The price of privilege

💥Biased legal rules can have a harmful consequence

Many tend to believe that the best way to help a group of people may be to offer them special legal privileges that others do not enjoy. In India, for instance, governments looking to capture power often allow distressed borrowers to stop paying their loans. The lenders in such cases do not possess sufficient legal protection to uphold their contractual rights. Economic history suggests that such legal bias, however, may not be the best way to do good to people. This is because, according to “The financial power of the powerless: Socio-economic status and interest rates under partial rule of law”, a paper by Timur Kuran and Jared Rubin published in The Economic Journal, there are long-term costs associated with such bias.

Kuran and Rubin studied data on private loans issued between 1602 and 1799 in Istanbul under the rule of the Ottoman Empire and found that privileged groups like Muslims (who were given rights that were denied to Christians and Jews), men (who were privileged over women) and elites (who were connected to the Sultan) eventually had to pay higher rates of interest than others to avail of credit. To be precise, these privileged groups had to pay interest rate premiums of 3.4, 2.5, and 3.4 percentage points respectively. This, the authors argue, is due to the fact that in the eyes of the lenders, the borrowers who were protected by biased courts became high-risk individuals who were more likely to default. The lenders had very little legal protection to recover their dues. So, in response, they cut down their lending to these groups, which in turn caused interest rates to rise.

Legal rules biased in favour of privileged groups can thus have the harmful consequence of raising their borrowing rates. This applies not just to elites but also to disadvantaged groups that seem to require any special treatment. When the law is biased in favour of the poor, through, say, provisions that allow them to default on their loans, it can end up hurting them eventually as lenders would begin to cut down lending to the poor.