Trusting the Government

• Author: Marc Quintyn and Geneviève Verdier
• Position: a Division Chief in the IMF Institute, and is an Economist in the IMF's African Department.

THE epicenter of the recent financial crisis was in countries with the most developed financial systems, raising questions about the advantages of such systems. But there is still broad consensus that financial development—the creation of a financial system that ensures effective intermediation between saving and investment via banking, insurance, and stock and bond markets—contributes to economic growth and a better standard of living.

To reap the benefits of deep and well-functioning financial markets, many countries liberalized their financial systems in the hope of jump-starting financial development. Industrialized countries led the reform efforts in the 1970s, followed by many middle- and low-income countries. However, efforts to stimulate the financial sector have had uneven results: liberalization has fostered financial development in a number of countries, but financial systems in a majority of countries have remained small and underdeveloped by most standards. In some cases, short-term surges in financial development even led to severe financial crises following liberalization. These varied outcomes (see chart) prompted a decades-long search for policies and institutional features conducive to financial development.

We have found that financial liberalization is a necessary but not sufficient condition for financial development (Quintyn and Verdier, 2010). Our research concludes that financial development depends not only on the prevailing macroeconomic environment, policy design, and principles such as property rights and contract enforcement, but especially on the quality of the political systems that uphold these principles. Political institutions that keep politicians’ actions in check reassure savers, investors, and borrowers that their property rights will be protected.

From repression to liberalization

Post–World War II attempts to use the financial system as an engine for economic growth were characterized by direct state intervention to channel funds to sectors designated as crucial for development. This strategy was popular in low- and middle-income countries and was employed to some degree even in several advanced economies. In its extreme form, such government-led strategy relied on state-owned banks and a host of administrative controls on financial institutions (including interest rate controls, credit ceilings, directed credit, and strict limits on entry into the sector). Far from yielding the expected economic growth and development outcomes, it had perverse effects, including suboptimal allocation of capital...