Why the Rule of Law Matters for the Economy

Today’s post is about why the rule of law is essential for economic activity. Most of us believe that the “rule of law” is important for many reasons. But people may underestimate how vital it is for the economy. Sometimes people’s views of competitive markets is that firms prefer an “anything goes” atmosphere. But while firms certainly have some preferences that aren’t in society’s best interests—like not having any limits on their market power—when it comes to rule of law, everyone benefits.

In simple terms, the rule of law means that everyone — including powerful people and government officials — must follow the same laws. Those laws should be clear, stable, and enforced fairly.

From an economic point of view, having such a legal environment matters a lot. Imagine trying to start a business in a country where contracts aren't enforced. You sign a deal and if the other side doesn’t pay, the courts do nothing. Or a politicians comes in and pressures the court to rule against you even if the law is on your side. Would you feel confident hiring people? Taking risks? Investing in new ideas?

Now imagine you’re a foreign investor. Would you put your money into a country where the government could seize your assets on a whim or favor politically connected companies over yours?

These questions aren’t hypothetical. In Venezuela in the 2000s, the government nationalized entire industries — oil, steel, food production — often taking them from private companies without fair compensation. Predictably, investment collapsed, production fell, and the economy spiraled into crisis.

Or take Russia. As the rule of law weakened after the fall of the Soviet Union, a handful of politically connected businessmen — the "oligarchs" — gained control over huge parts of the economy. Without fair rules, economic success depended more on political connections than on innovation or efficiency, and the economy stagnated.

But it’s not just about fairness to existing companies — the rule of law is also essential for future innovation. If you're an entrepreneur with a new idea, you're less likely to start a company if you believe large incumbents can use their political clout to crush you. That might mean getting favorable regulations, blocking licenses, or using lawsuits as a weapon — not because they offer better products, but because they know the right people in power.

When new businesses don’t feel protected by the legal system, innovation slows down. Fewer people take risks. Fewer new technologies emerge. The economy becomes stagnant — dominated by large, politically connected firms instead of creative, competitive ones.

Even in the US, we’ve seen lobbying efforts by large firms shape regulation in ways that can hurt smaller competitors. That’s why strong, impartial legal institutions are so important — to keep the playing field level.

So while it might sound abstract, the rule of law is actually one of the foundations of a healthy economy. Without it, even the best economies can fall apart.