The great reversals: the politics of financial development in the 20th century Authors:R. G. Rajan, L. Zingales Journal of Financial Economics(2003) Presenter: Wang Xiaxin

Outline 1 Introduction 2 Evolution of financial development over the 20th century 3 An interest group theory of financial development 4 A test of the private interest theory of financial development 5 Conclusion 6 Comments

1 Introduction Great reversal: In 1913, the main countries of continental Europe were more financially developed than America. Indicators of financial development fell in all countries after 1929, reaching their nadir around Since then, there has been a revival of financial market. How to explain it?—An interest group theory

2 Evolution of financial development over the 20th century Financial development: focus on the availability of arm’s length market finance Arm’s length market: a financial market in which parties engaging in transactions are separate and have no contact with each other outside the buying and selling of securities.

Various measures of financial development: –Banking sector: ratio of commercial and savings bank deposits to GDP –Equity issues: ratio of equity issues by domestic corporations to gross fixed capital formation (GFCF) during the year –Capitalization: ratio of the aggregate mkt value of equity of domestic companies divided by GDP –Number of companies listed: number of publicly traded domestic companies per million of population Each indicator has its own drawback, so they should be looked at together for a better sense of financial development.

Table 1 Evolution of the different indicators of financial development Whole sample indicates an average across all the countries we have data for. Constant sample indicates an average across countries for which we have data every year.

Stylized facts: –The average level of financial development was quite high in 1913, compared to that in 1980 or –Between 1913 and 1999, indicators of financial development fell considerably and rised again.

3 An interest group theory of financial development Incumbents: established large industrial firms in an economy They can do well in financing in less developed financial systems. Similar arguments apply to incumbent financiers. A more efficient financial system facilitates entry, thus leading to lower profits for incumbent firms and financial institutions.

In an industrialized economy, incumbent industrialists and financiers ordinarily would have enough political power, because of their large economic weight and small numbers, to collectively decide the development of the economy’s financial sector. It is when both cross-border trade flows and capital flows are unimpeded that industrial and financial incumbents will have convergent incentives to push for financial development.

4 A test of the private interest theory of financial development Direct measures of the political power of interest groups and their ability to influence outcomes are controversial at best. Our theory does lead to some indirect, but more objective, tests. According to it, incumbent interests are least able to coordinate to obstruct financial development when a country is open to both trade and capital flows.

Hypothesis to be tested: –(1) For any given level of demand for financing, a country’s domestic financial development should be positively correlated with trade openness at a time when the world is open to cross-border capital flows. –(2) The positive correlation between a country’s trade openness and financial development should be weaker when world cross-border capital flows are low.

Various measures of financial development: equity mkt capitalization/GDP; number of domestic companies/million population; total securities issued/GDP Measure of openness: trade volume/GDP Measure of demand for financing: Bairoch’s index of industrialization across a group of countries

Result for hypothesis (1): financial development is more advanced in more open countries. (for data in 1913 and late 1990s) Result for hypothesis (2): the interaction between openness and demand for finance has a positive and statistically significant correlation with financial development in 1913, 1929, and 1997, the periods having high international capital mobility. During the period of low capital mobility, the effect is statistically insignificant or even negative when we measure financial development by equity mkt capitalization/GDP.

The reversal in financial development then can be explained by the diminution of cross-border trade ang capital flows that started during the Depression and continued until the breakdown of the Bretton Woods agreement. Then why most countries shut borders in the 1930s and 1940s and reopened up only recently?

Logic for shutting borders: –Great Depression—high level unemployment— governments restricted by the Gold Standard to dislocate budgets to provide support to the needy—Gold Standard abandoned, currency devalued—tariffs introduced to minimize the competitive devaluations by trade partners

The breakdown of the Bretton Woods system led to the dismantling of capital controls. By the end of the 1980s, controls had been removed throughout west Europe, Japan. The competetion generated by trade and free international capital movements forced a modernization of the financial system.

5 Conclusion Four contributions of this work: –To show the reversal in financial market –To show that trade openness is correlated with financial mkt development, especially when cross-border capital flows are free –To argue that these findings are consistent with interest group politics –To suggest that a country’s institutions might slow or speed up interest group activities

6 Comments 1 What had the interest groups done in the great reversal on earth? In shutting borders, no evidence shows that they had done anything. In the breakdown of Bretten Woods agreement, which is critical to the dismantling of capital controls, no evidence shows that they had done anything, either.

2 The test for the two hypothesis may be reliable, but this might not be a good support for the interest group theory. A more direct test for the theory should be implemented. After all, the hypothesis that has been tested has only weak correlation with the interest group theory.

Thank you for listening!