12. The Role of Law

in a Market Economy

David Kennett

One of the most serious, although frequently neglected, problems of the transforming economies is the lack of a viable legal framework within which market institutions can develop. In turn, the development of such a framework is one of the most difficult and complex tasks in the whole of the transformation process.

This absence of infrastructure is, of course, no accident. The theory of the centrally planned economy (CPE) relied on the absolute power of the government and the assumption at the center of total control over all aspects of the economic system. In that sense the government lay above the law. Only when individuals are convinced that their property and rights are above infringement by the government will enterprise prosper. The growth of all Western free market economies has been accompanied by the extension of an ever-more complex system of civil and business law. Modern scholarship tends to see this legal structure as contributing to economic efficiency through the reduction of transaction costs. It can be convincingly argued that no free market system can prosper where manipulation of the law is the unchecked preserve of the government of the day.

If the formerly centrally planned economies are to grow into the complex economic systems of the West they must develop legal institutions that are in turn like those found in the West.

Ownership as a Fundamental of a Market System

The first and most fundamental right to enable the operation of a free market is the right to own property.

Ownership seems at first glance a simple concept, but in fact it comprises three separate rights. The first of these is the right to use property as the owner sees fit; the second is the right of the owner to enjoy income from that property; and the third is the right of the owner to exchange or sell that property at a price accepted as fair by the seller.

In the classic centrally planned economy (CPE), the citizens have had only minimal rights in any of these dimensions of ownership. In the Soviet Union, for example, Article 10 of the old constitution was clear. "The foundation of the economic system of the USSR is socialist ownership of the means of production in the form of state property." Thus, the institution of private property ownership is, in and of itself, a revolutionary step forward; it was the first of the necessary rights defined in the Shatalin/Yavlinsky 500 Day Plan.(1)

We should note that as a practical matter, it is not necessary for a workable market system that an individual, or private economic enterprise, should have universal rights to own any and all kinds of property. Most mixed market economies grant to the individual less than full freedom in the acquisition, use, and disposal of property. Society may wish to collectively own certain classes of property or prevent individuals from exercising all of the three aspects of ownership, implicitly justifying such action by the presence of market imperfections and externalities. Even casual consideration reveals that in Western economies rights of ownership are often constrained: some types of property cannot be owned, let alone produced, by private citizens (firearms, drugs, nuclear power stations); planning restrictions prevent individuals from using some property as they see fit factories cannot be located in residential areas, or landfills in resort areas; the State will frequently intervene to prevent sellers from charging whatever the "market will bear"; the tax systems in all economies intervene to prevent the individual from enjoying the full income stream from practically any economic activity.

An important feature of the right to ownership is that to play a role in the economy it must be effective, not merely nominal, and be perceived as having permanence. The legal system must, therefore, have both the intent, and the power to prevent property from being stolen by others or appropriated by the State for a foreseeable time horizon, and this must be accepted by the populace. Again, Litwack addresses this and defines as part of legality a "belief by the population in the stability and enforcement" of a legal system. Without this condition any, would-be entrepreneur or trader will have one eye always looking for a capricious intervention by the State and that will adversely affect his or her behavior and hence the rational structure of prices.

The Role of the Law in Promoting Economic Efficiency

While even the limited right of ownership will ensure the development of some form of market, alone it will only go a limited way in stimulating efficiency. It will, in the words of Evgenii Yasin, the Russian reform economist, be a "bazaar" rather than a "market." A market system requires much more. The legal system that has grown up in western nations can be viewed as a complex series of rules one of the tasks of which is to promote efficiency and economize on scarce resources. Of course, this is not the sole function of the law in western nations. It must also protect individual and group rights against a variety of incursions, and the emergent legal codes in the Eastern European nations must fulfill the same tasks too. Also, it must be admitted that a good deal of legislation has been passed in developed nations, at the behest of narrow interest groups, that does little either for economic efficiency or human rights. However, a great deal of legislation has evolved to contribute to the efficient operation of a market economy. These too must at least be matched, and if possible improved upon, in Eastern Europe if the economies there are to thrive and to be as efficient as those in the West.

Freedom to Engage in Economic Activity

In order for prices of goods to approximate resource costs,(2) markets must be relatively competitive, and this involves the right of individuals, and groups of individuals or firms, to engage in whatever economic activity they perceive as having the greatest return. In simple terms, individuals must have the right to choose their own professions, among them being a self-employed entrepreneur, and choose the physical locations of where they pursue these professions. This is much the same as giving individuals the right to enter any business or industry that they choose and to live wherever they choose.

In most of Eastern Europe and the Soviet Union these rights were not guaranteed; most trades, especially those of buying and selling or wholesaling, could not be pursued by individuals under threat of punishment. Such activity, which depended on buying cheap and selling dear, was frequently labelled as simply "speculation."(3) Many of the social benefits of a market system depend on legal codes allowing individuals to respond to incentives. Indeed, one of the most fundamental recommendations of the joint report of the multilateral agencies, produced pursuant to the Houston Summit, was the decriminalization of activity that was "both rational and socially beneficial."(4)

Without a guarantee of free entry, private monopolies, with their attendant inefficiencies, replace state monopoly. Prices will not reflect the resource costs of production and monopoly rents(5) are earned, yielding inefficiency. A major target of Smith's Wealth of Nations was the system of royal licensing and monopoly that restricted the action of the individual. If the state can prevent the entry of individuals into a trade or profession, then the consumer, and society as a whole, is the loser while the monopolist, or the official that grants him monopoly powers, the winner.

This freedom must also embrace the ability to move and to relocate in pursuit of economic goals. In the Soviet Union, especially, freedom of movement was restrained by the government and movement into certain areas required a pass, or propiska. In any case, under central planning wage rates were determined by the planners; labor did not automatically flow to where demand was highest.

Once again, however, we must recognize that free entry into all economic activities in Western systems is not guaranteed. Many professions and trades require licenses or permits; these are usually defended as being efficient in that customers cannot always gather all the information they need, and certifying lawyers, stockbrokers, or auto-mechanics provides cheap information and protects the customer. Although market radicals, like Milton Friedman, denounce them in many cases as monopolistic and therefore inefficient restrictions, such barriers are an integral part of economic life in most market systems.

The Enforcement of Contracts, and Compensation

While ownership and entry will create an infrastructure in which a rudimentary market can exist, such a market would by necessity operate with a very short time horizon. Longer term views of economic relationships can be made viable by the use of contracts that bind parties to specific performance standards. Contracts are an integral part of moving from the "bazaar," where already-produced goods are exchanged, into a longer term system of stable inter-relations enabling planning and foresight. A contract binds both parties to specific performance standards, whatever the change in external circumstance, and provides for enforcement or compensation for non-performance.

The ability of individuals to make contracts, either verbally or in written form, and to have those contracts enforced by the law, is an important part of even the simplest economies and this provides some evidence of its social value. Some forms of long-term relationships can take place even in the absence of enforceable contracts, since the market can produce its own remedies. A supplier, for example, who persistently failed to deliver would have a great deal of difficulty in finding future customers, as knowledge of his persistent failure to perform became widespread. However, contract law removes part of the costs of gathering information from the contracting parties by providing general remedies and compensation for failure to perform and to deliver. This obviates the need for a socially expensive search.

The current situation in much of Eastern Europe, and especially in the Soviet Union, is that the making of contracts is running ahead of the law. Western lawyers are attempting to establish joint ventures with Soviet entities in ways that are not at all covered by Soviet law. A form of contract did exist under Central planning, but such agreements were not freely entered into by the firms, the key element in Western contract theory. Rather they were a way of conveying to lower levels the decisions made by the center in the planning process.

The contracts being signed now in Eastern Europe are less than optimal for several reasons. First, because there is no body of contract law and no precedent, the contracts must be unusually detailed in establishing performance criteria, and must anticipate and provide for all eventualities; this is time consuming and costly in legal resources. Secondly, there is no real enforcement behind them; many contracts in fact stipulate recourse to a Swedish arbitration agency in the event of problems, but this has no real legal force behind it. Because of this the contracting parties will probably only maintain their relationship as long as the business is mutually beneficial; the contracts are unlikely to provide any protection for one party if the other finds the arrangement no longer to his liking.(6)

To promote economic efficiency, contract enforcement need not always require strict performance to the letter of the contract, but it may instead give the injured party compensation for the losses incurred as a result of non-performance. Strict enforcement would be burdensome and inefficient in some cases where expected circumstances have changed and fulfilling the contract in its literal terms is impossible. However, the law must provide both the means for the injured party to be compensated and an appropriate system of adjudicating damages resulting from non-performance.

A Fully Defined System of Property Rights

In the introduction to this section, we explicitly limited the discussion to one of physical property. Now we must broaden the definition to include rights as a form of property; economic efficiency may be best served if, in some cases, rights can be exchanged in much the same way as physical property. Economic analysis of the law has developed very quickly in recent years and one widely accepted result has been that a clear definition of property rights is necessary for the efficient use of resources, although the extreme position that full definition of property rights would eliminate all market failure due to externalities (known as the Coase theorem) is in dispute.

The range covered by the term property rights is broad; included in it are rights as varied as the right to clean air, the right to quiet, the right to access to sunlight, the right to earn income from an invention, the right to broadcast over the air waves. In the West, property rights have developed incrementally, and they have been adapted and extended to take account of new complexities, both by legislation and by precedent in law. New technologies and new external circumstances have required new rights to be defined. Environmental property rights, software property rights, and the right of access to radio frequencies are three areas that have recently leapt to prominence.

In centrally planned economies, the State not only owned the physical means of production but also almost all property rights. As a result, such rights were not well defined. Since the State owned everything, there was no need to enforce, exchange, or dispute over rights using either the market or the courts. In the Soviet Union, the institution of arbitrazh developed in part to resolve property rights disputes between state enterprises, but its scope was limited and its functions confused since it made rules, interpreted them, and enforced them.

In theory the State represented everyone; the old saying, "that which belongs to all belongs to none," was confirmed in the CPEs. Since no-one could patent an invention, and hence secure in pecuniary terms the economic rent, there was a lower incentive to invent, or even for foreign entities to disclose any modern technology, process, or software innovation. Environmental degradation reached extremes in Eastern Europe because the citizenry had no means to establish or defend property rights to air, ground, or water. Moreover, the bureaucracy was able to appropriate for personal gain the property rights of the state, providing a barrier to reform.(7)

The extent of required legislation is very large. Western societies have been codifying and amending rights for centuries, and still changes in technology reveal glaring gaps. For half a century, few property rights have existed in the centrally planned economies. As always, being a latecomer has its advantages; rights can, in theory, be assigned in equitable and socially efficient ways. But the magnitude of the sheer task of definition and the political struggle over the acquisition of property rights means that a lot of confusion will occur in the short run.

The Corporate Form

One of the most important innovations of Western economies is the ability to create corporations. A corporation is a legal entity that can, through the sale of shares, raise capital from a large number of individuals, each of whom shares in the profits of the firm. It has a second important feature; each investor is liable only for the amount of money that each has invested. Thus, the overall liabilities of the firm are limited to the net worth of the firm, rather than the total debts and obligations. Thus, the downside in a corporate form is less than that in an equivalent partnership or proprietorship, where the owners would be liable for the full value of the obligations.

The development of the corporate form in Western economies was crucial in providing a means to raise large sums of capital and limiting the risk of each investor, particularly important when the number of investors is large and no one investor can be responsible for the oversight of the operation of the firm. Without the corporate form it is difficult to gather together the finance to undertake large scale operations.

Corporations may be either privately held, where the shares are not traded on stock markets, or public corporations where ownership is liquid and traded on stock markets. The transforming economies must ultimately develop stock markets though there are considerable barriers to their rapid development, discussed by van Agtmael.(8)

It should be noted that although the corporation is efficient in encouraging large and risky ventures, its very presence does limit the effectiveness of contract law. A corporation's liability is limited to the extent of its assets, and situations may result where its liability under a contract exceed those assets.

Bankruptcy Law

Frequently overlooked in the discussions of infrastructure is the role of bankruptcy legislation. Capitalism is, in Schumpeter's words, a "gale of creative destruction." Company failure and the dissolution of corporations must be regarded as a normal aspect of the system.

The efficient operation of that system, however, is highly dependent on an orderly disposition of the assets of the firm in the event of failure. A necessary condition for orderly capital markets is a full and enforceable set of defined property rights; bankruptcy law is one component of these rights.(9) The risks that lenders and materials suppliers assume in supplying a firm can only be assessed when there is full knowledge of the "pecking order" in which debtors will be arrayed should the firm go into bankruptcy.

Accounting and Financial Disclosure

The law plays a vital role by requiring that firms must report their financial results in a specified standard accounting system and that this information is made publicly available. The efficiency aspects of this are made obvious by considering the alternative: without required and standardized disclosure the costs of information to an individual or other firms, whether potential shareholders, suppliers, or customers, would be very high. This, required disclosure has clear social efficiency in reducing information costs. This is obviously of the greatest importance in the operation of stock markets, where buying shares without access to company information would be undesirably risky, and share prices would not reflect underlying values. It is also of great relevance to those who supply the company with raw materials and inputs and those who provide credit to firms in more direct ways.

Tax Law

Taxes are, like death, inevitable; governments, even those highly limited in scope, must gather their resources from somewhere. One of the most important features of an overall legal system must be the creation of a tax regime that is visible, consistent, and, to some extent, regarded as fair. The particular form of the tax system is not absolutely important. Different, successful Western and western-style economies have widely different tax regimes, some reliant on indirect taxation (sale taxes and value added taxes) and others rest upon direct taxation (income and profits taxes). Some systems place more burden on the individual and less on business than others.

What is important is that the tax laws should be considered and consistent, and that they should be subject to adjudication by some authority external to the taxing authority. Businessmen, like sportsmen, can operate under widely different conditions as long as the rules of the game are clear and are not subject to capricious change. One of the greatest deterrents to investment is uncertainty with respect to the tax treatment. This is especially important for the foreign investor, whether setting up a wholly owned subsidiary or entering into the joint-ventures that are the most frequent of capital inflow into the former CPEs at the present time.

That said, it is desirable that tax systems should be as neutral as possible and not result in undesirable implicit subsidies for particular kinds of industrial organization, firm organization or ownership. Taxes that favor or disfavor (say) vertically integrated structures, individual proprietorship, or domestic ownership, lead to economically inefficient distortions.

A Clear Definition of Governmental Responsibility

Just as the lack of clarity and stability in tax matters is a major disincentive to investment, so is the lack of clarity as to the appropriate role of government, and where relevant, which level of government has what responsibilities. Under classical central planning, the State was all powerful. In an important sense, it was both the owner of everything, from land to air quality, and responsible for everything, from housing to providing food. What is required now is that there should be a scaling down of governmental responsibility and a definition of where the public sector ends and the private sector begins. Under central planning, because the State was both a producer and a provider of social services, firms quite frequently assumed a social role inappropriate in a free market economy. What may be required for an efficient labor market is a complete overhaul and redefinition of what is known in the West as the social safety net. Without a well-defined social safety net, the strains on society of growing unemployment may prove too great for fragile democratic movements to survive.

Similarly because all power was, in theory at least, held in the center, the responsibilities of various governmental levels was not appropriately defined. Again, as in much of what we have discussed, the "developed" economies have many of the same flaws. Disputes between the competencies of federal, state, and local governments in the United States are frequent, and when they occur are socially costly in terms of delay and wasted resources. This set of problems is particularly pressing in the natural resource area where, in the pre-Commonwealth USSR, there was dispute between three levels of government over the ownership of natural resources located in the "entrails" of the earth. Now, of course, the "center" has ceased to be a contender, but strain still exists between the Republics and the localities.

This, again, is not dissimilar from the United States; however, in the United States there is a both a body of legislation and a body of legal precedent to resort to. An individual can with foresight take legal opinion, and either narrow his liability or at least know better the distribution of risk. Uncertainty is always and everywhere the enemy of stable economic activity and part of the law's function is to narrow that uncertainty.

A System of Civil Compensation

The law of liability, as it existed in centrally planned economies, has been likened to military law. Blame, when it could be assigned, was a criminal matter and would be redressed by the punishment of the offender rather than by the compensation of the victim. Tort law, which deals with the redressing of private or civil wrongs through suit, did not exist in the centrally planned economies. The United States may suffer from what its vice-president refers to as a plague of lawyers, many of whom make their business through civil suit, and the prospect of a tort-free society might seem attractive. However, it is clear that the threat of suit does have positive consequences; a firm found guilty of injury will ameliorate its behavior in the future, the more so if it is forced to pay punitive damages.

It might be argued that a chief executive officer will be even more careful about the behavior of his corporation and underlings if he were liable to a jail-term rather than merely dipping into the shareholders' profits to settle a suit. However, this system of criminal redress would have two consequences. First, it would affect the behavior of potential victims by encouraging untoward caution since they know no monetary compensation will be available. Second, it will discourage quite legitimate business activity, because of fear of criminal punishment.

Consider a Western business engaged in (say) an extractive industry, wishing to start operations in (say) Russia. The technique, like most, is not without risk either to his own workers or other nearby individuals. In the West, the businessman would know that he is subject to civil suit in the case of accidents, but to criminal liability only in the case of gross negligence. In Eastern Europe and the former USSR, it is quite possible that the redress would occur only through criminal proceedings. What is true for the Western investor is also true for the domestic Russian businessman. Removing the greatest problems to investment while retaining some censure over dangerous behavior, and ensuring the ability of the victim to be compensated, requires the development of a civil liability code.


In a short piece it is only possible to give some idea of the role of law in market economies, and the extent of required legal reforms in the transforming ones. The problems faced are large but on the whole well-known. Access to foreign experts in each of these fields of law has opened and already large amounts of legislation have been passed. Moreover, the situation is not wholly without precedent: the commercial and tax codes of Japan were entirely rewritten on an American model by the occupying forces in the aftermath of World War II. For Eastern Europe, the more appropriate models may be French or German codes, especially since the ultimate objective of much of Eastern Europe is to join the European Community.

While the codes may be reformed in a relatively short space of time, the legal infrastructure will take several years to adapt and become efficient. Well trained lawyers and judges will be in short supply for many years and this will hamper the speed and, therefore, the efficiency of the courts. Also, law in Eastern Europe will have to build its own history of precedence. Thus, reform cannot be achieved overnight, though it is necessary for the efficient operation of a modern economy.




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