“Mother, can I trust the government?” Stable democracies are more likely to enjoy sustained financial development

by Marc Quintyn and Geneviève Verdier

VOX
September 23, 2010

What do countries need for sustainable financial development? This column argues that protection of property rights is necessary but not sufficient. Using a sample of 160 countries from 1960 to 2005, it finds that checks and balances on power and political stability are the vital ingredients.

The epicentre of the global crisis can be traced to the world’s most developed financial systems, but few would consider this enough to challenge the broad consensus that financial development is good for economic growth. Yet despite this consensus, levels of financial development vary widely across countries (Figure 1), and many governments have failed to jumpstart their country’s financial markets.

Figure 1. Cross-country disparities in the ratio of credit to private sector GDP (2005) (each bar represents a country)

These observations have led to a decades of research on the right policies and institutional features conducive to financial development.

First, after a few decades of financial repression, financial liberalisation was considered the key to success. Industrialised countries led the reform efforts in the 1970s, followed by many middle- and low-income countries. The resulting mixed outcomes gradually made clear that liberalisation, while necessary, was not a sufficient condition for financial development and that other factors, such as the quality of institutions, might be critical to ensure success. One body of research has focused on differences in legal origin among countries but empirical results have remained inconclusive. Effective enforcement of property rights has subsequently been singled out as an institution contributing to financial development (Acemoglu and Johnson 2005) – more so than other legal institutions.

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