sou · GOB311d5 · 2001-01-01 00:00:00 — Thus in opening up, countries should distinguish between foreign intermediaries that open domestic branches, develop local expertise, are well tied into the system, and thus serve to stabilize it, and foreign portfolio inflows that rely on domestic intermediaries and could overload the system. Volym D:40 Supplement 23 4 Conclusion: And the winner is We started this study by documenting that there does seem to be a causal relationship between financial development and economic growth. Furthermore, financial development seems to particularly help the financing of firms that typically do not get institutional credit because they lack physical collateral. This lead us to a comparative analysis of relationship based banking systems and arms length market based systems. We concluded that for the kinds of industries that are now engines of world growth, a hybrid is probably best, though not all the best properties of each system survive in the hybrid. Finally, we argue that the developed legal infrastructure necessary to sustain a large banking system or arms length markets also tends to diminish risk. From a policy perspective, it would appear that a country intent on economic development should fix its financial plumbing – specifically its accounting and disclosure system and its legal and bankruptcy codes. In a companion study, we will argue that political forces, more than anything else, prevent the emergence of financial systems that are appropriate for economic activity. On the one hand, this is good news because it suggests that wholesale systemic change – in fundamental legal infrastructure, for example – is not needed to achieve financial development. On the other, this is bad news because political forces are hard to overcome. We believe, however, that the natural increase in competition between firms in different nations will force political forces to eventually give way. Finally, it is tempting to anoint a specific country as having the best financial system. We want to refrain from this. One reason is that we have so much to learn about how financial systems work, even though we have come a long way in recent years. But perhaps a more important reason is that even a cursory study of a sample of the richest countries in the world will reveal a variety of financial systems. Clearly, there are many paths to gold. While there are signs that indicate convergence to a hybrid (the using venture capital and opening the New Market), these are far from conclusive. Moreover, many of the stylized facts about the effects of particular systems – such as the fact that bank oriented economies tend to have firms with more debt – are illusory when examined more closely, see and Zingales (1995). Therefore, we will not go beyond the facts and the interpretations , Industrial Structure, and Growth Volym D:41 detailed above, and like all good academics, leave further speculation to future research. Volym D:42 Supplement 23 , E., (1994), A control theory of venture capital finance, , Economics and Organization, 10, 247-267. , B. and R. Gilson, (1998), Venture Capital and the Structure of Capital Markets: Banks vs Stock Markets, 47, No. 3, 243-278. Boot, A., S. , and A. Thakor, (1993), Reputation and Discretion in Financial Contracting, 83, 1165-1183. Calomiris, C., (1994), The Costs of : in the German Mirror, 1870-1914, mimeo, , . , W., and C. , (1998), Finance, Investment and growth, mimeo, , . , A., (1977), The Visible Hand: The Managerial Revolution in American Business, : MA. Demirguc-Kunt, A., R. , and H. Min, (1998), Opening to Foreign Banks: Issues of Stability, Efficiency, and Growth, mimeo, . Demirguc-Kunt, A. and V. 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Politics, and Financial Development Raghuram G. * Supplement number 24 to the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. Views, suggestions, and opinions expressed in this study represent the personal views of the authors and not necessarily those of the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. *. Gidwitz Professor of Finance, , Area, . 1101 , , IL 60637, . **Professor of Finance, , Area, . 1101 , , IL 60637, . Volym D:48 Supplement 24 Kort sammanfattning (in Swedish) ....................................................... Financial development across countries....................................... Fixed costs and time-to-build theories of financial The Nature of the ................................................................. : Common and Civil ........................... Does the Really Matter for Financial Measurement Ahead of Theory ................................................ Common as a Process ...................................................... Legal Incompleteness – Some examples.................................... Adaptation in Civil ........................................................... The Superiority of Common : A Historical Test .................. A Political Economy of Financial Development ........................... 6.1Why the Dominant Elite Development?. Financial Markets and the Government..................................... Interaction Between Politics and the ................................. The Emergence of ..................................................... The French Experience .......................................................... British and Spanish colonies................................................... The Contrast with the ......................................... The Triumph of the Bourgeoisie............................................. Politics, and Financial Development Volym D:49 Volym D:50 Supplement 24 Kort sammanfattning (in Swedish) Forskning visar att utvecklingen av ett lands finansiella marknader och institutioner tydligt påverkar den ekonomiska tillväxten i en positiv riktning. Frågan är då varför inte de finansiella marknader och institutioner som ett land behöver uppstår automatiskt. Historien visar att de institutionella hindren för ekonomisk utveckling nästan undantagslöst är politiska. Centraliserad och oinskränkt politisk makt har alltid hämmat ekonomisk utveckling. Detta är en förklaring till varför den finansiella utvecklingen inte har skett i jämn takt utan med språng, där politiska händelser som krig och revolutioner har hämmat eller t.o.m. reverserat utvecklingen. Ekonomiska marknader nådde i många länder en höjdpunkt strax före , kollapsade med kriget och dess följder, och har återhämtat sig först under det senaste årtiondet. Det juridiska systemets utformning i dessa länder har varit en orsak till utvecklingen, dock endast en bidragande orsak. Politics, and Financial Development Volym D:51 In recent years, research has shown that the development of a countrys financial markets and institutions contribute substantially to its subsequent economic growth. But why does finance not develop to meet a countrys needs? History suggests that the institutional impediment to financial development is almost always political. In particular, centralized and unconstrained political power has invariably retarded financial development. This can explain why financial development has not progressed smoothly but has had ups and downs, buffeted by political events such as war and revolution. Financial markets in many countries reached their pinnacle just before the First World War, collapsed with the war and its aftermath, and have reemerged only in the last decade. The nature of the legal system in these countries plays only a supporting role in explaining what happened. Volym D:52 Supplement 24 The development of a countrys financial markets and institutions dramatically increases the growth of industries, such as Computers or Pharmaceuticals, that need a lot of external, long-term finance.2 interestingly, financial development leads to more firms being born in industries whose assets are largely long term, or in industries where assets are primarily intangible ones such as R&D.3 Thus financial development facilitates the spread of new ideas and leads to the creative destruction of the old. By freeing those with ideas from the need for personal wealth to finance them, financial development creates equality of opportunity for everyone in society, something that hitherto has only been a dream. But how can an economy reach this utopia? In other words, what drives the development of financial markets and institutions? The simple answer, and one favored by many economists, is demand. When opportunities arise in an economy that require financing, the economy will develop the necessary markets and institutions to finance these opportunities. For example, the enormous financing requirements of railroads in the (one 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 of this capital coming from Europe.4 Financial institutions such as investment banks, including the famous bank, emerged to underwrite and distribute these securities and to reassure European investors that the money was properly invested. Thus the needs of the railroads lead to the creation of financial infrastructure in the that was then available to finance other industries that came later. What we have just described is nothing but the reverse of Says – demand creates its own supply. Unfortunately, this is, almost always, an oversimplification. It cannot explain why countries at a similar level of economic development differ 1Prepared for the Symposium on the International Competitiveness of the organized by . We benefitted from conversations with , , , and . 2See and Zingales (1998a). 3See and Zingales (2000). 4See Engelbourg and Bushkoff (1996) and (1990). Politics, and Financial Development Volym D:53 so much in the level of their financial development. While there is great controversy on how to measure financial development properly, there is disagreement that, overall, Anglo-American countries score better on most measures than other, similarly developed countries, like , , and Italy.5 Perhaps these countries do not need a system like the Anglo-American ones. Yet the for countries all over the world to imitate Anglo-American institutions such as venture capital, transparent accounting standards, and liquid equity markets suggests either that investment opportunities all over the world have become similar to what Anglo-American countries faced in the past, or that cross-border competition in financial and product markets is forcing financial systems to evolve towards more efficient structures. The latter explanation seems more plausible; The implication is there are impediments to financial development that prevent the demand for finance from being met efficiently. The failure of our version of Says law could be attributed to four, non-mutually exclusive, factors. First, there might be significant fixed costs that need to be covered before any financial intermediary can operate. Not surprisingly, in the Middle Ages money changers (the precursors of modern banks) were concentrated only in the major cities or where seasonal fairs took place, because only in these locations was business volume sufficient to pay for the fixed cost of operating. For similar reasons, some small rural towns even today have no banks. We will argue that this factor should not be ignored in underdeveloped economies or geographically isolated communities, but it is not a satisfactory explanation for the differences in financial development across countries. It is hard to argue that financial systems in today are underdeveloped relative to Anglo- American ones because the amount of funds that need to be intermediated in is not sufficient to pay for the initial set-up costs. A second impediment in the way of finance responding to economic needs is the time required to acquire knowledge and develop certain skills. For example, most banks today extend credit to their clientele on the basis of formal models of the credit worthiness of the borrowers. These models are based on statistical estimates of the influence various indicators have in predicting default. Thus, they can only be adopted when there exists a large enough data set with the borrower characteristics and default histories, so that financial intermediaries can compute reliable estimates. Obviously, these data and the accompanying evaluation expertise cannot be created overnight, but require time to 5 See La Porta et al. (1997). Volym D:54 Supplement 24 Another factor that requires time to build is reputation. to the difficulties in writing and enforcing fully comprehensive contracts, the reputation of the parties involved becomes essential in smoothing the working of financial markets. Reputations cannot be acquired overnight: they can only be built slowly. The time-to-build argument can certainly explain a lag between the development of the need for finance and the emergence of a system able to fully satisfy those needs. But this friction alone cannot explain why European financial systems are less developed than Anglo- American ones. In both sets of countries the need for finance arose long time ago, and any difference in the set of skills and knowledge initially available should have long disappeared. Even after the set-up costs are incurred, a financial market needs liquidity – the ability for an agent (a seller or borrower) to get full value for her goods. A number of factors determine a markets liquidity but perhaps most important is that a large number of persons think of that particular market as the natural location for their trades. Thus there is a chicken and egg problem with liquidity – people will not trade in a particular market unless they think the market is liquid, but the market will not be liquid unless they trade. Liquidity reasons alone cannot explain the emergence of a financial center, but they can explain why an established financial center can survive after the reasons that spurt its birth have vanished. An established financial center attracts traders, because they anticipate many other traders will go there (it becomes a focal point). This can easily explain why is still so prominent, but it can explain why, for instance, in the importance of the equity market is much larger than in (a country with a per capita income almost six times as big). The third potential explanation for why the demand for financing does not automatically generate its own supply is the need for an enabling infrastructure. In a financial contract, the parties exchange money for the promise of more money in the future. The value of this promise, however, depends crucially on the legal environment. The legal environment affects the possibility of writing certain contracts, the precision and speed with which these contracts are enforced by courts, and the punishment imposed in case these contracts are breached. For example, in the 18th century it was impossible for private parties to create a limited liability corporation without the consent of the Crown. Even today certain legal systems do not recognize or enforce certain contracts. For example, the possibility of obtaining a loan secured by the value of the entire company is a standard contract in (called floating charge), but it is not enforced in the . Politics, and Financial Development Volym D:55 most European codes ban legal fees contingent on outcome, which are common practice in the . These differences in legal system might matter. Recent influential research by La Porta et al (1997, 1998) finds countries belonging to the Common tradition have more statutes protecting investors, and more developed financial markets. But if certain norms or statutes are better in promoting financial development, why do other countries not simply adopt them? For instance, while joint stock companies were first allowed to incorporate freely in in 1853, the concept was quickly imitated in , where laws passed in 1863 and 1867 allowed free incorporation. Thus, while different legal systems might have a different propensity to generate legal and contractual innovation, in principle there is no restriction to imitation, eliminating the possibility of enduring differences in the level of financial development. In fact, we will show that with the exception of , the most developed countries in the world had a similar level of financial market development in 1913. The differences in the legal system existed then also, suggesting that if they did not create differences in financial development then, we should not attribute differences in financial development between countries today solely to differences in legal system. This leads us to the last possible cause of financial backwardness: the lack of political support in favor of financial development. Governments have great influence on financial markets. Excessive regulation and taxation (or worse expropriation) can kill a market, as can the lack of just and swift enforcement of contracts. The government also has an important role in designing and enforcing laws. Thus, it is obvious that the lack of political support can seriously jeopardize financial development. But why do some political systems financial development, while others do not? Before answering this question, we need to review the working of the political system and its two main players: the main interest groups and the Government. Interest groups pressure the government to favor them. The nature of the government – whether democratic, oligarchic or a monarchy – will determine which group has more saying and to what extent its wishes get translated into actions. But the government does not simply reflect the wishes of the dominant interest group, it also has its own agenda. This is clearly the case in a monarchy, but also in a democracy where the entrenched government bureaucracy has its own perks and survival at stake. Thus, asking why some political systems oppose financial development is tantamount to asking why some influential groups or the Government (or both) oppose financial development. Volym D:56 Supplement 24 There are certainly groups that win and those that lose from financial development. In a primitive financial system, the only people who can take advantage of profitable new opportunities are those that have the financial resources to do so, or can easily them using as collateral their stock of initial wealth. These sources of have an incentive to prevent competition by opposing financial development. Moreover, even if the is incapable of taking advantage of the opportunities, it has an incentive to prevent others from doing so since its relative position and power is much better in an underdeveloped economy, and the resources it can command greater. Thus, for example, the land-owning gentry invariably opposed financial development. By contrast, the industrial bourgeoisie has strong incentives to press for financial development, because of the tremendous opportunities it affords them to improve their lot. This may explain why the countries of developed vibrant financial markets only after the bourgeois revolutions of 1848 and beyond. , on the other hand, never had such a revolution and, probably as a result, had the most underdeveloped markets in Europe. As Gerschenkron (1962) argues, the Russian elites actively opposed financial development and it was the state that had to finance large investment such as the railways. Thus, the exent to which the dominant elite support or oppose financial development crucially depends on the nature of the dominant elite and of the opportunities it faces. Also the Government itself can be in favor or against financial development, depending on the circumstances. The opposition arises for two reasons. First, the emergence of vibrant financial markets and institutions requires constitutional limitations on the arbitrary powers of government, in particular to ensure that investors property rights are protected against expropriation. These limitations may impede government ambitions in other areas.