only a historical observation, based on a specific, non-generalizable case, the Roman case presented here overcomes a basic identification problem faced in the empirical analysis of law, politics, and finance: As law and politics evolve over time, they often develop in the same direction—either fostering or limiting financial development. That makes it difficult to attribute financial development to either source. The societas publicanorum provides a rare case in which the evolution of law and politics diverged. During the Roman Republic, when Roman law was still far from a complete body of civil law (“pre-classical” period), political interests demanded stable business organizations that could raise large-scale financing. During the Roman Empire, when Roman legal science peaked (“classical” period) and the lawrelated transaction costs of economic interaction diminished, political interests reversed and grew less favorable toward the smooth operation of large-scale economic activities.

Financial contracting regressed despite the progress in legal framework. My findings suggest that economic development that coincides with government interest requires little formal legal underpinning other than a willingness to sanction experimentation with existing legal forms on a case-by-case basis. Without government support however, it may wither despite an existing legal framework.

These insights do not rule out that law does affect financial development. The Romans might never have arrived at developing an early type of corporation without their advanced legal environment. Nor do we observe the counterfactual history where the formalization of Roman law in the classical period gives explicit sanction to legal forms such as the societas publicanorum and codifies their rights. Rather, the historical case illustrates that a failure to account for the political economy and its effect on the legal environment leads to a misreading of the relationship between law, finance, and growth.

2 A Historical Case Study: the Roman Corporation

2.1 Roman Economics and Roman Law Historical evidence about the publicans and their companies stretches from the beginnings of the Republic into the Empire. The height of their activities falls into the last two centuries BC. I provide a brief overview of the economic and legal development at the time. Table 1 provides a chronological overview.

Economics A starting point for my analysis is the question of how an early economy could be sophisticated enough to generate a business form as advanced as the societas publicanorum. Peter Temin (2001, 2006) uses evidence from grain markets, employment contracts, the manumission of slaves, and loan contracts to argue that Rome’s economic institutions during the Early Empire were more market-oriented than even in the medieval economy many centuries later. In this subsection, I provide examples that illustrate the same point and extend the discussion to the period of the Roman Republic.

From the third to the first century BC, Rome grew from a rural community to a power stretching all over Italy and then beyond the Mediterranean, including West and South Europe, Asia Minor, the Near East, Egypt, and North Africa. In the wake of this geographic expansion (see Table 1), large-scale commerce, industries and financial sectors developed, and the volume of trade exploded. This appears to be particularly true for seaborne trade. For example, Hopkins (1980) infers from data on 545 dated ancient shipwrecks, found near the coasts of France, Italy, and Spain, that interregional trade was higher in the period from 200 BC to AD 200 than either before or during any time in the following millennium. Analyses of the number of silver coins minted in Rome during the late Republic (157-50 BC) supports this hypothesis: the circulation of coins increased tenfold over that sample period.

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