Political Institutions and Financial Development

Published by EH.NET (July 2008)

Stephen Haber, Douglass C. North, and Barry R. Weingast, editors, Political Institutions and Financial Development. Stanford, CA: Stanford University Press, 2007. xii + 304 pp. $30 (paperback), ISBN: 978-0-8047-5693-8.

Reviewed for EH.NET by Claudia Rei, Department of Economics, Vanderbilt University.

Much has been written about institutions and their impact on countries’ economic performance, to the point that some institutions are labeled good and others bad for economic development. Much, however, is still unclear. What institutions? What mechanisms? What channels? The existence of correlations between certain institutional arrangements and economic growth has been well demonstrated, but the economic incentives that bring about institutions and the historical context in which they are constructed have been somewhat neglected. Political Institutions and Financial Development tackles the second of these issues, taking into account the impact of the political history of several countries on their early financial institutions, which are correlated with subsequent economic growth. The book consists of essays organized in four parts: 1) an introduction of the theme by the editors; 2) three historical studies exploring the evolution of political institutions and banking systems in the U.S. and Mexico; 3) three empirical studies on the interactions between governments and financial-banking institutions beyond the U.S. and Mexico; and 4) two case studies on Brazil.

In Chapter 1, the editors start by stating the undeniable importance of a country’s financial development on its level of economic growth, and also the lack of consensus about causes for the observed variance of financial systems across countries. The legal origins view argues that a country’s financial development is largely determined by the country’s colonial heritage, whereas the political institutions view suggests that laws and regulations resulting from political institutions are a far more relevant determinant. The remaining chapters side with the political institutions view and further investigate which political institutions matter and how they matter.

In Chapter 2, Stephen Haber points at the government’s role in overcoming market failures in the banking sector, but notes that the government is subject to conflicting interests which can often lead to less than first best outcomes. Haber argues that political institutions that check and limit government have a positive impact in the development of the banking system. The author proceeds with a theoretical framework and case studies in order to explain the divergent performances of Mexico and the U.S.

Chapter 3 focuses on the early political features of the U.S. Richard Sylla provides an analytical narrative of the historical events that led to the foundation of the U.S. financial system shortly after independence, not forgetting the political context in which the events took place. The subsequent emergence, development and expansion of corporations formed a distinctive feature of the U.S. financial development with an extraordinary ability to generate wealth. Sylla concludes that even though limited government seems to have facilitated a more effective financial system in the U.S., the counter examples of Canada and Mexico show that this is by no means a sufficient condition for financial development.

In Chapter 4, John Wallis brings forth historical facts of early American banking to show divergent institutional paths in the northern and southern U.S. Wallis argues that the non-uniform institutional pattern within the U.S. raises concerns about the importance of legal origins on financial development.

In Chapter 5, Philip Keefer uses regression analysis to show that political checks and balances, incentives to provide public goods and security of property rights determine financial sector development, even after controlling for legal origin. Keefer uses objective measures of political institutions to account for the degree of government capture, which render legal origin insignificant.

In Chapter 6, Barth, Caprio, and Levine focus on the impacts of different approaches to banking supervision on banking efficiency and corruption. Using cross-country data on efficiency and supervision measures, and controlling for country-specific factors, the authors find that powerful supervisory agencies aimed at market failure amelioration are associated with increasing bank corruption and decreasing efficiency.

Chapter 7 analyzes the effects of minority shareholder protection by the government on corporate governance. Using a sample of thirty-nine countries of different legal families, Gourevitch and Shinn find that high minority shareholder protection and strong neo-liberal economic policy are more likely to create shareholder diffusion. The legal origin variable is found to exhibit much variation with respect to the conditions in the importing country, that is, the former colony.

Chapters 8 and 9 consist of two case studies centered on Brazil, an emerging country of civil law origin with a surprisingly developed financial system in the nineteenth century. In Chapter 8, William Summerhill analyzes the role of institutions in establishing state credibility. Summerhill studies the evolution of Brazil’s credit risk from 1825 to 1890 and finds several structural breaks consistent with the country’s political history. In Chapter 9, Aldo Musacchio takes into account the political economy of Brazil in the late nineteenth and early twentieth centuries in order to convincingly document the country’s institutional path. By analyzing Brazil’s corporate bond markets, Musacchio concludes that the factors at play in the Brazilian financial system go far beyond the inherited legal family.

Reading Political Institutions and Financial Development one can learn about the political histories behind the foundation of financial institutions ? especially in the U.S., Mexico and Brazil ? and the expected correlations regarding economic growth. Do not expect a unified theory on how political choices may affect financial systems, or on how financial systems impact economic development. The channels at work in the U.S. do not seem to be at play in Brazil, and even within the U.S. there is considerable variation. The importance of country/region specific historical paths is reinforced, and the degree of government capture is suggested to be of major importance in explaining the divergence between good financial systems that enhance economic growth and deficient financial systems that impair economic performance.

Claudia Rei recently completed her Ph.D. at Boston University and will be joining the economics department at Vanderbilt University as an assistant professor in the fall. Her work focuses on the incentives behind the organization of fifteenth to seventeenth century merchant empires and the impacts on their long run economic performance.