07/12/2010 10:28 pm ET Updated May 25, 2011

Does Rule of Law Really Matter for Development?

We hear it often: the rule of law is essential for investment. For over a decade, a legion of organizations and scholars--from the World Bank to Douglass North--have argued that if countries really want to develop they need to develop an independent, impartial, pro-market system for the application of laws and their adjudication. And those that don't will be ignored by international investors and banished from the global market.

If only it were true.

The relationship isn't that easy or clear. There are plenty of examples of countries and economies that have prospered without the effective rule of law; ones that haven't even though they may have it; and plenty of companies that are willing to invest even in abysmal or deteriorating conditions.

It may be heretical to say it, but we have oversold the rule of law.

Truth is: it matters most for small and medium enterprises. For large investors, national economies and specific economic sectors, it matters far less than we've convinced ourselves.

Let me highlight some of the overblown assumptions we've made about the rule of law and economic growth. Only by understanding them can we really recognize, in a more nuanced and targeted way, the limited, though important, way that the rule of law is important and for whom.

Myth 1: Big Investors Need the Rule of Law:

In a famous speech, then-Secretary of State Colin Powell made an argument for countries to reform their judicial systems by stating that "capital is a coward. It flees from corruption, bad policies, conflict and unpredictability." Left out of this was the bald truth that big investors can afford to invest in less-safe conditions nationally because they come with their own protection: arbitration agreements. Many of the contracts negotiated in private equity, vendor agreements, and even fixed investments establish that in the event of a contract dispute both parties will submit to international arbitration--often under the Inter-American Convention on International Commercial Arbitration (1975) and the UNICITRAL Model Law on International Commercial Arbitration (1985)--with arbitration occurring outside the country.

What this does is effectively take the issue outside the country's system for the rule of law, obviating the sweeping reform of the judicial system, an overhaul of commercial codes, and the creation of an effective, transparent independent system for the naming and oversight of justice officials necessary for the rule of law.

Sure, this international arbitration is great for investors who don't have to wait for the lengthy, uncertain process of wholesale reform of a country's legal and judicial system. And it's a boon to policymakers who can establish an effective, quick pathway to attract investors. But it does little for pressuring the system as a whole for reform and reduces the advocacy and urgency for broader reform. Yes, other disputes will arise that do not rise to the level of arbitration and that will need to be dealt with in the local courts, even for the big investors. This can include matters of resolution of bankruptcy claims, contract violation, arbitrary regulatory changes, and intellectual property violation. To be sure, the threat of these complications--often costly--is a disincentive for investment. But, for many of the largest investors looking to sink their funds into a lucrative market, these are only one of the calculations among many that they make, which brings me to the next point.

Myth 2: The Rule of Law Is Equally Important to All Sectors of the Economy

The rule of law matters more for some sectors of the economy and investors than others. There are three specific times when investors may be less concerned--even to the point of being unconcerned--about rule of law. The first is when investors already have considerable infrastructural investments in the country. When there are factories, property and long-term projects, rather than flee, investors will often stay and may--as I discuss below--even continue investing. The second is when the investment horizon is long term. Capital may not be a coward but it is surprisingly optimistic--even blindly so at times. The third is when global markets promise a lucrative return. In fact, on this point, investor tolerance of "rule-of-law risk" is directly correlated to the promise of easy profit.

The cases that best exemplify this higher tolerance of "rule of law risk" are Venezuela and Bolivia. In both cases, in situations which have rapidly deteriorated in terms of rule of law--and with all signs that they will likely only become worse--oil, gas, and mining companies are still surprisingly willing to invest. Sure, some like Shell and Exxon Mobile sat out on the recent bids to explore the Orinoco Belt in Venezuela. But for every Shell and Exxon Mobile there is a Chevron, Inpex, Repsol, Videsh, Oil India, and Petronas. The same is true in Bolivia, where despite getting burned by the nationalizations in 2007, Brazilian Petrobras and Argentine gas companies have been willing to stand in line to gain access to Bolivia's rich gas fields.

To be sure, interest has dimmed, financing for Venezuelan state-oil company PDVSA is becoming increasingly difficult, and high tech investment has lagged dangerously. But in both Venezuela and Bolivia, despite unarguably the worst conditions and short-term prospects for rule of law, they have not been as punished in international markets as most would have liked to believe (and predicted). The reason? The natural resource extraction sector is far less bound by rule of law concerns because of the extent of existing investment that locks in investors, the long-term strategy that comes with it and the price of commodities that promise high returns and make risk more palatable. Which brings me to the next point.

Myth 3: All International Investors Care about the Rule of Law

One word: China. In the midst of our self-congratulatory celebration of the importance of the rule of law in the 1990s, if someone had described the conditions for rule of law in Venezuela and Bolivia and the lack of reform since that time in Brazil and said that investors would still be rushing in, they would have been laughed at. Enter China, India, Dubai, South Korea and the other voracious consumers of commodities in the world, from soy to iron to oil to lithium.

U.S. investors may be more discriminating about investing in unpredictable, arbitrary institutional environments (though with the caveat about the big investors), but for the Chinese, Indians and others it's a way of life. Their appetite for these commodities has in fact defied (and allowed countries to defy) the international punishment that many believed had become a golden rule of the neo-liberal model: reform or die. Not only have China, India and others kept the rule-of-law laggards on life support, they have allowed some to thrive.

Myth 4: The Rule of Law Is Organic

At the time, many thought and spoke of the rule of law as if it were a seamless public good that--while it may come slowly--was almost indivisible. Instead, what has emerged are pockets of reform and opportunity, carve outs for investors (like large international investors) and sectors (like natural resources or high tech). The result is a fragmented and at times contradictory system of laws and their interpretation that apply to different investors, businesses and sectors even within a single economy.

This also applies to citizens in general. Advances in the predictability of contract law and human rights have not been met in, say, labor law or access to justice for the indigent and disenfranchised. Change across these sectors is not even and carve outs for coveted international investors have removed one of the most powerful advocates for reform with their own advantages and weakening their support for broader reform. At the same time, in other countries, crises in one sector have sparked change in that narrow sector but have stalled in others.

Take the case of Argentina, which, after the wave of bankruptcies in the wake of the financial crisis of 2001, developed one of the model bankruptcy laws in the region. The law allows two thirds of creditors to negotiate their own agreement with the debtor that is then sanctioned by a judge. The idea is to not unduly punish the company with heavy debt or harm investors by allowing the company to simply walk or meet only its labor contracts.

Also, the investigation and prosecution of human rights abuses committed before and during the military government of 1977 to 1983 and a judicial system that allows the application of international human rights law in domestic courts, have made Argentina one of the most advanced countries in the region regarding addressing impunity and human rights law. Compare that with the country's appalling disregard for the sanctity of contracts, the government's arbitrary and politicized enforcement of regulations in sectors like energy and telecommunications and the lack of respect of private property (most notably in the seizure of the private pension funds in 2009).

Myth 5: Rule of Law Is the Great Equalizer Among Economies

Ten or 20 years ago we believed that establishing clear, predictable pro-market rules for investment could convert even the smallest country into a market paradise. In reality, other factor endowments remain as, and in some cases more, important. The level of education of the labor force, modern infrastructure, natural resources, and market size can either singularly or in combination trump the rule of law. Sure, people can point to Chile's success: a small market with limited natural resources (save copper) that managed through a stable political system and pro-market legal environment to become the region's Asian Tiger. Equally important, though, was its level of education and infrastructure. Compare this to El Salvador, which has done everything by the book in terms of the institutional reform consensus, streamlining bureaucracy, reducing paperwork and adopting commercial legal and judicial reforms as part of the U.S.-Central American Free Trade Agreement. Despite these reforms, international investment in El Salvador has barely budged, never reaching hoped for levels.

Of course, there are also those who will make the caveat that it's about sustainable development, and that what we see in China cannot be sustained without deep and potentially destabilizing change. That may be true. But that doesn't prove the opposite: that rule of law is the missing ingredient for those who aspire to even half of China's levels of economic growth. Again, consider the case of El Salvador which has done all the right things and has failed to see the level of investment or growth that many believed would accompany such institutional courage.

Does this add up to the fact that the rule of law doesn't matter? Of course not. But it should inject a note of caution. First, because by overselling any development concept as a magic bullet, a good, solid concept risks becoming a victim of its own sense of invincibility. With the soaring prospects of Brazil, the failure of the shoe to drop on Argentina as soon as most people thought and Venezuela and Bolivia's ongoing ability to thumb their nose at the international community the general wisdom has already begun to shift.

Second, and most important, rule of law is still important for small and medium-sized businesses and entrepreneurs. The Microsofts and ADMs of the world may not need a domestic avenue for access to independent arbitration or court systems; but those without their market power or international connections do. And the Chevrons and Vales may be willing to invest in their isolated industries; but there aren't many small or start-up businesses in resource extraction any more. It is the local, small investor who requires the rule of law to start and expand. Sadly, because the rule of law is not organic they are often left out of the picture as other companies and sectors carve out their segment of judicial access, integrity and efficiency.