The political economy of financial development

Abstract

The article deals with political and economic determinants of financial development. Most empirical studies corroborate that there is a positive correlation between the quality of political institutions and financial development. The paper highlights the advantages and weak points of most widespread indices of democracy and other political variables based on the "Polity IV" database. These indicators exhibit higher statistical significance in comparison with alternative institutional proxies, e.g. legal origin. The article discussies the theoretical concepts underlying the political economy of financial deepening. In particular, the paper juxtaposes the endowment and interest group theories of financial development. In line with the endowment theory, financial development may be hampered by political instability stemming from the inefficient institutions shaped during colonial times. The interest group theory puts forward that financial development depends on the relative rents that its proponents and adversaries can reap. Also, the paper identifies the issues that call for a more detailed investigation, e.g. the interrelation between political institutions and financial structure which is a measure of relative importance of financial markets and banks in an economy. In this regard, it is found that securities markets tend to be more important than banks in mature democracies. The paper also asserts that the political economy of financial development in resource-rich economies and regional disparities in big federations should be examined more carefully. Both avenues of research are relevant to the Russian economy.