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...
This paper reviews and synthesizes
theoretical and empirical research on the role of finance in
developing countries. First, the paper presents the stylized
facts about firms in developing nations as well as the
legal, financial and broader institutional framework in
which these firms operate. Next, the paper focuses on the
financing choices available to small and medium firms in
developing countries and highlights areas needing additional research.
The first part of this paper reviews the
literature on the relation between finance and growth. The
second part of the paper reviews the literature on the
historical and policy determinants of financial development.
Governments play a central role in shaping the operation of
financial systems and the degree to which large segments of
the financial system have access to financial services. The
paper discusses the relationship between financial sector
policies and economic development.