Guaranty: Where Private Ordering Meets the Legal System
This paper explores conditions under which guaranty contracts and joint liability arrangements can be efficient, and examines whether such conditions are currently being met in Japan. Guaranty contracts and joint liability are necessary only when some form of market inefficiency, such as weaknesses in the legal system, exists. There is no need for such contracts if the market functions efficiently. Conditions that must be met for guaranty contracts and joint liability to achieve efficiency include:
- Social or geographical distance between a debtor and other debtors or guarantor needs to be short, enabling the latter to acquire information about the former easily;
- Debtors side needs to have social cohesion and the debtor needs to find benefit in its continuation, so that the guarantor can employ the relationship to induce contract performance.
When these conditions are met, joint liability and guaranty arrangement can transform social capital into general financial assets, which an external financier can access. The study states that social cohesion has diminished in Japan because of its high level of industrialization and urbanization. Hence it would be difficult to infer that social cohesion can overcome limited enforcement in Japan.
