IMF working paper No. 18/8
15 January 2018
Source: International Monetary Fund
Jihad Dagher, International Monetary Fund
Financial crises are traditionally analyzed as purely economic phenomena. The political economy of financial booms and busts remains both under-emphasized and limited to isolated episodes. This paper examines the political economy of financial policy during ten of the most infamous financial booms and busts since the 18th century, and presents consistent evidence of pro-cyclical regulatory policies by governments. Financial booms, and risk-taking during these episodes, were often amplified by political regulatory stimuli, credit subsidies, and an increasing light-touch approach to financial supervision. The regulatory backlash that ensues from financial crises can only be understood in the context of the deep political ramifications of these crises. Post-crisis regulations do not always survive the following boom. The interplay between politics and financial policy over these cycles deserves further attention. History suggests that politics can be the undoing of macro-prudential regulations.
Financial crises are a recurring phenomena in market economies. An impressive body of economic research has been devoted to understanding these crises in the aim of making economies less prone to these enormously costly episodes. This literature saw a revival following the Global Financial Crisis. While there are various explanations to the roots of the crisis, the idea that more stringent financial regulation and supervision could have averted, or at least helped dampen the boom-bust cycle, is well accepted and shared among most economists and policy-makers. This explains the massive regulatory backlash from these crises.
This paper reviews some of the most infamous financial crisis in history and brings several patterns that are rarely discussed in the literature, at least not in a historical and crosssectional approach. It shows that in most cases regulation has been pro-cyclical, effectively weakening during the boom and strengthening during the bust. Regulators do not operate in a vacuum, and this paper shows how, in most cases, political interventions have helped fuel the boom in similar ways across time and countries. The political repercussions of crises, partly due to changes in the public’s perception about the role of the government, are usually very significant. They help explain the reversal of policies and the regulatory backlash.
The interplay between politics and financial policy, described in this paper, has not received sufficient attention. The focus of the literature, which has been mostly cast in technical terms, is to find the optimal level of regulation that regulators should be enforcing. Will new regulations and their enforcement survive the test of time? History offers a relatively pessimistic answer to this question. It offers plenty of examples where regulatory failures can be attributed to political failures. Strengthened regulations and supervision are, in essence, tools given to regulators to use as long as the political climate allows them to. To what extent can regulators be insulated from changes in politicians’ (and voters’) philosophy toward regulation? What changes need to be made at the institutional level? This is an important question left for future research. Acknowledging the fact that politics can be the undoing of macro-prudential policy would be a step in the right direction.