DP2783 | The Great Reversals: The Politics of Financial Development in the 20th Century

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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 cross-border trade and capital flows. This theory can go some way towards accounting for the cross-country differences and the time series variation of financial development.