Part 2 of What needs to be done to get INDIA back into 8% growth …. Why is stable, fair and transparent Rule of Law critical for a well functioning economy

A stable, fair and transparent rule of law allows for 2 very important things :

1) No coercion of any sort and 2) Contracts can be enforced

Let’s take the latter first. If contracts can be easily and timely enforced, it creates a high trust society, which increases efficiency all around. In the absence of ability to quickly and cheaply enforce contracts , societies rely on family and clans and their social enforcement mechanism like ostracism, which by definition reduces the talent and partners pool and therefore the size and output of the enterprise. 

If entrepreneur 1 has setup a b2b business – supplying to entrepreneur 2 under a contract and entrepreneur 2 refuses to honour the contract for whatever reasons, entrepreneur 1’s business is impaired and if it takes years for restitution, many such businesses will not even start reducing the overall output. Therefore countries in which the legal system is slow, complex (like in India) and consequently expensive lose out by having a less thriving economy. 

Ability to function without coercion is equally if not more important. Coercion of any kind , including misusing monopolist power, anti competitive employment contracts, coercive unionisation etc act as sand in the gears of a well functioning economic system. The purpose of “rules” is to ensure that there is a level playing field and coercion is not possible. I have personally seen very closely a situation where a powerful competitor used the threat of a series of frivolous legal cases (which would involve high cost and time to defend which the startup could not afford) to effectively shut down a startup competitor- a situation which would not have been possible in a place with quick justice. 

Stability and transparency in the “rules” is important to ensure fair play and long range planning which are needed to build complex economic machines by entrepreneurs.

If rules are not fair ; ie, if the rule making system is captured by vested interests, you get Russia’s oligarchs who capture a disproportionate share of the economy but are themselves subject to sudden seizures and changes in fortune. 

If the local governments apply the rules whimsically and where the courts are suborned to the executive and not independent, then you get the “guanxi” (personal connection) driven economy of China – which is a milder version of the Russian oligarch situation where economic outcomes at the province level depend on guanxi and restitution is not through courts but through appealing to a higher power (the central government). In the absence of a fast and effective judiciary, rules can be applied whimsically by local authorities without any fear of being called out in the short term and therefore it increases friction and one of the critical success factors for entrepreneurs becomes guanxi and not necessarily the strength of their ideas and execution. 

If the government itself does not honour fairly entered contracts (for example state governments choosing to default on their commitments to buy renewable power at premium prices or disputing and delaying regular payments ), it greatly reduces their credibility all around and only entrepreneurs with guanxi (who have the confidence to “manage” the system ) thrive in such an environment. 

There is therefore a very high correlation between rule of law and economic activity and therefore prosperity. It is the foundation on which economic systems are build.

More than any other policy, judicial reforms to make justice quick and efficient would be the biggest contributor to the Indian economy. Simple and stable rules with little leeway for discretion or exceptions is a related and equally important mindset shift. 

To be continued..Next article: free markets and confusions relating to it link to next article

Published by Deep Mishra

Deep Mishra is an IIT Kanpur , IIM Kolkata alumni. He has about 25 years of experience. He spend 10 years investing in consumer and pharma companies as a Managing Director at Everstone Capital, 3 years in a global hedge fund Och Ziff and 3 years as an I-Banker with EY and has been a tech entrepreneur. Views expressed here are purely personal.

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