sou · GOB311d5 · 2001-01-01 00:00:00 — Moreover, even when governments do become law-bound, they have a better ability to direct finance when the financial system consists of cartelized institutions than when it consists largely of securities markets. Thus they have an incentive to favor institutionalized finance over markets. For example, the militaristic Japanese government in the 1930s suppressed smaller banks and forced them to merge with large banks in an effort to direct finance towards armaments, thus initiating the bank system.6 The hitherto vibrant arms length markets were also suppressed; banks, with the acquiescence of the , formed a in 1933 which determined which firms could issue bonds, on what terms, and when. Clearly, banks had incentive to allow firms to finance in the bond 6 See Ueda (1994). Politics, and Financial Development Volym D:57 Of course, government can also be a force for the development of financial system if it is also in its own interest. Finally, the ability of the dominant elite and the Government to affect the final outcome is not independent of the legal and political system. A political system where power is more concentrated makes it easier for a Government to act swiftly. Similarly, a legal system where the legislator makes the law, as in the civil law system, facilitates Government intervention, while a legal system based on precedents, like the common law one, makes it more difficult for the Government to alter the status quo. Thus, the political will of the Government and/or the dominant elite does not translate into action in the same way in different legal environments. Actions, whether favorable to or against financial development, will bear fruit more quickly in more centralized Governments and in civil law countries. Can this theory explain the historical evolution of financial markets? It certainly is consistent with the broad outlines. Consistent with the political theory, all the early financial centers of the Modern world, starting with and , moving on to and the cities of the , and culminating in , emerged in independent political entities controlled by the bourgeoisie. None of the political centers of big and powerful centralized states (, , or ) emerged early on as important financial centers. Also the emergence of can be traced to the fortuitous coincidence of the two crucial catalysts predicted by the theory: an elite who could benefit from financial development and a weak Government. In , as in all the other States, the dominant elite was the land aristocracy (gentry). But unlike other States the English land aristocracy in the 17th century could benefit from a development of the capital markets. About the same time, the English crown, which had lost its credibility by expropriating bankers in the famous Stop on the Exchequer (1672), was forced to introduce reforms that facilitated its own borrowing, and coincidentally, financial development. The result was that by the end of the 18th century emerged as the financial capital of the world. This predominance of carried well into the 20th century. But during the second half of the 19th century, other financial centers started to emerge: not only , but also and, to a less extent, . In fact, in 1907 the total amount of securities traded in was slightly larger than that traded in , despite the fact that French GNP was only one fourth of U.S. GNP.7 Interestingly, of the securities traded in were foreign, while almost no foreign securities 7 and (1998). Volym D:58 Supplement 24 traded in the U.S. Thus, in spite of a slow start, had become the second financial capital of the world. What explains this catch up? The second half of the nineteenth century saw, according to , the of Capitalism and the triumph of pro market forces. The revolutions following 1848 put the bourgeoisie in power in most European states. The prolonged period of peace in Europe, between 1870 and 1914, brought economic interests to the fore. The major countries of Europe went on the Gold Standard to facilitate cross-border trade and international capital flows. Governments, even if not propelled by their bourgeois supporters, found it in their interest to aid the process of integration because it enhanced their revenue and financing options. In fact, the breathless prose of learned commentators in 1913 is reminiscent of what one hears today: The world is becoming one in an altogether new senseAs the earth has been narrowed through the new forces science has placed at our disposalthe movements of politics, of economics, and of thought, in each of its regions, become more closely interwovenWhatever happens in any part of the globe has now a significance for every other part. World History is tending to become One History. With the industrial bourgeoisie in power, Governments throughout Europe promoted financial development. Where legislative power was more concentrated at the top, as in civil law countries, this promarket intervention could be more effective. While it took over a century and a half for the English common law system to work out the limited liability form to its satisfaction, ten years were sufficient for the French civil code to imitate it. This explains the almost instant success of European Governments in promoting financial development. But World War I and its aftermath changed everything. Financial markets declined significantly in many countries between 1913 and 1948 even as a proportion of GDP, and in some cases have not reverted back to their prewar level even today. In , for example, the number of publicly traded companies was higher in 1913 than in 1985.9 Interestingly, this decline was experienced not only by countries that lost one or both wars, but also by countries (like ) that won both, and even by countries, like , that did not participate in either. What caused the retreat of financial markets? Why was it more pronounced in some countries than in others? 8Address on April 3, 1913 of , President of , cited in (1915), p. 9Pagano, Panetta, and Zingales (1998). Politics, and Financial Development Volym D:59 In our view, there were two main reasons; one a bottomup upwelling of the for insurance, the other, a top down for national security that required the coordination of national resources. These political forces managed to assert themselves, especially in economies with centralizing tendencies. Since insurance and coordination of the kind desired are not easily supplied by the market, the market was forced to retreat in country after country, and supplanted by hierarchical organizational structures. Let us explain in greater detail. The expansion of markets creates risks, which are not easily insured. For example, the lowering of trade barriers by an economy motivated by international trade could lead to entire industries becoming uncompetitive and the human capital of their workers redundant. It is hard to insure against this risk because the risk is hard to diversify away, and also insurance breeds standard problems of moral hazard and adverse selection. Similarly, the existence of competitive arms length securities markets makes it for long term bank-firm relationships to form, and increases the risks to firms of being shut off from credit. The rationale is that these relationships are a form of insurance; a firm in trouble gets credit at a below-competitive rate in return for which it pays the premium by giving more of its business to the relationship bank in good times. A more competitive outside environment puts great stress on a relationship because opportunities outside the relationship become more attractive. It becomes much for either party to feel confidant in the give-and-take that is necessary for the relationship to work becomes the other party could just leave after taking. Since a relationship is governed by mutual confidence rather than contracts, an increase in competition in financial markets leads to a breakdown in confidence, and the quick demise of relationships founded on nothing more substantial than the absence of alternatives.10 generally, as first suggested by Polanyi (1944), competitive markets whether in labor, industry, or finance tend to put strains on social relationships, which are based on implicit contracts. These social relationships are the primary source of insurance before the advent of the market. Moreover, markets tend to accentuate the difference between the incompetent, the unskilled, or the untalented and the more qualified, thus exacerbating the need for insurance. Thus competitive markets destroy old sources of insurance while creating new needs for it. Unfortunately, competition again – when coupled with the lack of commitment that 10 This idea was initially proposed by C.Mayer New Issues in , , 32 (1988), p. and (1995) model it formally and find empirical evidence for it. Volym D:60 Supplement 24 leads to incomplete contracting or free-riding – makes it hard for markets to provide the necessary cross-subsidies that mitigate its harshness.11 In good times, the greater allocative efficiency of the market papers over the lack of insurance. Everyone benefits from the rise in incomes. But in major downturns, the political pressure from the large masses of losers becomes hard to resist. In particular, the post-war unemployment, financial crises, and eventually the Great Depression – that could all be traced back to the disequilibrating effects of the World War – stood in direct contrast to the full employment, productive efficiency, and stability that most European economies enjoyed under the command structure necessary for military production during the war. To the common man there seemed something wrong with the market economy and these beliefs fuelled the antimarket revolt that Polanyi called the Great Transformation. In order to provide insurance in the form of higher employment, higher prices or wages to certain sectors, and financial sector stability, governments had to intervene massively in the working of markets – be they financial, labor or trade. But these typically distortionary actions were hard to undertake while the economy remained open to international competition. Protectionist tendencies therefore came to the fore. As more and more countries closed themselves off from the international economy, and went off the Gold Standard so as to better effect internal cross-subsidies, the benefit to any country of resisting internal pressure and maintaining open markets diminished. International markets closed down. The anti-market reaction took different forms. In , the Fascists started the first major wave of nationalization of industry. In , the populist movement of handed out large subsidies. In , the 60-year domination of the Labor party, which created the Swedish welfare state, began. In , the rate set by the ostensibly independent stood at a political 2 percent between 1932 and the outbreak of the war. Even the , traditional paladin of the free market economy, had its New under . The intensity of this anti-market revolt varied country by country, depending on the severity of the economic shock, its exposure to those rearming, and most importantly, the countrys inherent centralizing tendencies. In particular, we will argue that the different legal and institutional environments provided widely varying degrees of protection against the anti-market backlash. Countries with a civil law system, 11 For models showing the difficulties of cross-subsidization in a market environment, see and Dybvig (1983) and Jacklin (1986). Politics, and Financial Development Volym D:61 where the legislature makes the law, became an easy prey for the political movements advocating a command and control system. Common provided a stronger bulwark against centralization. First, the English common law tradition emphasizes restraining the government and protecting the individual, making more difficult the centralization of the economy. Second, Common is based primarily on judicial precedent, rather than upon the act of a legislator. Thus, a new political climate is less able to transform the structure of society. Third, even though Common is hard to change from the center, it evolves at the periphery, and innovates around legislative or administrative roadblocks set up by the center. In our view the decentralized nature of the Common system, and its ability to resist anti-market forces can explain the continued vibrancy of financial markets in Common countries even when markets elsewhere declined. Our analysis emphasizes the importance that political consensus (or lack of) plays in the development and defense of markets in general and financial markets in particular. Its implications are not that all countries that did not have the good of being colonized by the British should adopt British common law. Rather, it is a note of caution against taking for granted that financial development is unidirectional, and that the generalized consensus in favor of markets is irreversible because of their obvious efficiency. History shows that in time of crisis a political backlash may occur and it can have very long-term consequences. As a result, any policy designed to promote financial development cannot ignore its political effects. Only if the reforms can enhance popular consensus for markets can they have positive long-lasting effects. To summarize our main thesis: 1)Financial development results when the politically powerful develop a consensus in its favor. 2)The centralization of political power in an economy tends to magnify the interests of those in power. This can speed up financial development when the center is in favor of markets – an all too rare occurrence – and reverse it when it is not. 3)Decentralization of political power, coupled with an efficient legal system tends to be most conducive for the protection of property rights and the financial innovation necessary for financial development. Decentralization also ensures that financial development is hard to reverse when the consensus at the center changes. 4)A Common system allows for more contractual and legal innovation, which makes it easier to by pass the potential roadblock imposed by an elite that opposes financial development. Volym D:62 Supplement 24 more conducive to financial development. But its innovations can easily be imitated by a suitably motivated Civil law system. Thus, the greater financial development in Common countries is not because laws are better in those countries, but because the decentralization of Common makes it easier for financial markets to develop in spite of political opposition and makes it to reverse this development in the face of political challenges. Now that we have laid down the main arguments, we move to explore them in greater detail. In the first section we present some aggregate data on the differences in financial development across countries. Section 2 briefly reviews the fixed costs and learning-by-doing theories of financial backwardness. Section 3 reviews the nature of different legal systems. Section 4 explores the possible theoretical links between legal system and financial development. Section 5 tests the predictions of the legal theories of financial development by comparing the level of financial development circa 1913. Section 6 proposes a political theory of why and when the dominant elite and the Government will oppose the development of an efficient financial system. Section 7 analyzes how historically financial systems emerged in spite of this resistance. Section 8 tries to identify why the evolution of finance in the last ninety years has differed so greatly across countries. Section 9 discusses the policy implication of our analysis. Section 10 concludes. Politics, and Financial Development Volym D:63 1Financial development across countries There is no consensus on the correct method to measure financial development. Theoretically, the right measure would be the ease with which companies in need of external funds can access them and the premium they have to pay for these funds. Unfortunately, these are not measures that can be easily computed even in the most developed countries, let alone for a large cross section of countries. Thus, the standard practice, which we will follow here, is to compute ratios of the size of different components of the financial system to measures of the size of the economy. Table 1 reports such indicators for all the countries that have a stock exchange listed with the Bourse (FIBV), the international association of Stock Exchanges.12 Even though this is a fairly comprehensive list, which includes a lot of developing and former socialist economies, it is important to note that countries enter the sample only if they have a stock exchange. For ease of comparison, the countries are ordered in terms of per capita GDP at the end of 1996. The first measure reported is stock market capitalization over GDP. While there is a positive correlation between relative size of the stock market and the level of economic development (measured as per capita income), this association is far from overwhelming. and the are two countries that are very similar in every dimension (including the level of per capita GDP), but in the the equity market capitalization is almost as much as the GDP, while in only . The same can be said for the and . Thus, the size of the equity market does not seem to be a simple reflection of the level of economic development. 12 We omit information for , , , , , , , and because the International Financial Statistics do not report GNP data for these countries. Volym D:64 Supplement 24 Financial and Economic Development around the World 1996, end of Politics, and Financial Development Volym D:65 Sources: FIBV, Annual Reports and IMF: International Financial Statistics. Volym D:66 Supplement 24 This is true also for the size of the bond market. While the available data from the FIBV suggests a stronger association between the level of economic development and the size of the bond market, this is not the entire story. For example, and the have a similar per capita income, but very different bond markets (of GDP for , for the U.K.). Interestingly, among the countries for which data are available there is no association between the level of development of the bond market and that of the equity market. , which has a relatively small equity market (of GDP) has a relatively large bond market (). A third indicator of financial development, although not necessarily an indicator of development of financial markets, is the amount of domestic credit over GDP. This is a measure of the amount of credit extended by banks. Again there is a strong association between this indicator and the per capita income, as also considerable unexplained variation: , which has a per capita income very similar to , has three times the level of credit per unit of GDP. Similarly, the U.K. has two and a half times the level of domestic credit as . Interestingly, the level of domestic credit is positively correlated with the importance of the equity market, suggesting complementarity rather than substitution between the two. Some countries appear to be more financially developed on every dimension. One important drawback of the above measures is that they record the stock of financial instruments outstanding, rather than the flow of investments intermediated by the financial system. This drawback is particularly serious in the case of the equity market capitalization, which measures the market value of the existing companies rather than the amount of funds raised in the equity market. Thus, the Dutch stock market appears very large because of the presence of the oil giant Royal Dutch . But Royal Dutch does not raise much funds externally, thus its presence in the does not necessarily indicate that companies can raise funds easily in the Dutch equity market. A better measure, therefore, is the fraction of total investment that is financed by equity issues (the sum of equity issued in secondary markets by publicly traded companies and shares sold at the initial public offering by newly listed firms). Unfortunately, this datum is not available for many countries. For the countries for which it is available, however, it confirms the previous results. The level of financial development differs greatly across countries even if we compare countries with a similar level of economic development. Furthermore, Anglo-American countries, (and its former colonies) financed a much larger fraction of their investment from the market, than Politics, and Financial Development Volym D:67 the rest of the world (vs. even after eliminating , which is a big outlier). The data on funds raised through bond issues should be interpreted with caution because they are gross bond issues, that is, they do not subtract the amount of bond retirement. Nevertheless, they seem to confirm the overall pattern, as do the sum of the two. In sum, the data on financial development around the world seem to reject a simple variant of Says law. Financial development does not go hand-in-hand with economic development. In fact, all the different measures of financial development indicate wide differences across countries with a very similar level of economic development. Why is this the case? This is the question we will try to address in what follows. Volym D:68 Supplement 24 2Fixed costs and time-to-build theories of financial backwardness Clearly, there are large fixed costs in setting up financial infrastructure.13 Furthermore, it may be hard for private enterprise to internalize all the gains to doing so, especially if these gains are spread over a long period of time. If there is no preexisting financial infrastructure, the economy needs either the fortuitous combination of rich individuals with the will at a time when there is a sudden large demand for financing (or a farsighted government that can pool resources) for the infrastructure to be set up. (1977) suggests this is, in fact, what happened in the . The financial sector, especially investment banks and the corporate bond market, developed to meet the enormous financing needs of railroads in the midnineteenth century. The total investment in American railroads came to a billion dollars in 1867, three billion in 1873, five billion in 1880, and fully ten billion in 1890.14 This was far in excess of the financing ability of a young nation, especially given the enormous financial strains caused by the civil war. Therefore, the source for over forty percent of this capital before 1914 was Europe. At that time, capital in Europe could be obtained for about half its cost in the . But European investors were fearful due to the lack of reliable information and the fact that legal and quasi legal safeguards for the buyer were almost entirely lacking. Recourse to American courts would help investors in far-off Europe, who were confused in any case by the differences between state and federal jurisdictions. 15 The solution to this problem was the creation of institutional investors, who looked after the interest of British investors on the American soil. This infrastructure, built to finance railroads, was later available to meet the less demanding needs of industrial firms around the turn of the century. 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 13For models on fixed costs of financial development and growth, see Bencivenga and (1991) and Greenwood and Jovanovic (1990). 14Egelbourg and Bushkoff (1996). 15Egelbourg and Bushkoff (1996). Politics, and Financial Development Volym D:69 perhaps most important is that a large number of persons think of that particular market as the natural location for their trades.