Institutional Effects As Predictors Of Crisis Risk: Evidence From Former European Colonies Charles Shaw May 5, 2015 Abstract Macroeconomic policies are crucial to providing a stable economic environment. Institutions, such as a justice system and the rule of law are also important, as are other political economy considera- tions. This paper asks whether it is possible to find, by examining a variety of institutional settings and macroeconomic channels, a set of early warning indicators that can flag vulnerability to financial turmoil in former European colonies Applied Statistics & Econometrics essay (year 2). 1 Introduction What role do institutions play in affecting, and perhaps even predicting, financial turmoil? How do legal traditions differ in their economic impact and what are their implications for financial devel- opment? Which institutions matter? Such trite yet crucial questions have been studied extensively and are the driving force of the political economy of institutions. In this paper I look at the role of institutions in predicting economic crises for a broad sample of former European colonies. Conventional wisdom would have it that macroeconomic policies are crucial to providing a stable economic environment. Institutions are also important, as Adam Smith, John Locke and John Stuart Mill observed in great detail. For example, the Wealth of Nations draws particular attention to the importance of judicial efficiency, policy choices, institutional frameworks and other political economy considerations. Modern economic theory also supports the idea that good legal institutions - such as clear and value-promoting rules, investor protection, well-functioning courts - facilitate economic growth. North (1990, p. 3) provides the following broad definition: ”Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction”. Although the role of institutions in any economy, legal or otherwise, is widely acknowledged to be an important determinant of a country’s development prospects, there is seemingly mixed empirical 1