Political Instability: Its Effects on Financial Development, Its Roots in the Severity of Economic Inequality

60 Pages Posted: 6 Apr 2007 Last revised: 11 Jul 2013

See all articles by Mark J. Roe

Mark J. Roe

Harvard Law School

Jordan I. Siegel

University of Michigan

Date Written: February 3, 2011

Abstract

We here bring forward strong evidence that political instability impedes financial development, with its variation a primary determinant of differences in financial development around the world. As such, it needs to be added to the short list of major determinants of financial development. First, structural conditions first postulated by Engerman and Sokoloff (2002) as generating long-term inequality are shown here empirically to be exogenous determinants of political instability. Second, that exogenously-determined political instability in turn holds back financial development, even when we control for factors prominent in the last decade’s cross-country studies of financial development. The findings indicate that inequality-perpetuating conditions that result in political instability are fundamental roadblocks for international organizations like the World Bank that seek to promote financial development. The evidence here includes country fixed effect regressions and an instrumental model inspired by Engerman and Sokoloff’s (2002) work, which to our knowledge has not yet been used in finance and which is consistent with current tests as valid instruments. Four conventional measures of national political instability - Alesina and Perotti’s (1996) well-known index of instability, a subsequent index derived from Banks’ (2005) work, and two indices of managerial perceptions of nation-by-nation political instability - persistently predict a wide range of national financial development outcomes for recent decades. Political instability’s significance is time consistent in cross-sectional regressions back to the 1960’s, the period when the key data becomes available, robust in both country fixed-effects and instrumental variable regressions, and consistent across multiple measures of instability and of financial development. Overall, the results indicate the existence of an important channel running from structural inequality to political instability, principally in nondemocratic settings, and then to financial backwardness. The robust significance of that channel extends existing work demonstrating the importance of political economy explanations for financial development and financial backwardness. It should help to better understand which policies will work for financial development, because political instability has causes, cures, and effects quite distinct from those of many of the key institutions most studied in the past decade as explaining financial backwardness.

Keywords: financial development, investor protection, political instability, debt market development, stock market capitalization, political economy

JEL Classification: G18, G30, K11, K22, M16, N20, O16, O43, P16, P51

Suggested Citation

Roe, Mark J. and Siegel, Jordan I., Political Instability: Its Effects on Financial Development, Its Roots in the Severity of Economic Inequality (February 3, 2011). Journal of Comparative Economics 39 (2011) 279-309. Available at SSRN: https://ssrn.com/abstract=963214

Mark J. Roe (Contact Author)

Harvard Law School ( email )

Griswold 502
Cambridge, MA 02138
United States
617-495-8099 (Phone)
617-495-4299 (Fax)

Jordan I. Siegel

University of Michigan ( email )

Ann Arbor, MI
United States

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