Constitutions and Commitment: Evidence on the Relation Between Institutions and the Cost of Capital

This Paper challenges the North and Weingast (1989) view that institutional reforms and better protection of property rights lead to economic growth through a reduction in interest rates, and that a mechanism of this type accounted for Britain’s ascendancy to economic supremacy. We show that, in contrast with North and Weingast, the risk premium on British sovereign debt remained high and even increased in the decades following the Glorious Revolution, and that during much of the 18th century interest rates in Britain fluctuated considerably in response to wars and political instability. We also show that debt per capita – a measure of financial deepening – remained lower in Britain than in Holland for over a century after the institutional changes described by North and Weingast. Finally, we show that British interest rates moved in tandem with interest rates in Holland, suggesting that Britain did not embark on a different path following the institutional changes of the late 17th century. We conclude that, in the short run, institutional reforms do not lead to higher growth by lowering the cost of capital.