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The policy roots of finance

Financial interconnectedness across countries has reached unprecedented levels – but what has driven this change? This column finds that financial deregulation is responsible for 16 percentage points of the increase in financial development, but openness to trade and the size of government off-set one another. This is because the structural association between trade openness and financial development is mildly negative.

Finance boomed for quite some time. And then it crashed. To understand what might happen as the world begins to emerge from the crisis, we need to try and understand where finance came from. At the global level, finance grew along with international economic integration at the turn of this century, as well as at the beginning of the 20th century. Sensible theoretical mechanisms can link international trade and finance; foreign investment opportunities and more intense competition make it more necessary for domestic firms to draw on external finance, and shift political equilibria towards financial market deregulation (Rajan and Zingales 2003).

In our CEPR Discussion Paper No. 7820 we point out that deregulation and competition in the financial market are not the only channels through which policy influences financial development in integrating economies. International trade may or may not face workers and households with new sources of risk, but it certainly reduces the extent to which risk may be controlled by government policies because national governments are less powerful if economic integration allows private agents to seek more lenient taxes and more generous subsidies across countries’ borders.

As financial markets can fill the void left by the resulting retreat of government, it is far from surprising to see in the top-left panel of Figure 1 that, across countries and over 5-year segments of the 1980-2007 period, deviations from country means of financial development (measured as private credit/GDP) are positively associated with those of economic integration (measured as imports+exports over GDP).

Figure 1. The financial development relationships

Openness to international trade is itself at least partly a matter of policy choice, of course, and its association with increasingly intense financial transactions also reflects other policy choices that pertain to substitution of imperfect financial relationships with (also far from ideal) redistribution schemes. Figure 1 shows that financial development is also correlated with financial market institutions (the Abiad et al, 2009 index of financial deregulation), with the overall relevance of national policies that may be subject to “race to the bottom” tensions (government share of GDP), and with redistribution policies (public social expenditure /GDP).

How has the supply and demand of finance been affected by each of these (and many other) policies? The recent crisis has shown that financial development is a two-edged sword, but it would be inappropriate to relate financial development directly to policies meant to achieve objectives that, among other things, depend on the intensity of financial transactions. Moreover, because determinants of country-level policies are likely to be correlated with those of financial development for given policies, regressing financial development on policies would neither measure the all-else-equal effects of policies, nor tell us anything about the deeper determinants of policies on financial development.

To disentangle the role of various policies in shaping financial development, we focus on the powerful globalisation trend that has swept all countries at the turn of this century. We build a country-and-time specific indicator of “globalisation pressures” based on the interaction of Frankel and Romer’s (1999) measure of policy-independent determinants of trade openness (like country size and location) with the intensity of global trade, which also does not respond to country-specific policies since individual countries are either too small or too closed to account for more than a small portion of global imports and exports. And we account for the fact that different countries may find it more or less easy to substitute private markets with public sector intervention allowing observed policy reactions to depend on the La Porta et al. (1998) indicator of how each country’s legal origin might shape its market friendliness.

These country-specific indicators fit our purposes in two key respects. They have been abundantly argued to be theoretically and empirically relevant to trade and finance, and cannot be influenced by subsequent policy choices. To be useful, they do not need to measure very precisely the intensity of globalisation pressures, under the hypothesis (that the data do not reject) that the level and interactions of natural openness, legal origin, and world trade influence finance only through policies. And they do not need to be more important, as drivers of national policies, than technological progress, demographic trends, or political fashions. In a similar vein to (Rodrik et al. 2004) who use historically remote sources of policy variation to assess the structural role of subsequent policies, we isolate exogenously different responses across countries to common exogenous developments, making it possible to identify the financial development effects of policies.

We find that these exogenous sources of country-and-time specific variation push and pull each of the four policy indicators enough to disentangle their separate effects on financial development. Our regression results trace how policymakers reacted to developments that made it more beneficial for their countries to trade, and more difficult for them to erect barriers to trade. Figure 2 paints a picture of the policy and finance consequences of globalisation, in terms of a variation in the intensity of global trade.

Easier trade opportunities have different implications for different policies across countries with different legal origin and geographical characteristics, and for the resulting financial development. This perspective on past developments is interesting because the technological, cultural, and political forces that drove the expansion of world trade since the end of the cold war may sooner or later wane. Should the crisis-related trade collapse persist over at least the 5-year horizon considered by our empirical specifications, for example, Figure 2 suggests that policies might be reshaped substantially – and differently – in different countries.

Figure 2. Implications for policy and finance of a 10 percentage point decline in Global trade

Of course, policies are, and continue to be, driven by many other less visible factors. If policy changes play the same role in all countries and periods (the debatable premise of any comparative empirical work), the estimated coefficients can also be used to trace actual financial developments to actual policy choices. Policy variation explains about 40% of the sample’s financial development variation, and the model offers a decomposition of this sizeable systematic component in terms of different policies’ contributions. For example, across the OECD countries in our sample, between 1985-89 and 2000-04, average policy changes predict a 19.8 percentage point increase in the private credit to GDP ratio – very close to the actual 18.3 percentage point change. But as might be expected the model does not do as well for individual countries and shorter periods, where such direct shocks to financial development as the Swedish and Finnish financial crises are important and visible. Our model attributes some 16 percentage points of the increase to financial deregulation, while the contributions of the 17 percentage point increase in openness and of the 1 percentage point change in the government share of GDP nearly offset each other. The increased openness to trade leads to a reduction of 5.76 percentage points and the change in the government share of GDP increases financial development by 6.97 percentage points. On the basis of these estimates, those who would like to reduce reliance on financial transactions after the crisis should not try and do so by reducing openness: because the structural association between openness and finance at given levels of other policies is mildly negative, rather than positive as in the overall plot above.

Our estimation strategy traces the roots of financial development to policy changes, whether resulting from responses to globalisation, or from other country-specific motives. It cannot tell us whether those changes were chosen by occasionally ill-advised politicians, or were suitable responses to new conditions. Finance was a good thing while it lasted, and it is good to have it back after the crisis. Like all things, however, finance has costs as well as benefits, which may or may not have been taken into account correctly at the time policy choices were made. In future work, it will be important to make and discuss further identifying assumption in order to relate policy reactions to the growth, inequality, and instability of incomes.


Abiad, A, E Detragiache, and T Tressel (2008), “A New Database of Financial Reforms”, IMF Working Paper 266.
Bertola, G, and A Lo Prete (2010), “Whence Policy? Government policies, finance, and economic integration”, CEPR Discussion Paper 7820 .
Frankel, JA, and D Romer (1999), “Does Trade Cause Growth?”, American Economic Review, 89(3):379-399.
La Porta, R, F Lopez-de-Silanes, A Shleifer, and RW Vishny (1998), “Law and Finance”, Journal of Political Economy, 106(6):1113-1155.
Rajan, RG, and L Zingales (2003), “The great reversals: the politics of financial development in the twentieth century”, Journal of Financial Economics, 69:5-50.
Rodrik, D, A Subramanian, and F Trebbi (2004), “Institutions Rule: The Primacy of Institutions Over Geography and Integration in Economic Development”, Journal of Economic Growth, 9(2):131-165.


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