Preliminary

Financial market imperfections can prevent entrepreneurs from fully diversifying id-iosyncratic business risk. Because of this idiosyncratic risk discourages entrepreneurial activity and hinders growth. The effect is stronger the lower the risk diversification opportunities in the economy. We use various measures of diversification opportunities (such as the relevance of family firms or of widely held companies) and show that OECD countries with low levels of diversification perform relatively worse (in terms of produc-tivity, investment, and business creation) in sectors characterized by high idiosyncratic volatility. Given that volatility is endogenous with respect to risk diversification op-portunities, we instrument volatility at the country-sector level with the corresponding sectoral volatility in the US, a country where financial imperfections are less relevant than elsewhere. Diversification measures are instrumented using demographic changes induced by World War II. We also provide firm-level evidence suggesting that firms controlled by less diversified owners display lower mean and dispersion of productivity growth. The results can shed some light on the diverging productivity performance experienced by the US and Europe over the recent past. ∗Both authors are affiliated to CEPR. We would like to thank Luigi Guiso, Thomas Philippon, Mario Padula and seminar participants at the University of Naples, Sassari, Cagliari, Venice and at the EIEF for helpful comments. We would also like to thank Diana Nicoletti for helping us with Thomson Datastream