Law, Politics, and Finance

Abstract:     
A country's legal origin - whether British, French, German, or Scandinavian - helps explain the development of its financial institutions today. Legal systems differ in their ability to facilitate private exchanges and to adapt to support new financial and commercial transactions. A country cannot change its legal origin, but it can (with considerable effort) reform its judicial system by emphasizing the rights of outside investors, by providing more certain and efficient contract enforcement, and by creating a legal system that adapts more readily to changing economic conditions.

Beck, Demirguc-Kunt, and Levine assess three established theories about the historical determinants of financial development. They also propose an augmented version of one of these theories.

The law and finance view stresses that different legal traditions emphasize to differing degrees the rights of individual investors relative to the state, which has important ramifications for financial development.

The dynamic law and finance view augments the law and finance view, stressing that legal traditions also differ in their ability to adapt to changing conditions.

The politics and finance view rejects the central role of legal tradition, stressing instead that political factors shape financial development.

The endowment view argues that the mortality rates of European settlers as they colonized various parts of the globe influenced the institutions they initially created, which has had enduring effects on institutions today. When initial conditions produced an unfavorable environment for European settlers, colonialists tended to create institutions designed to extract resources expeditiously, not to foster long-run prosperity.

The authors' empirical results are most consistent with theories that stress the role of legal tradition. The results provide qualified support for the endowment view. The data are least consistent with theories that focus on specific characteristics of the political structure, although politics can obviously affect the financial sector.

In other words, legal origin - whether a country has a British, French, German, or Scandinavian legal heritage - helps explain the development of the country's financial institutions today, even after other factors are controlled for. Countries with a French legal tradition tend to have weaker financial institutions, while those with common law and German civil laws tend to have stronger financial institutions.

This paper - a product of Finance, Development Research Group - is part of a larger effort in the group to understand the link between financial development and economic growth. The study was funded by the Bank's Research Support Budget under the research project "Financial Structure and Economic Development" (RPO 682-41). The authors may be contacted at [e-mail], [e-mail], or [e-mail].

JEL Classifications: G28, G38, H11, O16

Working Paper Series