How Does Culture Shape Financial Policies? A Macro-Level Analysis Using Instrumental Variables

How does culture affect countries’ decisions to liberalize their financial sector? Although culture is receiving increasing attention from political economists, it is still largely absent in the financial liberalization literature. This study seeks to fill this gap by providing a novel theory of the cultural factors that shape policies of financial openness. I argue that cultural distance between countries and cultural homogeneity within countries can explain policymakers’ decisions regarding financial liberalization. Methodologically, this study offers innovative identification strategies for estimating the causal effect using genetic and pathogen factors as instrumental variables. Using dyadic and monadic panel data of 181 countries from 1970 to 2018, the analysis shows that culturally homogeneous countries tend to impose more capital controls and that culturally distant countries are less likely to integrate financially with each other. The mechanism behind this relationship is trust. In-group favoritism, which is reflected in a higher degree of trust among in-group members and a lower degree in out-group members, is greater in culturally homogeneous countries. Homogeneous societies are composed of strong close-knit networks that cultivate solidarity and trust among the society’s members through norms and values of cooperation and reciprocity. While any deviation from these norms would cost the member social sanctioning. In heterogeneous countries, kinship may be less critical for trust, as individuals encounter out-group members on a daily basis, and cooperating with them does not cause a severe social sanction. It follows that as the cultural distance between in-group and out-group members increases, the level of trust decreases. Hence, the less likely they are to integrate financially. The logic is that individuals and policymakers alike would prefer to conduct business with others who share their cultural traits since the financial market is highly trust-intensive (people exchange money for promises). These findings have implications for the debate over the heterogeneous pattern of financial reforms across countries and regions, which became the focus of attention of scholars after the negative effect of the 2008 global financial crisis and the current COVID-19 pandemic. Additionally, this study helps understand the obstacles policymakers might encounter when adopting a financial liberalization policy in general, particularly those facing the internationalization of the Chinese currency. Since financial liberalization is essential to currency internationalization, culture provides an adequate explanation for the ongoing Chinese reluctance to free its capital account. Lastly, the proposed research argues that in-group favoritism also occurs in financial decision-making involving interactions with foreigners and that discrimination based on group identity can negatively impact both sides. Hence, understanding the roots of (un)cooperation is primarily significant.