The Political Economy of Dominant Investors

We allow the preference of a political majority to determine both the corporate governance structure and the division of profits between human and financial capital. In a democratic society where financial wealth is concentrated, a political majority may prefer to restrain governance by dispersed equity investors even if this reduces profits. The reason is that labor claims are exposed to undiversifiable risk, so voters with small financial stakes may prefer lender (or large share- holder) dominance, as they choose lower risk strategies. The model may explain the "great reversal" phenomenon in the first half of the 20th century (Rajan and Zingales, 2003), when some financially very developed countries moved towards bank or state control as a finan- cially weakened middle class became concerned about income risk. We offer evidence using post WW1 inflationary shocks as the source of identifying exogenous variation.