Regulatory Cycles: Revisiting the Political Economy of Financial Crises

Abstract

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 mostly 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. The narrative usually revolves around the fact that financial innovations are ahead of regulators. 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 by governments. Financial booms, and risk-taking during these episodes, were often amplified, if not ignited, by political regulatory stimuli 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. History suggests that politics can be the undoing of macro-prudential regulations.