The Evolution of Financial Markets: 1870-2010 - Legal Origin and the Great Reversal

Abstract

Why did some countries develop larger capital markets than others? To shed light on this perennial question, I present a new macro-historical dataset on stock market capitalization, bank deposits and the output of the financial sector for eighteen advanced economies between 1870 and 2010. Based on historical data from more than a hundred sources, I study the evolution of financial systems in common and civil law countries. In line with legal origins theory (La Porta et al. 1997), I show that civil law countries have significantly smaller capital markets, smaller financial sectors and more bank-reliant financial systems than common law countries since at least 1870. The gap between common law and civil law countries varies substantially over time: In 1885, capital markets in common law countries were twice as large as in civil law countries. This ratio fell substantially until World War I, but increased strongly during the Interwar and Postwar Period. I argue that high levels of financial integration and free capital movement led to convergence between common and civil law countries prior to World War I. Financial fragmentation, as well as shocks to the capital stock and political uncertainty during and after the war help explain the strong divergence immediately after World War I.