Financial deepening and innovation: The role of political institutions

This study investigates the effects of financial deepening on innovation for various democratic levels of political institutions using panel data from 74 countries spanning 1970-2010. Our results show that banking market deepening is associated with increased innovation only when political institutions are sufficiently democratic. In contrast, the enhancing effect of stock market deepening on innovation requires a lower level of political democracy. Further, we find that increasing the state's openness and competitiveness in the executive recruitment of leaders is the main channel through which political democratization promotes the role of banking and stock markets for financing innovation. Our results are robust to the use of the instrumental variable approach; alternative measures for financial deepening, democracy and innovation input; long-differenced variables; and alternative specifications.