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Legal Institutions, Credit Markets, and Economic Activity


This paper provides novel evidence on the causal connections between legal institutions, credit markets, and real economic activity. Our analysis exploits an unexplored within-country setting—Native American reservations—together with quasi-experimental variation in legal contract enforcement wherein the US Congress externally assigned state courts to adjudicate contracts on a subset of reservations. According to area-specific data on small business credit, reservations assigned to state courts, which enforce contracts more predictably than tribal courts, have stronger credit markets. Moreover, the law-driven component of credit market development is associated with significantly higher levels of per capita income, with stronger effects in sectors that depend more on external financing. By using exogenous variation in legal institutions across relatively similar sovereign entities, our study offers compelling evidence that stronger contract enforcement and better-developed credit markets lead to significant improvements in broad economic outcomes.

Keywords: courts, law and finance, economic growth, external financing, contract enforcement.

JEL codes: O43, N22, K12, G21, G31.


Suggested citation: Brown, James, R., J. Anthony Cookson, and Rawley Z. Heimer, 2014. “Legal Institutions, Credit Markets, and Economic Activity,” Federal Reserve Bank of Cleveland, Working Paper no 14-34.

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