Will Egypt's Next Revolution Be Economic?

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If democracy takes hold, financial growth could follow

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Inside and outside Egypt, many are wondering whether the country will build an open, democratic political system or relapse into some form -- new or old -- of autocracy. But an equally important question is the economic impact of its revolution.

For the past quarter-century, a major focus of international development organizations, mainly the International Monetary Fund and the World Bank, has been to bolster financial markets in developing nations such as Egypt. Stronger financial markets can move savings to where they can do the most to spur economic growth. This is especially true in post-revolution societies such as Egypt, where making finance work could boost economic development significantly.

Economic historians point to financial revolutions as setting the stage for strong economic development in England in the seventeenth and eighteenth centuries following the Glorious Revolution, in the United States after Alexander Hamilton built up major financial structures in a primarily agricultural country, and in Japan after the Meiji Restoration.

The World Bank, the IMF, and dozens of academics have studied long and hard what makes financial markets grow and what holds them back. Many focus on the quality of institutions, such as courts and tax authorities. Others emphasize the quality of corporate law. Still others look at policies, such as trade openness or lightness of taxation. Everyone extols property rights.

Yet when one looks at what actually happens in post-revolutionary, developing countries, political stability -- preferably democratic -- appears to be the most important factor. Financial markets leaped forward in eighteenth century Great Britain, and in the nineteenth and early twentieth centuries in Japan and the U.S., a time when several key institutions, such as corporate law and the court system, were woefully substandard.

American courts in the 19th century were notably corrupt, sometimes incompetent, and often irrelevant, yet stock and bond markets grew, and continent-spanning firms rose up and got the financing they needed to operate, expand, and industrialize the U.S. economy. Protective legal institution for outside finance, the federal securities laws, didn't fall into place until the 1930s -- decades after U.S. financial markets had grown to finance America's economic rise.

Britain and Japan seem to have followed the same sequence: finance first, protective institutions later. Japan had no corporate law until complex business finance started developing at the end of the nineteenth century.

So, in Britain, Japan, and the U.S., something more foundational must have been in place before financial markets started operating. Something else must affect which countries are most likely to get strong finance, which won't, and when it all happens.

That "something" seems to be basic political stability, often of the democratic kind. In a stable political environment, informal mechanisms -- such as reputations for reliability, trade associations, and stock exchanges -- can develop and facilitate financial dealings. Investors and businesses don't fear that a new regime can take power and call off all, or too many, bets, leading to losses on their investments.

The data linking democratic political instability and financial backwardness in the modern era indicate that instability powerfully predicts an inability to develop financial markets. Democratic political stability is the most important harbinger of financial development.

There is a deep logic to this finding. Even if all of the rules for finance are right, few will part with their money if they fear that an unfavorable regime change might occur during the lifetime of their investment.

More importantly, the grim stability of the type displayed by Hosni Mubarak's Egypt is oftentimes insufficient for genuine financial development. Authoritarian regimes, especially those with severe income and wealth inequality, inherently create a risk of arbitrariness, unpredictability, and instability. They are themselves arbitrary. And everyone knows that beneath the stability of the moment lurk explosive forces that can change the regime and devalue huge investments. Because financiers and savers have limited confidence in the future, such regimes can't readily build and maintain strong foundations for financial development.

By contrast, democratic regimes with widespread property ownership typically best protect property rights over the long term, because enough people within these regimes want to protect property. The political system has a continuing, stable stake in keeping those rules in place and making them work for finance and economic growth.

So, what does this mean for Egypt? So far, the Egyptian revolution is political, not economic. Yet if the revolution leads to a more open, democratic, middle-class-oriented political system, in which enough people believe that they have a stake in the government's continuity, the economic benefits for Egyptians could be large. Financial markets will more likely flourish, and more rapid and equitable development will more likely follow.

A version of this article also appears at Democracy Digest; it is distributed by Project Syndicate, 2011.
Photo: Cairo stock exchange by Cris Bouroncle/AFP/Getty
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Mark Roe is a professor at Harvard Law School.

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