The Great Reversals : The Politics of Financial Development in the 20 th Century 1

We show that the development of the financial sector does not change 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 is inconsistent with most recent theories of why cross-country differences in financial development do not track differences in economic development, since these theories are based upon time-invariant factors, such as a country’s legal origin. We propose instead an “interest group” theory of financial development. Incumbents oppose financial development because it breeds competition. The theory predicts that incumbents’ opposition will be weaker when an economy allows both crossborder 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. 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 Lucian Bebchuk, Colin Mayer, Peter Hogfeldt, Mark Roe, Andrei Shleifer, and Richard Sylla.