Experiments in Financial Democracy: Corporate Governance and Financial Development in Brazil, 1882-1950 (review)

Harvard Business School's Aldo Musacchio has written a terrific monograph that both improves scholars' understanding of the long-term economic and financial development of an important emerging market and thoroughly discredits the legal origins hypothesis.

To understand the determinants of long-term growth, scholars seek to explain why some small, desolate islands like Iceland, Ireland, and, stretching the definition of island a little, Israel (the Is) enjoy higher per capita incomes than large, well-endowed nations such as Brazil, Russia, India, and China (the BRICs). As Musacchio notes, most scholars now agree that a necessary prerequisite to sustained economic growth is financial system development, including a stable unit of account, a private commercial banking system, active markets for stocks and bonds, and institutions and markets for reducing, spreading, and trading risk. But why do the Is have more highly developed financial systems than the BRICs?

According to the legal origins hypothesis of Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny ("Law and Finance," Journal of Political Economy 106 (December 1998): 1,113-55 and subsequent papers), financial development is largely a function of legal systems. Nations that trace their legal origins to the common law traditions of Britain experienced more financial development than those with roots in German, Scandinavian, or, worst of all, French civil law because the common law provided more and better protections for investors, including stockholder voting rights, prohibitions against expropriation by managers, and the legal enforceability of debt contracts. Backed by that plausible-sounding story and impressive-looking cross-country regressions, the legal origins hypothesis gained considerable influence at first.

In the last few years, however, careful historical studies (like that of StephenHaber, Douglass North, and Barry Weingast, eds., Political Institutions and Financial Development (2007)) have shown that the assumptions and data used in those regressions were dubious at best. For example, La Porta et al. code Brazil as having French legal origins and hence very weak investor protections. But as Musacchio shows, Brazilian courts sometimes followed common law precedents and Britain's bankruptcy rules. Moreover, Brazil's protection of investor rights varied considerably over time. From the foundation of the republic in 1889 until World War I, the Brazilian government implemented a spate of pro-investor policies and, more importantly, encouraged stockholders to protect their own interests via corporate bylaws that established transparent management compensation schemes and highly graduated stockholder voting rights (in 1913, for example, the top three shareholders in Antarctica Brewery controlled 58 percent of total equity but only 12 percent of votes). A golden age of financial development, one that Musacchio convincingly argues was in many ways superior to Brazil's more recent financial efflorescence, quickly ensued. In other words, investor protections were indeed crucial to financial development (and hence, as Musacchio also shows, to economic growth), but legal origins were more complex than their eponymous hypothesis suggests and did not always, or perhaps even usually, determine the quantity or quality of those protections.

Musacchio accomplishes the destruction of the legal origins hypothesis in eleven tolerably well-written but often repetitive chapters, including an introduction and conclusion. The first seven body chapters cover Brazilian financial development in the nineteenth century, stock exchanges and industrialization around the turn of the twentieth century, voting rights and ownership concentration, executive compensation, bond markets and creditor rights, and investment banking practices. The final two chapters examine the post-World War I reversal of Brazil's financial development, which was initiated by a series of macroeconomic shocks, and the subsequent rise of concentrated ownership of corporation "grupos" by families, a profound devolution driven by legal changes that aided union workers, the government, and other debtors at the expense of creditors and stockholders.

Unfortunately, the book does not contain a general explanation of why some countries develop financially more than others do, only an admonition to dig hard and deep in...