Law, Politics, and Finance

The authors 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 vie, 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.