First Draft : July 2000 This Draft : June 2001 The Great Reversals : The Politics of Financial Development in the 20 th Century 1 Raghuram

Indicators of the development of the financial sector do not improve monotonically over time. In particular, we find that by most measures, countries were more financially developed in 1913 than in 1980 and only recently have they surpassed their 1913 levels. This pattern cannot be explained by structural theories that attribute cross-country differences in financial development to time-invariant factors, such as a country’s legal origin or culture. We propose an “interest group” theory of financial development where incumbents oppose financial development because it breeds competition. The theory predicts that incumbents’ opposition will be weaker when an economy allows both cross-border trade and capital flows. This theory can go some way in accounting for the cross-country differences and the time series variation of financial development. When we recognize that different kinds of institutional heritages afford different scope for private interests to express themselves, we obtain a synthesis between the structural theories and private interest theory, which is supported by the data. 1 Rajan is visiting M.I.T., and Zingales is at the University of Chicago. This paper is a development of some ideas in a previous working paper entitled “The Politics of Financial Development”. We thank the Bradley Foundation, the Center for Study of the State and the Economy, the Center for Research on Securities Prices, the Kauffman Foundation, and the World Bank for funding support. Rajan also thanks the National Science Foundation and M.I.T. for research support. Claudio Callegari, Henrik Cronqvist, Shola Fafunso, Isidro Ferrer, Jorg Kukies, Roger Laeven, Galina Ovtcharova, Nahid Rahman , Sofia Ramos, Ruy Ribeiro, Amir Sasson, and Elfani Wen provided excellent research assistantship and Arnoud Boot, Pratip Kar, Claus Parum, Kristian Rydqvist, and Elu Von Thadden provided invaluable help. We benefited from comments by Oren Bar-Gill, Lucian Bebchuk, Charles Borden, Peter Hogfeldt, Louis Kaplow, Fred Link, Colin Mayer, Mark Ramseyer, Eric Rasmussen, Mark Roe, Andrei Shleifer, and Richard Sylla.

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