The Little Reversal: Capital Markets and Financial Repression in Western Europe In the Second Half of the 20th Century

Abstract

Securities markets in Continental Europe remained relatively underdeveloped throughout the 20th century as compared with those of Anglo-Saxon countries. The “law and finance” strand of literature argues that their secular stagnation can be traced back to legal origins and explained in terms of path dependency – ie, due to the lower protection of shareholders’ and debtors’ rights guaranteed by commercial codes based on the civil law tradition. Recent studies, however, provide ample evidence that the long-term development pattern of securities markets in Europe was not monotonical, but rather follows the ebb and flow of globalization. In fact, capital markets were well developed in a number of civil law countries on the eve of WW1. A “Great Reversal” occurred in the interwar period, from which they did not recover fully until the 1990s. The paper argues that this view of a longterm U-shaped pattern does not reflect accurately the historical experience of European securities markets. In fact, a W-shaped pattern can be observed: securities markets noticeably recovered in the 1960s, before being again marginalized in the 1970s and 80s. The paper attempts to explain this “Little Reversal” within the context of the rise of financial repression regimes in Western Europe. The paper tests empirically the public finance hypothesis, which argues that financial repression is motivated by the government’s attempt to impose implicit taxation on domestic currency- and debt-holders, including the banking system. An index measuring the intensity of financial repression is constructed for a panel of 16 European countries in the period 1950-1991. The determinants of financial repression are then empirically investigated using cross-section time-series data for a set of economic, institutional and political variables.