Regulatory Cycles: Revisiting The Political Economy Of Financial Crises
Jihad C. Dagher
International Monetary Fund (IMF) – Research Department
April 1, 2016
Financial crises are usually perceived and analyzed as purely economic phenomena. The political economy of financial booms and busts, while far from ignored, remains under-emphasized and has often been analyzed in isolated episodes. The recent wave of financial crises has brought unprecedented attention to financial regulatory policy; yet the policy discussions and economic literature, which are usually cast in technical terms, tend to overlook political forces that shape regulations and impact their effectiveness over time. This paper examines the political economy of financial policy during some of the most infamous financial booms and busts and finds consistent evidence of pro-cyclical policies. Financial booms, and risk-taking during these episodes, were often amplified, if not ignited, by a political regulatory stimulus and interventions. The bust has always resulted in an overhaul of the regulatory and supervisory framework and a political turnover. The interplay between politics and financial policy over these cycles, and their institutional underpinnings, deserve further attention. Politics can be the undoing of macro-prudential policy.
Regulatory Cycles: Revisiting The Political Economy Of Financial Crises – Introduction
The economic role of the state has managed to hold the attention of scholars for over two centuries without arousing their curiosity. — George Stigler, 1964
The year 1720 marked one of the earliest stock market crashes. It took place in England following the South Sea Bubble, a bubble that is well known to have been in part induced by government policies at the time.1 The end of the bubble has witnessed the passage of a severely restrictive legislation prohibiting the formation of joint-stock companies without explicit approval by the Parliament. This Bubble Act, which lasted for around a century, was repealed under intense lobbying at the height of the next bubble that led to the Financial Crisis of 1825 which, in turn, led to a series of far-reaching reforms and regulations. While the world has since seen tremendous progress on all fronts including in political and economic organization, it is curious that even the most recent financial cycles bear painful resemblance to the earliest documented crises.
This paper takes a look through the rear view mirror at some of the well known financial cycles, from the distant past as well as the most recent, and examines the regulatory stance during the booms and busts relying on a wealth of scholarship on each episode. Episodes of financial boom have generally witnessed an actively complacent policy, of either increasingly laissez-faire, deregulation, a decay of existing regulations (weakening of supervision), and regulatory forbearance. In some important cases the booms were at least partially induced by government policies. Financial crises are consistently followed by an episode of re-regulation. Crises also typically engender significant change in the political landscape, at least in the short run, with the newly elected officials being typically from parties that subscribe less to laissez-faire policies. This is not surprising in view the changes in voters’ perceptions following crises, as I illustrate with an example from opinion polls in the United States. The paper focuses on episodes of financial cycles characterized by either a private credit or stock market boom. It does not deal with sovereign debt crises for many reasons since the paper is not about government’s management of its own finances, but rather its financial policies aimed at the private sector. The paper explores how while governments are in a position to smooth the costly financial cycles historically they have, on average, done the opposite.
It is of course not possible to cover, in one paper, all financial booms and busts. It is possible that some episodes do not fit the stylized patterns discussed in this paper. Never-the-less, the fact that some of the most notorious financial cycles, including the most recent, agree with the above description is in itself an indication of the relevance of the regulatory cycles hypothesis put forth in this paper.
Compared to fiscal or monetary policy, financial regulation is often perceived as an abstruse subject. Regulations have often several dimensions that make them complex to analyze. Policies that could on the surface seem to tighten regulation on the financial sector could in fact be the result of regulatory capture and their consequences can be much different then their advertised goal. Further the drivers of financial regulations are very opaque in nature; this is an issue that has received much attention from a long standing literature in regulation economics trying to disentangle private vs. public interests behind government regulations. For example a government that imposes entry barriers during a boom might be driven not by a public interest, i.e., with an objective to tame a potentially unsustainable boom, but by private interests. These issues, while are very important in nature, are beyond the objective of this paper which aims to understand whether de-facto financial regulations were pro-cyclical (helped fuel the boom and restricted credit during busts) or counter-cyclical. For this, I rely on the extensive scholarship available on government policies during these financial cycles to guide my interpretation of these policies. Understanding why governments have tended to implement pro-cyclical policies in regard to financial sector is an important avenue of research. It is important to stress that the pro-cyclicality of policies are not necessarily a proof of inefficiency ex-ante although the hypothesis that governments are often unaware of the risks associated with booms, in real time, is relatively weak. A long strand of research in political economy suggest that government behavior is.
The patterns presented in the paper are not merely a re-writing of existing history on financial crises. While each financial cycle has received tremendous attention for the literature, and many seminal works have also been written about financial cycles in general with important contributions to our understanding of these episodes, this paper is the first, to the best of my knowledge, that emphasize the consistent pattern of pro-cyclical regulatory policies. This will become clearer as I go over the literature in Section [ ].
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