Financial system sophistication and unemployment around the world

Abstract

Using data on 78 countries from 1984 to 2008 and a large number of controls, this article studies the unemployment effect of a major characteristic of the financial system: its level of sophistication, i.e. the variety of financial institutions and instruments available to the economy. It finds that a higher level of sophistication is likely to reduce unemployment. The magnitude of the estimated effect is moderate but noticeable.

Keywords:

• financial institutions
• financial instruments
• financial system
• unemployment

JEL Classification:

• E24
• E44
• G00
• J64

Notes

1 While ‘private credit’ refers to the value of credit to the private sector, ‘financial system deposits’ refers to demand, time and saving deposits. ‘Stock market activity’ (‘stock market capitalization’) refers to the value of shares traded (listed) on domestic stock exchanges. All four variables are in decimal fraction of GDP. Source: Beck et al. (2012).

2 ‘Collective bargaining’, ‘income & payroll taxes’ as well as the regulation variables are scaled to range from zero to one, with higher values indicating a higher degree of centralization in collective bargaining, higher top marginal income and payroll tax rates, and stricter regulation, respectively. While ‘minimum wage’ is in decimal fraction of the mean wage, ‘unemployment benefits’ is in decimal fraction of previous wage earnings. Sources: ‘credit market regulation’, ‘labour market regulation’, ‘collective bargaining’ and ‘income & payroll taxes’ – Gwartney and Lawson (2009; gaps filled by linear interpolation); ‘minimum wage’, ‘employment protection legislation’ and ‘unemployment benefits’ – constructed by the author of this paper using Aleksynska and Schindler's (2011) data; ‘financial sector regulation’ – Abiad et al. (2008); regulation of product markets, international trade and capital account transactions – constructed by the author of this article using Ostry et al. (2009) data. ‘GDP growth rate’, ‘real interest rate’ and ‘inflation rate’ are in decimal fraction. ‘Openness’ is the ratio of exports and imports to GDP. ‘GDP per capita’ is in tens of thousands of constant dollars, converted at PPP rates. ‘FDI net inflows’ and ‘FDI net outflows’ are in decimal fraction of GDP. The last seven variables mentioned are from World Bank (2011). Using data from this source, we constructed ‘output gap’, ‘terms of trade shocks’ and ‘real effective exchange rate shocks’ as actual series as a decimal fraction of smoothed series. ‘War’ is a dummy variable that takes the value one if, in the respective year, there was an interstate or internal war on the country's territory; constructed using data from the Centre for the Study of Civil Wars (2009). ‘Systemic banking crises’ is also a dummy variable (Laeven and Valencia, 2008). The data for the unemployment rate (%) are based on labour force surveys and are harmonized to a large extent (ILO, 2010).