How Does Investors' Legal Protection Affect Productivity and Growth?

Abstract

This paper analyzes the implications of investors' legal protection on aggregate productivity and growth. We have two main results. First, that better investors' legal protection can mitigate agency problems between investors and innovators and therefore expand the range of high-tech projects that can be financed by non-bank investors. Second, investors' legal protection shifts investment resources from less productive (medium-tech) to highly productive (high-tech) projects and therefore enhances economic growth. These results stem from two forces. On one hand, private investors' moral hazard problems (in which entrepreneurs shift investors' resources to their own benefit), and on the other hand innovators' risk of project termination by banks due to wrong signals about projects' probability of success. Our results are consistent with recent empirical studies that show a high correlation between legal investors' protection and the structure of the financial system as well as the economic performance at industry and macroeconomic levels.

Agency costs and credit availability: an international study

“…Armour et al (2008) test the link between increased shareholders protection and stock market development using stock market capitalization, the value of stocks traded and the number of listed firms and concluded that there is no evidence of a long-run impact of legal change on stock market development. Berdugo and Hadad (2009) propose a model in which legal investors' protection in the high-tech industry mitigates agency problems between investors and innovators and leads to higher productivity and growth. They predict a high correlation between legal investors' protection and the size, productivity, and growth of the high-tech industry.…”