Financial crises and dynamics of financial liberalization

Financial crises play a key role in changing existing policies regarding markets and financial institutions. Orkun Saka, Nauro Campos, Paul De Grauwe, Yuemei Ji and Angelo Martelli provide further evidence of the negative impact of financial crises on the process of financial liberalisation. They also show that these interventions are only temporary and that the process of liberalization restarts quickly after a financial crisis. These results support the idea that governments use short-term policy reversals as a tool to ease the pressures of the crisis.

Great economic and political turmoil occurs as a result of financial crises. What begins as a panic in a single market or financial institution usually quickly spreads to other agents in the economy and may require an urgent and decisive response from policymakers. However, it is difficult to predict, a priori, whether the reaction of political decision-makers to the crisis will be in the direction of greater liberalisation.

On the one hand, as financial institutions and markets become dysfunctional in the midst of a crisis, governments may feel the need to intervene, for example by bailing out failing banks or stepping up efforts to better regulate institutions. who behave badly. This could be politically inevitable especially when the cause of the crisis is widely seen as the result of “unregulated capitalism” and public opinion turns against the financial sector as well as the bankers at its helm.

On the other hand, such periods of instability can serve as a catalyst to advance liberalization programs that may have been stalled due to private interests or lack of political enthusiasm. In this case, financial crises could open a window of opportunity to make sweeping changes to the political space. This point of view agrees with the more general one crises-beget-reforms hypothesis.

In one recent articlewe investigate how financial reforms evolve in the aftermath of financial crises by carefully merging the classical dataset on financial liberalizations by Abiad et al. with the more recent but narrow dataset of Denk and Gomes and the recently updated IMF dataset on financial crises. This provides us with one of the most comprehensive sets of observations that have been used on the crisis-reform nexus covering 94 countries over the period between 1973 and 2015. The dataset includes 7 main areas of financial reform, of which 5 indices directly related to domestic politics. banking sector (credit control, interest rate control, entry barriers, privatization and supervision), an index on restrictions on international capital movements and an index on asset markets (securities market regulation ).

Using a quasi-difference-in-differences approach, we first find that the immediate impact of financial crises is to lead to liberalisation. This result is generally valid for all areas of reform and all types of crisis (banking, currency or sovereign debt crises, in ascending order of magnitude of effect). It seems that, at least in the specific context of “financial” crises and “financial” reforms, periods of turmoil do not stimulate liberalization efforts; on the contrary, they end up reversing some of the earlier liberal policies. This contrasts with the predictions of earlier literature on the political economy of reform.

Instead, our results align with the idea that governments can view crises as market failures and respond by increasing their interventions in the hope of an urgent market correction. Therefore, governments are likely to use reform reversals as a form of self-help. This could be especially true for bank bailouts (privatization reversals) as there has been a growing demand since the 1970s for the protection of middle class wealth during financial crises. As argued Chwieroth and Walter, it can even lead to the punishment of incumbent politicians if they do not provide such protection. If this view is true, government interventions should be temporary and therefore phase out in the medium term as the crisis subsides.

An alternative argument to explain our findings on reform reversals could be that politics is collapsing and governments are fracturing in the wake of financial crises, with more actors with veto power coming into play and affecting the government’s reform agenda. In this case, one would expect reversals to be persistent over time and crises to have a longer-term negative effect on the liberalization process. In order to study this hypothesis, we use local projections at the Jordan and plot the impulse-response function of a continuous measure of banking crises on the average level of financial liberalization.

Figure 1: The effects of a banking crisis on the average level of financial liberalization

To note: The figure shows the impulse responses estimated via the local projections (PL) method (see Equation 2 in our article) using average financial reform as the endogenous variable and banking crises as the exogenous shock with four lags included as controls on the right . -main side for each variable. The shaded area represents the 90% confidence intervals. Source: Saka et al. (2019)

Figure 1 illustrates the time horizon of the relationship between financial crises and reversals clearly showing us that the effects are concentrated in the very short term. After the simultaneous fall in the levels of liberalization, there is no further divergence between crisis and non-crisis countries in the following years. In fact, after 3 years – ie approximately the average duration of a banking crisis in our sample – the countries which have experienced a crisis are beginning to catch up with those which have not. Overall, over a period of 5 to 6 years, there is practically no effect of the banking crisis on the average levels of liberalisation. Some countries may even end up being more liberalized than their counterparts a decade after experiencing a banking crisis.

These results are more in line with the argument that governments respond to crises by using short-term policy reversals to intervene and correct market failures. Such urgent political reactions could be in high demand, especially with the middle class voters and thus explain our finding that the negative effect is almost entirely due to the contemporaneous relationship in Chart 1. As soon as the pressures of the crisis ease, countries resume their liberalization path and catch up with others.

These results also have important implications for the general literature on the crisis-reform nexus. As documented previously, many studies on the determinants of the political economy of reform produce contradictory and inconsistent results that make it difficult to reach a consensus. Our findings imply that not only the contemporaneous relationship, but also the persistence of effects, might be important in this discussion and might reconcile some of the contrasting results from the literature that examines the effects of crises on reforms at different horizons.

Finally, our results support case study evidence reported in dagher arguing that financial regulation is inherently procyclical – being more lenient during booms and stricter during recessions – and that crises can act as turning points. Whether such regulatory cycles occur because of changing public sentiments and how they interact with the lobbying power of the financial industry and the electoral incentives of incumbent politicians are fruitful avenues for future research.

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Note: This article gives the point of view of the authors, and not the position of EUROPP – European Politics and Policy or the London School of Economics. Featured image credit: Marco Nuernberger (DC BY 2.0)


About the authors

Orkun Saka – University of Sussex/LSE
Orkun Saka is an assistant professor of finance at the University of Sussex and a research associate at the Systemic Risk Center and the European Institute at the London School of Economics and Political Science (LSE). His main research interests focus on financial intermediation, international finance and political economy. He tweets @orknsk.

Nauro Campos – Brunel University London
Nauro Campos is Professor of Economics and Finance at Brunel University London, a post he has held since 2005. He is also a researcher at IZA-Bonn and a research professor at ETH-Zürich. His main fields of interest are political economy and European integration.

Paul de Grauwe – LSE
Paul De Grauwe is Professor and John Paulson Chair in European Political Economy at the London School of Economics and Political Science (LSE). His research interests are international monetary relations, monetary integration, theory and empirical analysis of foreign exchange markets, and open economy macroeconomics.

Yuemei Ji – University College London
Yuemei Ji is a Lecturer in Economics at University College London (UCL). His interests cover three aspects. 1. International macroeconomics in general and European monetary union in the post-crisis period in particular. 2. Behavioral macroeconomics. 3. The Chinese economy, in particular its financial development and public and private debt problems.

Angelo Martelli – LSE
Angelo Martelli will soon be Assistant Professor of European and International Political Economy at the London School of Economics and Political Science (LSE). His research interests cover labor economics and European political economy.