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The Rules of the Game and the Development of Security Markets 313
Our interpretation has clear implications for the debate about financial liberalization
in developing countries. It highlights the danger of a rapid loosening of
restrictions on financial transactions in an inadequately structured, or politically
ambiguous, legal framework. In the absence of a credible macroeconomic and
regulatory policy, capital flight toward countries with more established legal protection
and macroeconomic credibility is the natural result.
In general, the establishment of credibility by a legal system requires time. The
reason is that a sovereign government can prove its intent to abstain from discretionary
interference only by maintaining a rigorous policy and building reputation
capital. In effect, once such capital has been established, its economic
benefits may well restrain even an opportunistic government from excessive
interference.
Perhaps this notion can be utilized to interpret the pattern of development of
the financial superstructure, impressively documented by Goldsmith (1969,
1985). If the credibility of the legal infrastructure, and thus favorable conditions
for arm’s-length transacting, develop slowly, acceptance by private agents of
financial instruments which facilitate exchange will be gradual and will be highly
correlated with the general increase in economic specialization and productivity.
However, as their credibility improves, financial assets will grow at a rate faster
than that of the economy; and their composition over time will tend to shift from
collateralized or self-enforced credit (agricultural and merchant loans), to direct
or indirect nominal claims on the government, to claims issued by independent
economic units in deficit and subscribed by units in surplus through enforceable,
transferrable claims.
This may explain why very few developing countries become major financial
centers. Credibility is established mostly on consistency of policy record. Interestingly,
the only exceptions, Hong Kong and Singapore, are small city-states
with a tradition of common law and a tremendous dependence on foreign investment
in their capital markets. In their case, a rigorous policy is credible because
too much would be lost by opportunistic action.
IV Conclusions
We have linked the development of security markets to the emergence of a credible
enforcement rule designed to protect minority interests as well as small and
foreign investors.
We summarize our definition of an inadequate legal rule as follows. Legal inadequacy
is the consequence of a regime of intervention which is at the same time
excessive and insufficient: excessive because executive and administrative