The Financial Power of the Powerless: Socio-Economic Status and Interest Rates under Partial Rule of Law

Abstract

In advanced economies interest rates generally vary inversely with the borrower’s socio-economic status, because status tends to depend inversely on default risk. Both of these relationships depend critically on the impartiality of the law. Specifically, they require a lender to be able to sue a recalcitrant borrower in a sufficiently impartial court. Where the law is markedly biased in favor of elites, privileged socio-economic classes will pay a surcharge for capital. This is because they pose a greater risk to lenders who have limited means of punishing them. Legal power, as measured by privileges before the law, thus undermines financial power, which is the capacity to borrow cheaply. Developing the underlying theory, this paper also tests it through a data set consisting of judicial records from Ottoman Istanbul, 1602-1799. Pre-modern Istanbul offers an ideal testing ground because rule of law existed but was highly partial. Court data show that titled elites, men, and Muslims all paid higher interest rates conditional on various loan characteristics. A general implication is that elites can benefit from instituting impartially enforced rules in financial markets. The beginnings of legal modernization in the Ottoman Empire included the establishment of relatively impartial commercial courts.

Keywords: Rule of law, elite, status, religion, gender, court, interest rate, credit, financial market, Ottoman Empire, Istanbul, Islam, Islamic law, Sharia

JEL Classification: G10, K42, N2, N4, N95