Interaction of Financial Markets and Contracts: The Case of the Tokugawa Period in Japan

Title: Interaction of Financial Markets and Contracts: The Case of the Tokugawa Period in Japan

Abstract: We describe two features of financial markets and contracts from the seventeenth to the mid-nineteenth century in Japan and attempt to understand them both theoretically and empirically. First, the government did not enforce loan contracts between the borrower (local lord) and the lender (merchant), so that many loads reneged on loans. Despite this lack of legal enforcement, some merchants developed long-term financial relationships with local lords and grew as "relational merchants." Furthermore, those merchants who could not build such relationships instead offered short-term financial contracts to those relational merchants, that were legally enforceable. We develop a model of the local lord matching market where loads and relational merchants search and are matched, and the short-term loan matching market where relational merchants and short-term lenders are matched, and how these markets interact and exhibit complementarities in stationary equilibria. Second, legal rules affected how lenders designed financial contracts. In particular, some lenders prepared a combination of two written documents, a legally enforceable main contract and a legally unenforceable special contract. The latter informal contract played a complementary role with the former formal contract. We study interaction between formal contracts and relational contracts and show that relational contracts make formal contracts more likely to be legally enforced.