The Real Effects of Judicial Enforcement

The Real Effects of Judicial Enforcement
Vincenzo Pezone
Review of Finance, Volume 27, Issue 3, May 2023, Pages 889–933,

Well-functioning legal institutions are crucial for enforcing contracts and facilitating transactions. For this reason, improving judicial enforcement, and in particular speeding up trial resolution by courts, has been a priority for many judicial systems. This paper examines the real effects, especially on firms’ employment policies, of changes in judicial enforcement by employing a natural experiment. Such strategy is necessary because differences in enforcement across countries or regions are not random, but related to institutional and historical features that make causal inferences problematic.

I exploit a reorganization of the court districts occurred in Italy at the end of 2013. 26 courts were suppressed, and their judicial districts merged with those of 23 remaining courts. Because prior to the reform courts were heterogeneous in their productivity, measured by their speed in resolving trials, these mergers generate shocks to the quality of the judicial enforcement for firms located in their districts that can be used to establish causality through an instrumental variable strategy.

I find that an improvement in enforcement has a large, positive effect on firm employment. This result is robust to a number of tests and variations over the baseline econometric specification. This is in contrast to naïve OLS regression, which do not display any relationship between employment and enforcement.

Several cross-sectional tests help identify the economic channels at play. First, I hypothesize that faster trial resolution increases the expected value of the collateral lenders may seize in presence of default. Consistent with this, results are stronger for firms characterized by higher levels of tangibility. Moreover, in line with this financing channel, firms more dependent by external financing and more likely to be financially constraints respond more to changes in enforcement. Results are stronger also in industries characterized by higher complementarity between labor and capital and higher likelihood of using courts.

 I also find that, in the presence of stronger enforcement, firms can raise more debt to dampen the impact of negative shocks and, in this way, reduce employment fluctuations. Consistent with this result, worker-level evidence shows that strong enforcement reduces the likelihood of unemployment. Hence, improving judicial enforcement, and thus access to financing, helps firms provide “insurance” against unemployment risk.

This insurance is priced by risk-averse workers in lower wages: Average wages are negatively related to the quality of enforcement, especially in firms characterized by high earnings or sale volatility. This reduction in labor costs further boosts employment.

To conclude, courts have substantial effects on the real economy. Improving judicial enforcement not only boosts firm growth but, by relaxing firms’ financial constraints, reduces workers’ layoff risk, resulting in meaningful welfare gains

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