The project developed a parsimonious model of relational contracts that help rationalize empirical evidence showing that countries with better rule of law – where courts are more easily enforce contracts—experience less economic volatility, have less productivity dispersion amongst its firms and lower wage inequality.
In the first part of the project, we collected data in order to establish the relationship between rule of law and economic volatility. Collecting data from the World Bank (in particular, World Bank’s World Development Indicators (WDI) database) for rule of law indicators we show a negative relationship between rule of law indicators and macroeconomic volatility. This is the case for countries like China, India, and Russia, which rely more on relational contracts based mostly on trust between two parties. Countries with better rule of law, however, like the U.S. the U.K. and Australia, see overall less economic volatility. We find that countries with better institutions that enforce rule of law experience smaller volatility in output. The second finding suggests that countries with weak institutions for rule of law can achieve a reduction in productivity dispersion if they improve the quality of their legal system. Finally, we also find a negative relationship between the rule of law measure and wage inequality. All three findings are consistent with our main theorem: countries with poor contractual environments experience greater aggregate volatility, productivity dispersion and wage inequality.
To rationalize these empirical relationships between the country’s quality of contract enforcement institutions and economic outcomes, in the second part of the project we offer a model of relational contracting. We show that a very tractable model of relational contracts can simultaneously explain both micro and macro phenomena. We compare two theoretical economic environments, one with good rule of law, or contract enforcement, and the other marked by poor enforcement. Our analysis shows that, when contract enforcement is poor, employee morale suffers, ultimately sparking more economic volatility and greater differences in productivity across companies. Our model features two main building blocks. The first assumption is that firms experience adverse shocks that make them less profitable. Importantly, these shocks are persistent. The second key ingredient is that when coping with uncertainty, contracts might not be perfectly enforceable, depending on the legal environment. This lack of contract enforcement can tempt an employer to renege on a promise. When an employer reneges, however, there is a cost: the business relationship is damaged.
In summary, our model highlights the role of persistence in productivity during bad times. When the current productivity is low, the future value from maintaining the relationship is low, and the firm cannot credibly promise to make bonus payments. Thus, in recessions, the firm experience difficulty in motivating the worker to exert high effort. Consistently with the empirical evidence, this “low morale effect” in turn amplifies the adverse effect of uncertainty in productivity. This amplification effect also sheds light on wage inequality in countries with limited legal enforcement.
The project has been published in the Journal of Monetary Economics in May 2022. It has been presented in various prestigious workshops and conferences (see the full list in the published paper).
