Modern economic growth is driven by large-scale corporate enterprises with the capacity for self-sustaining investments in technological innovation and factor productivity. In spite of the central role of corporations in the global economy, conditions of corporate and financial market development are not yet adequately understood. Anomalous cases are not well accounted for by legal origins theory, which emphasizes effectiveness of common law in protecting shareholders from expropriation by corporate insiders (La Porta et al. 2008). For example, why do some civil law countries such as Switzerland have market capitalization rates of more than 200% of GDP, while others such as Italy stagnate at less than 40%? And why are some of the newly industrialized countries able to rely so heavily on external funding, while so many developing countries are unable to institute financial markets?

Recent economic explanation of financial market and corporate development has focused on the incentive structure of shareholders and creditors. This principal-agent approach interprets the problem facing financial market development as arising from incomplete contracts between shareholders and management. The core dilemma is that monitoring of managers would involve considerable agency costs. As the risk of shareholder expropriation cannot be resolved through corporate governance structures internal to the firm (Hart 1995), law and finance scholars argue that corporations and financial market development depend on effective legal protection of shareholders and creditors (Shleifer and Vishny 1997).

The underlying logic of the law and finance literature is as straight-forward as appealing: Corporate laws provide shareholder protection against insider expropriation and thereby reduce agency costs that are naturally connected with a separation of ownership and control. In essence, appropriate minority shareholder protection is a precondition of ownership separation and enables the development of securities markets. Scope and effectiveness of legal protection of investments in corporations by shareholders indeed varies considerably across countries. In their seminal paper, La Porta et al 1997) find that shareholder protection across these four broad families of law—French civil- law, English common law, German- and Scandinavian civil law—differ widely and have a significant effect on the ability of businesses to fund investments through external sources. Comparative studies of corporate law extended the view that legal system origin is closely correlated with the extent of shareholder protection in empirical analyses of financial markets (Demirguc-Kunt and Maksimovic 1998).

However appealing the ‘legal protection’ framework may be, the theory did not remain without criticism. In response to the debate generated by their seminal articles, La Porta et al. (2008) provide a nuanced and balanced assessment of the empirical literature. While they address convincingly the cultural and political perspectives criticizing legal origins theory, they acknowledge that “the most difficult challenge to the hypothesis that legal origins cause outcomes has been posed by historical arguments” (p.315). Most importantly, the historical development of national stock markets does not conform well to the claim that increasing shareholder protection drives financial market development. Market capitalization of the US stock market for instance, already reached 80% of GDP in the late 1920s, when security regulation was almost absent. In spite of a wave of new securities laws and amendments specifying rules on voting rights, proxy contests (Holding Company Act 1935), and insider trading (section 14 of the 1934 Securities Exchange Act), the market remained within its earlier high of 80% of GDP until the mid 1970s. For a broader panel of 24 countries, Rajan and Zingales (2003) confirm that most countries were financially more developed in 1913 than in 1980 in spite of a general increase of legal shareholder protection in the same period.

Similarly, development of legal protection is not in line with the pattern of historical security market developments worldwide. In Amsterdam, home of the world’s first stock market and stock company (the East India Company founded in 1602), formal shareholder rights were largely absent and much of the financial transactions were even prohibited by law. Securities trading relied on self-interest and self-enforcement (Stringham 2003). By the 1630s the Netherlands was already “a highly commercialized country with well-developed and innovative financial markets and a large population of sophisticated traders” (Garber 2001:23). Nonetheless, the Amsterdam Stock Exchange Association was not founded before 1851 to organize and regulate share trading. Also the London Stock Exchange did not receive its first codified rule book before 1812, while organized securities trading had started as early as 1698 and Brussels stock exchange worked for more than 100 years up to 1935 with minimal regulation. The observed pattern is widespread: the inception of securities markets worldwide was usually not accompanied or even preceded by respective formal rules protecting shareholder rights. Company stocks were traded informally and transactions were treated as gentlemen agreements, often conducted in local coffee houses or open market places. Evidently the focus on legal origins provides a strong but nonetheless partial explanation of cross country variation of financial market development.

Our approach builds on the fact that development of modern corporations and arm’s length finance requires an institutional environment in which trust is not dependent on strength of personal ties, but more importantly on confidence of economic actors—individuals and firms—in the credible commitment of government in enforcing contracts, protecting property rights and facilitating markets (North 1981; Olson 2000; Tabellini 2005; Gwartney et al. 2006). North and Weingast (1989) highlight the effect of political competition in limiting rulers from expropriating wealth from producers. As in legal origins theory, the emphasis is not focused on examining variability in the administrative capability of the state, but on the nature of the formal rules. Yet in modern capitalism, not only the legal system but also the bureaucracy enable ex ante predictability and calculability of decisions (Weber 1988:321). As Weber (1978) observed in his historical research on the rise of modern capitalism, predictable and methodical organizational action underlies complex transactions in markets and large- scale production in capitalist economies: “Today, it is primarily the capitalist market economy which demands that the official business of public administration be discharged precisely, unambiguously, continuously, and with as much speed as possible” (p.974).

Methodical and predictable bureaucratic performance in support of markets facilitates capital accounting and calculable risk-taking and hence, the development of large-scale capitalist enterprises. In this sense, public administration plays a crucial role in providing and guaranteeing the institutional environment for securities development and the separation of ownership and control. Our core argument is that the calculability of risks embedded in the institutional environment lowers transaction costs and promotes public trust in financial markets that provide external funding to corporations. Country case studies of the 20th century confirm that securities markets and owner separation typically develop when the state-firm interface is characterized by routinely performed, calculable, impersonal and rule-based transactions; in contrast, owner-management and family-owned firms prevail in the context of highly personalized and relationship-based state structures (Whitley 1999). Also, the historical account of stock trading seems to support a crucial role of the state. Whether the old commodities markets of Bruges, Venice, Genoa, or Pisa, or the early stock markets in Amsterdam, Brussels or London, they all developed in an atmosphere of reliable and supportive public governance, which was trusted by merchants, traders and investors (North and Thomas 1973; Gelderblom and Junker 2004; Prak 2005; Greif 2006).

To examine the association between state bureaucratic performance and corporate development, we first explain why bureaucratic quality strengthens the state’s effectiveness in establishing an institutional environment favorable to the development of modern corporations. Following, we use a sample of 56 national financial markets to test our hypothesis positing a positive connection between the quality of bureaucratic performance and capitalist economic development.

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