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Unclassified ECO/WKP(2000)38

Organisation de Coopération et de Développement Economiques OLIS : 12-Oct-2000

Organisation for Economic Co-operation and Development Dist. : 20-Oct-2000


English text only







by Raghuram G. Rajan and Luigi Zingales Most Economics Department Working Papers beginning with No. 144 are now available through OECD’s Internet Web site at http://ww.oecd.org/eco/eco.

English text only Document complet disponible sur OLIS dans son format d’origine Complete document available on OLIS in its original format ECO/WKP(2000)38 ABSTRACT/RÉSUMÉ We attempt to identify and explain the broad patterns of financial development in developed countries over the twentieth century. We find that, contrary to the predictions of most existing theories, indicators of financial development do not seem monotonic over time. In particular, we find that by most measures, countries were more financially developed in 1913 than in 1980 and that a major reversal took place between 1913 and 1950. To explain this we outline a simple theory of the political economy of financial development. Empirically, our analysis suggests that the forces opposing financial development will be weaker when a country is open to international trade and capital flows. We find this to be true both in the cross-section and over time. In periods of free capital movement world-wide, a country’s level of financial development is directly related to its openness to trade. Similarly, the low frequency movements of financial development over time appear to be correlated with the degree to which capital is mobile world-wide.

JEL classification: G15, G18, G28, N20 Keywords: financial development, financial systems.

***** Nous essayons d’identifier et d’expliquer les tendances générales dans le domaine du développement financier dans les pays développés au vingtième siècle. Nous trouvons qu’à l’encontre de toutes les prédictions des théories existantes, les indicateurs de développement financier ne varient pas de façon monotone dans le temps. En particulier, nous trouvons que d’après la plupart des indicateurs, les pays étaient financièrement plus développés en 1913 qu’en 1980 et qu’un revirement majeur a eu lieu entre 1913 et 1950. Afin d’expliquer ceci, nous décrivons une théorie simple de l’économie politique du développement financier. Empiriquement notre analyse suggère que les forces qui s’opposent au développement financier seraient plus faibles lorsqu’un pays est ouvert au commerce international et aux mouvements de capitaux. Ceci est vrai à la fois en coupe internationale et dans le temps. Dans les périodes où les mouvements internationaux de capitaux sont libres, le niveau de développement financier d’un pays est lié directement à son ouverture commerciale. De même, les mouvements de faible fréquence du développement financier dans le temps semblent être corrélés selon le degré de la mobilité du capital au niveau international.

Classification JEL :.G15, G18, G28, N20 Mots-clés : développement financier, systèmes financiers Copyright: OECD 2000

Applications for permission to reproduce or translate all, or part of, this material should be made to:

Head of Publications Service, OECD, 2 rue André Pascal, 75775 PARIS CEDEX 16, France.

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1. Introduction

1. Evolution of financial development over the twentieth century

1.1. Historical differences in reporting data

1.2. Various measures of financial development

1.3. Data sources

1.4. Stylised facts

2. The political economy of financial development

2.1. The necessity for government intervention

2.2. The political economy of financial development

2.3. Why is financial repression a better way to protect incumbents’ rents?

2.4. What determines outcomes?

2.5. Financial development and openness

3. A test of the political theory of financial development

3.1. Preliminary concerns

3.2. Issues in 1912

3.3. Equity issues in 1999

3.3. Issues in intermediate years

4. Political backlash

4.1. Competitive markets and insurance

4.2. The turmoil caused by wars and depression

4.3. The political response

4.4. Autarky and its effect on the financial sector

4.5. Intervention in the financial sector

4.6. The demise of financial markets in Japan

4.7. Sweden

4.8. Summary

5. The aftermath of World War II and the resilience of financial markets in Europe

5.1. Bretton Woods and restrictions on capital movements

5.2. The breakdown of the Bretton Woods system

6. Discussion and conclusion


1. Evolution of the different indicators of financial development

2. Evolution of the ratio of deposits to GDP

3. Evolution of fraction of gross fixed capital formation raised via equity

4. Evolution of stock market capitalisation over GDP

5. Evolution of number of listed companies per million people

6. Issues to GDP in 1912

7. OLS regression for cross-section of countries in 1998-99

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1. Issues in 1913 vs. industrialisation

2. Issues in 1913 vs. industrialisation * openness

3. Capitalisation in 1913 vs. interaction

4. Listed companies per M in 1913 vs. interaction

5. Equity issues vs. per capita GDP * openness, 1913

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1. Introduction 1. It has long been observed that a country’s state of development is strongly positively correlated with the state of development of its financial sector. For example, on the basis of data from 35 countries between 1860 and 1963, Goldsmith (1969, p. 48) concludes that “a rough parallelism can be observed between economic and financial development if periods of several decades are considered” and “there are even indications in the few countries for which data are available that periods of more rapid economic growth have been accompanied, though not without exception, by an above-average rate of financial development”.

2. Recent studies suggest this association is more than simply correlation, and financial development does, in fact, advance economic growth. In a study of 80 countries over the period 1960King and Levine (1993) find that beginning-of-decade measures of a country’s financial development are strongly related to the country’s economic growth, capital accumulation, and productivity growth over the subsequent decade. Using the de-regulation of banking in different states of the United States between 1972 and 1991 as a proxy for a quantum jump in financial development, Jayaratne and Strahan (1996) find that annual growth rates in a state increased by 0.51 to 1.19 percentage points a year after de-regulation. Rajan and Zingales (1998a) find that the development of a country’s financial markets and institutions dramatically increases the growth of industries, such as Computers or Pharmaceuticals, which need long-term external finance. With all these studies indicating that financial development does indeed facilitate growth, one is compelled to ask why so many countries score so low on measures of financial sector health?

3. The simple answer, and one favoured by many economists, is the absence of demand. According to this view, when opportunities arise in an economy that require financing, the economy will develop the necessary markets and institutions to finance these opportunities; In other words (those of Joan Robinson, 1952, p. 86) “where enterprise leads, finance follows”. For example, the enormous financing requirements of railroads in the United States (1 billion dollars up to 1867 and 10 billion up to 1890) lead to the development of public markets for corporate debt and later for stock, with 40 per cent of this capital coming from Europe. Financial institutions such as investment banks, including the famous Morgan bank, emerged to underwrite and distribute these securities and to reassure European investors that the money was properly invested. Thus the financing needs of the railroads lead to the creation of financial

1. University of Chicago and NBER. This paper is a development of some ideas in a previous working paper entitled “The Politics of Financial Development”. We thank the Bradley Foundation, the Centre for Study of the State and the Economy, the Centre for Research on Securities Prices, and the World Bank for funding support. Rajan also thanks the National Science Foundation. We benefited from comments by Lucian Bebchuk, Peter Hogfeldt, Mark Roe and Andrei Shleifer.

2. See Engelbourg and Bushkoff (1996) and Chandler (1990).

ECO/WKP(2000)38 infrastructure in the United States that was then available to finance other industries that came later. What we have just described is nothing but the reverse of Say’s Law -- demand creates its own supply.

4. This argument is probably an oversimplification because it cannot explain why countries at similar levels of economic development differ so much in the level of their financial development. For instance, why was France’s stock market much bigger as a fraction of its GDP than markets in the United States in 1913, even though the per capita GDP in the United States was not any lower than France’s. It is hard to imagine that the demand for financing in the United States at this time was inadequate -- the demand for more, and cheaper, credit was a recurrent theme in political debates in the United States at that time.

5. An alternative explanation is there may be impediments to supply rising to meet demand. The fixed costs of setting up financial institutions and market infrastructure will not be met until there is an adequate demand for financing. Moreover, the financial sector needs time: to gain experience, build reputations, and develop appropriate financial technology. It also needs an enabling infrastructure -- for example, a legal environment that allows a wide variety of contracts to be written, enforces them at low cost, and speedily imposes punishment when they are breached.

6. These impediments, however, may not be enough to explain why France and the United States differed so much. Presumably, both countries were big enough that fixed costs were relatively small compared to the demand for finance. Moreover, the countries had experienced a significant demand for finance for a long enough period that the time to build is unlikely to have been a constraint. While the seminal work of La Porta et al. (1997, 1998) suggests a country’s legal tradition (in particular, whether it has a civil code or common law) may have a causal effect on its financial development -- presumably because the ease of creating the enabling infrastructure is affected by legal tradition -- the arguments in that literature would predict a relatively underdeveloped financial sector in civil code France and not the other way around.

7. The greater intellectual problem with relying on the impediments described above to explain differences in financial development is that they suggest financial development will either take-off permanently (for example, once fixed costs are overcome or minimum reputational levels attained), or remain permanently constrained (for example, if the French civil code is hostile to financial markets as suggested by La Porta et al.). Yet the historical evidence suggests measures of financial development wax and wane. In 1913, France’s stock market capitalisation as a fraction of GDP was almost twice the United States (0.78 vs. 0.41). By 1980, roles had reversed dramatically -- it was now barely one fourth the capitalisation in the United States (0.09 vs. 0.46). And in 1999, the two countries seem to have converged (1.17 vs. 1.52).

8. Similarly, Tilly (1992, p. 103-104) finds both the volume of total market issues, and the th proportion of issuance consisting of equity were greater in Germany in the beginning of the 20 century than they were in the United Kingdom. He concludes that in Germany “…banks and shareholders generally were well informed as to the financial status of most listed industrial companies…” while “British investor preferences in favour of fixed-interest securities reflected the paucity of information and relatively weak financial controls on the operations of company founders and insiders”. Yet La Porta et al.

(1998) find that in the middle of the 1990s, the United Kingdom (and other Common Law countries) scores very high on shareholder rights while Germany fares miserably. Moreover the United Kingdom has a score of 78 on accounting standards (a measure of disclosure) while Germany comes in with a score of only 62. It is no wonder that they claim the United Kingdom is more equity friendly than Germany, and this certainly is reflected in the relative stock market capitalisation of the two countries at the time of their study. But Tilly suggests the greater equity friendliness was not true historically, nor is it necessarily true today with the Deutsche Bourse being the chosen location for high technology IPOs in the failed merger with the London Stock Exchange.


9. Before we attempt an answer to these questions, let us outline the facts more systematically. We gather a time series of the main indicators of financial development for a large cross section of countries.

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