The Study of Political Institutions at the Centre of Financial Economics

In a recent survey of the literature on the political economy of finance (available here), we argue that understanding the evolution and functioning of financial systems cannot be fully appreciated without accounting for the critical role played by political institutions.

Institutions influence economic outcomes because they shape incentives in society and persist over time. The political economy approach is based on the idea that, within the hierarchy of institutions, political institutions come first because they are more difficult to change than other institutions. In particular, they change more slowly than contracting institutions, which are the institutions governing the private contracts between individuals (for example, financial regulations, competition laws, labour laws). Although more fundamental than contracting institutions, political institutions are themselves endogenous. They are subject to changes because they are determined by society, or a segment of it. In the spirit of Douglas North’s work, the political economy approach shows that changes in political institutions have a fundamental influence on the historical evolution of financial systems across countries, while they are at the same time affected by the distribution of power associated with a specific financial system.

We classify existing contributions to this field into three groups. The first group of papers, which also represent the first generation of studies on the politics of finance, takes a macro approach and asks the question of why there are so large differences in financial development across countries. The dominant view in comparative economics is that contracting institutions (especially investor protection) explain cross-country differences. Hence, countries adopting the ‘right’ contracting institutions should naturally catch up. However, this is not consistent with historical and international evidence. Contracting institutions are indeed endogenously determined, being the result of a political bargaining game between different constituencies. The papers we survey show that political institutions (for example, electoral rule and voting rights) are the omitted variables helping explain historical and international variations in financial development.

The second group of papers takes a micro approach and studies regulatory and legislative decisions and their consequences as the outcome of constituencies’ political power. This is currently the most popular area of research in the field. For example, empirical evidence shows how special and constituent interests swayed legislators’ position on US housing policy during the subprime mortgage credit expansion that took place prior to the 2008-09 financial crisis. Such political influence is not restricted to its impact on regulations and legislations but also extends to the way in which existing contracting institutions operate and are enforced. As another example, a recent paper documents that firms having access to high-level government officials during the Obama’s Administration tend to obtain more government contracts and regulatory relief, translating into enhanced financial performance. Although ample evidence shows that political connections are valuable, it also shows that they create distortions in the allocation of capital and access to finance in both developing and developed countries.

The third group of papers surveyed emphasizes the possibility of feedback effects going from resource distribution to political power and institutions and, in a sense, reconciles the micro with the macro approach. It does so by illuminating the directions of causality and giving new insights into the broad, historical patterns. This is the research approach that holds more promise for the future.

To conclude, our survey conveys an important message: political institutional analysis has advanced in major ways and has deepened our understanding of the development of financial systems as well as the emergence of financial crises. Progress in this area requires the skilful integration of several building blocks—from history, economics, law, and political science.

Thomas Lambert is Assistant Professor of Finance at Rotterdam School of Management, Erasmus University. Paolo Volpin is Professor of Finance at Cass Business School, City University of London.