Politics matters even after the crisis

Given how important the role of politics is emerging in this crisis, we might again see economics depts being renamed as department of political economy (this blog also hopes this happens).

Some economists have criticised how governments have led to the crisis (John Taylor), others  have argued how  governments have been too meek to resolve the crisis (Paul Krugman) and some more have argued how lesser government is way out of the crisis (Alberto Alesina).

Atif MianAmir Sufi &  Francesco Trebbi add another dimension to the issue of crisis and govt. In this paper they say political ideology changes post a crisis which leads governments to make policies which may not be as desired. Voxeu has a summary:

Financial crises of all colours (banking, currency, inflation, or debt crises) leave deep marks on an economy. Deep economic contractions, both in output and employment, are systematic in the interim and in the aftermath of financial crises, as thoroughly documented in research by Reinhart and Rogoff (2009) and Reinhart and Reinhart (2010).

Sustained waves of volatility, often resulting in secondary crises (e.g. debt crises following banking crashes), are almost the norm in the post-crisis period (Reinhart and Rogoff 2011). What exactly occurs in the aftermath of financial crises that makes recovering from such shocks so hard? This column argues that the answer may lie mostly with the politics, not the economics.

They say inequality rises in most crisis and this reflects the shift in political ideology.

A systematic analysis of ‘politics after the crisis’ fits this logic. In Mian et al. (2012) we show that not only economic, but political polarisation systematically increases around financial crises in a large sample of countries. Voters become more ideologically polarised in the aftermath of banking, debt, or inflation crises. Government coalitions become weaker in terms of both vote shares and seat shares. Opposition coalitions become larger. Party fragmentation increases across the board. Just as illustration, consider Figure 2, which traces an ideal distribution of voters’ ideological positions before and after banking crises, as averaged in the Reinhart and Rogoff (2011) sample of countries.

As one would expect, the population is mostly comprised of moderates, with fewer left-wing and right-wing extremists. However, after the crisis hits, the moderate middle sinks and the extremes rise. This is reminiscent of the rise of the Tea Party on the right and of Occupy Wall Street on the left in the post-Great Recession US. In Figure 3, you can further follow the support for the government coalition tanking after the crisis. Notice that we are not necessarily talking about the same government who led the country into the financial crisis. This is any government in charge in the aftermath of the crisis.

Amazing to see both the figures. So all this political girdlock should be expected. It has several negative implications:

The list of potential negative implication does not stop here though.

  1. Gridlock brings selective intervention. In the aftermath of a financial crisis, any type of reform, including bailouts, faces a higher bar for passage. Unfortunately, if a reform overcomes political gridlock, it may well be not because of efficiency or merit, but because of strong political organisation by its constituency (Olson 1965). Is it surprising that concentrated special interests (such as large US banks, see Johnson and Kwak 2010) got a sizeable bailout through TARP, while diffused special interests (such as mortgage debtors) did not? This selective intervention may then feed back into further increasing economic and political polarisation.
  2. Gridlock brings political uncertainty. Markets for sovereign debt do not seem particularly appreciative of governments engaging in stalemate or political bickering at the time a country needs decisive intervention the most. Recent credit rating downgrades of US or European debt fit this interpretation. Debt crises following other financial crises may be a natural outcome of the post-crisis political constraints.
  3. In the same way that financial crises appear to polarise constituencies at the national level, it is not hard to envision polarisation at the international level playing an important role. The EU is experiencing the painful drifting apart of creditor countries, like Germany, and debtor countries, like Greece and Italy.

In conclusion, to those of us interested in efficient policy response in the aftermath of financial crises, understanding the logic of political constraints may be useful. The chances are that a country will not achieve reform precisely when it needs it the most. Any model of post-crisis macro intervention that leaves this political feature aside forgoes an important dimension.

 Really well summarised…How much econs  live in an ideal world…Well reality is far more complex.

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