Beyond legal origin and checks and balances: Political credibility, citizen information and financial sector development
| Author | Philip Keefer |
| Profession | Development Research Group The World Bank |
| Pages | WPS4154 |
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The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org.
Two strands of analysis dominate the literature that analyzes the institutional sources of financial sector development. Both agree that governments prone to expropriation stifle growth on both sides of bank balance sheets: depositors are unwilling to risk their funds in expropriable bank accounts; bankers are unwilling to lend to those who might abscond with the funds under the protective umbrella of a sympathetic government; investors are unwilling to capitalize banks whose profitability is placed at risk by the prospect of government expropriation. However, the political economy literature underlines the role of political checks and balances to ensure the credibility of government commitments not to expropriate actors in financial markets. The finance literature argues for the primacy of legal systems as guarantors of private rights.
Several issues remain unresolved in this literature, including the role of political factors other than political checks and balances and the extent to which the effects of political institutions and legal origins are robust to systematic tests. This paper makes four contributions that address these issues. First, it presents the first cross-country evidence, using objective indicators of political institutions, that political checks and balances are important for financial sector development. However, government policy is also influenced by the conditions of political competition and not only by the institutions of government policy making. The security of property rights and the efficient regulation of banks are both public goods and the conditions of political competition determine political incentives to provide public goods. A second contribution of the paper is to demonstrate that these conditions, particularly the credibility of pre-electoral political promises and citizen information about political decisions, are also significant determinants of financial sector development. Third, empirical work below demonstrates for the first time that all of these Page 2 political influences operate in part through their impact on the security of property and contract rights in countries.
Finally, estimates below demonstrate that the political determinants of financial sector development are robust to controls for legal origin. More revealing, after controlling for the potential endogeneity of political influence, legal origins have no significant impact on financial sector development. This suggests that legal origins capture unobserved historical influences that condition the political evolution of countries; when that evolution is modeled directly, the impact of the legal origins proxies falls accordingly.
Most work on financial sector development focuses on the role of political institutions – particularly political checks and balances; on the incentives of political decision makers and particularly the economic interest of their constituents; and on the origins of a country’s legal system. The work here tests these links and introduces other political characteristics of countries into the debate.
Political checks and balances increase the chances that a potential target of expropriation is represented in government and can block the expropriation decision. North and Weingast (1989) underline the importance of political checks and balances as a source of credible commitment in the context of the financial sector. The role of checks and balances is also thoroughly documented in other areas in which government credibility is at issue (e.g., by Keefer and Stasavage (2003) in the case of monetary policy).
However, the necessity of checks and balances as a precondition for financial sector development and economic growth has been called into question by Haber, Razo and Maurer (2003) and others. They have demonstrated that the autocratic Porfirio Daz regime Page 3 in Mexico was able to stimulate financial sector growth and economic growth more generally by making self-enforcing or externally-enforced arrangements that allocated privileged bankers and industrialists high rents. Despite the empirical and theoretical caveats to the argument about political checks and balances, however, the empirical work below shows that political checks and balances are a robust determinant of financial sector development.
While acknowledging irrefutable evidence that autocrats can craft credible agreements with bankers and industrialists, the evidence suggests that in general they are less able to do this than governments nested in a system endowed with political checks and balances.
The evidence presented below also emphasizes the role that other political conditions play. This is a theme that has emerged as well in the financial sector literature. Revisiting the evidence presented in North and Weingast (1989), Stasavage (2003) emphasizes that the credibility of governments depends on more than the presence of multiple veto players, but also on the interests of veto players. He argues that only when veto players in the British Parliament began to care about the cost of capital did interest rates paid by England on sovereign loans begin to drop. Similarly, research into the political economy of financial sector regulation has tended to focus most on the political interests of politicians. The experiment, seen throughout the literature, particularly in American politics, is to ask whether legislators’ voting records reflect the economic interests that prevail in their electoral districts. Kroszner and Strahan (1996), Kroszner and Stratmann (1998), Broz (2002) and many others have demonstrated power of these arguments, showing that economic interests within districts are significant determinants of legislator voting behavior with respect to the financial legislation.
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The interest group approach to political economy is hard to extend to the question of why property rights, credibility or financial sector development are greater or faster in some countries than in others. The US is a fairly unique laboratory for identifying the role of economic interests, because of low district magnitudes (the number of legislators per electoral district is either one or two), weak party control over the nomination process and because of ample data. At the same time, while it is possible that policy differences across countries are purely a reflection of differences in the types and alignments of economic interests in a country, there is little qualitative evidence that this is the case. The empirical tests below therefore look to underlying characteristics in the nature of political competition that affect government incentives to cater to special interests at the expense of citizens at large. Two characteristics are, in particular, prominent in the literature: citizen information about the actions of political decision makers and the credibility of pre-electoral political promises.
A prominent approach, particularly in the finance literature, is to trace the financial development of countries back to their legal origins. The law and finance literature (the seminal contributors to which are La Porta, Lopez-de-Silanes, Shleifer and Vishny, e.g., 1998) has presented substantial evidence that legal origin is significantly associated with a variety of aspects of government performance and that, specifically, countries of English, German or Scandinavian legal origin perform significantly better on numerous dimensions than countries with legal systems rooted in French or socialist legal traditions. To explain these outcomes this literature argues that, in contrast to French or socialist legal systems, the English common law tradition offered judicial protection of private property rights against predation by the state. The German legal system, though also in the civil law tradition Page 5 adopted by the French, was consciously intended to be more amenable to change than the French. The Scandinavian was close to the German.
Particularly among legal scholars, these arguments have aroused considerable controversy. On the one hand, scholars dispute whether the posited differences in French and German systems (e.g., with respect to their dynamism) or between civil and common law systems (e.g., with respect to their acceptance of judge-made law) are correct (XXCITE, Gourevitch, Roe). On the other, while the evidence has been overwhelming that legal origin matters, it is less clear that the evidence matches the specific hypotheses regarding the ranking of legal traditions outlined in the literature.
For example, Beck, et...
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