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Tuesday, February 21, 2012

"Political Constraints in the Aftermath of Financial Crises"

Political constraints limit the options for rescuing the financial sector after a meltdown:

Political constraints in the aftermath of financial crises, by Atif Mian, Amir Sufi, and Francesco Trebbi, Vox EU: Financial crises of all colors (banking, currency, inflation, or debt crises) leave deep marks on an economy. ... 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.

Let us start with some stylized facts. One thing that happens with some regularity, but seems not to have been systematically documented, is an association of financial crises with ...  increases in income inequality...

Although the relationship between higher inequality and persistent contractions is not conceptually straightforward, the evidence is consistent with the view of a financial crisis damaging certain constituencies in society more than others.

As an example we can look at ... the disparity of how the value of real estate assets, mostly held by middle- and low-income indebted households, is still far from having recovered to pre-crisis levels, while financial assets, mostly held by the wealthy, have already bounced back. Some may be hit harder than others in a financial crisis, and this is a consequential phenomenon. ...

Individuals differentially affected will probably support different policy responses to the crisis. Agreement on unified reactions to the negative financial shock may become harder to achieve or nonexistent. This may stall potentially beneficial macro-financial reform, which could speed up the recovery. ...

A systematic analysis of ‘politics after the crisis’ fits this logic. ... Voters become more ideologically polarized... Government coalitions become weaker... Opposition coalitions become larger. Party fragmentation increases across the board. ...

As one would expect,... 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. ...

Political gridlock and lack of reform are natural outcomes of polarization. Gridlock delays reform and possibly makes recovery slower (explaining the long recessions and sluggish recoveries). ... Crises are occasionally thought of as critical junctures where macroeconomic reform unlocks by shattering entrenched conditions (Drazen and Easterly 2001). The opposite seems true.

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 organization by its constituency... Is it surprising that concentrated special interests (such as large US banks...) 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 polarization.
  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. ...
  3. In the same way that financial crises appear to polarize constituencies at the national level, it is not hard to envision polarization at the international level playing an important role. ...

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. ...

We didn't have until after the fact to learn this lesson. At the time, many of us were urging the administration to consider the distributional consequences of the financial bailout -- who was helped and who wasn't -- and to adjust policy accordingly (e.g. the banks could have been saved without rewarding financial executives who had a hand in creating the problems). But the administration was afraid that if it took the steps required to do this, i.e. if it nationalized the banks temporarily, removed the management, put the good assets in one pile, the junk in another, and then sold the good assets back to the private sector, Republicans would have been upset. They might have called the administration socialists, criticized the bailout, something like that, you know --like they did anyway.

The administration argues it had little choice about how to conduct the bailout due to legal restrictions that prevented it from taking over shadow banks in the same way it could traditional banks, and there was an urgent need of an intervention of some sort. Nevertheless, there were other options it could have pursued even within the structure the administration adopted, e.g. more aggressive clawback on profits resulting from the bailout through warrants and other means. In any case, I just wish more had been done for the households that were struggling every bit as much as the banks. A lot more.

    Posted by on Tuesday, February 21, 2012 at 01:22 AM in Economics, Financial System, Monetary Policy | Permalink  Comments (26)

          


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