Political constraints in the aftermath of financial crises

Francesco Trebbi, Atif Mian, Amir Sufi, 21 February 2012



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.

Economic polarisation

Let us start with some stylised facts. One thing that happens with some regularity, but seems not to have been systematically documented, is an association of financial crises with economic polarisation.

  • The World Bank (1999) reports increases in income inequality in 15 out of 20 crisis episodes of Latin American countries.
  • Klein and Shabbir (2007) report a 4% increase in Gini from 1996 to 1998 in the wake of the 1997 Asian Crisis.
  • South Korea experienced a 5% increase in income inequality over the same period.

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 Federal Reserve US flow of funds data in Figure 1. One can notice 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.

Figure 1. Real estate and financial asset values over time

Individual impacts and policy reform attitudes

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. Wars of attrition preventing useful policy intervention are not new to the economic literature (Alesian and Drazen 1991, Drazen and Grilli 1993 or, for empirical evidence, Alesina et al. 2006) or to anybody having witnessed the behaviour of the US Congress legislating on the public debt ceiling. Their detrimental effects are also well understood.

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.

Figure 2. Voter ideology around banking crises

Notes: All 70 Reinhart and Rogoff (2011) countries. All Crises 1975-2010. Pre-Crisis Sample: 5 years before first year of crisis. Post-Crisis Sample: 5 years after last year of crisis. Self Positioning in Political Scale, World Values Survey 1981-2008 Official Aggregate (e033, 2009).

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.

Figure 3. Support for the government around crises

Notes: All 70 Reinhart and Rogoff (2011) Countries. All Crises 1975-2010. Pre-Crisis Sample: 5 years before first year of crisis. Post-Crisis Sample: 5 years after last year of crisis. Government share from Database of Political Institutions (World Bank, 2010).

It is sufficient to turn to political-science research to understand what all this implies. McCarthy et al. (2006) have carefully documented relationships between inequality and political polarisation trends in the US, as well as between polarisation and legislative stalemate. Political gridlock and lack of reform are natural outcomes of polarisation. Gridlock delays reform and possibly makes recovery slower (explaining the long recessions and sluggish recoveries). The failure of the US Congressional Supercommittee on deficit reduction is the norm, not the exception. 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 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.


Alesina, A. and A. Drazen (1991), “Why Are Stabilizations Delayed?” American Economic Review, 81: 1170-88

Alesina, A., S. Ardagna, and F. Trebbi (2006), “Who Adjusts and When? On the Political Economy of Reforms,” IMF Staff Papers, 53, 1-29.

Drazen, A. and V. Grilli (1993), “The benefits of crisis for economic reform,” American Economic Review 83(3), 598—607.

Drazen, A. and W. Easterly (2001), “Do Crises Induce Reform? Simple Empirical Tests of Conventional Wisdom,” Economics and Politics, 13:2, 129-158.

Johnson, S. and J. Kwak (2010), 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Pantheon Books NY.

Klein Lawrence R., Tayyeb Shabbir (2007), Recent Financial Crises: Analysis, Challenges and Implications. Edward Elgar Publishing Inc. MA.

McCarty N., K. T. Poole, and H. Rosenthal (2006), Polarized America: The Dance of Political Ideology and Unequal Riches, MIT Press.

Mian, A. R., A. Sufi, and F. Trebbi (2012), " Resolving Debt Overhang: Political Constraints in the Aftermath of Financial Crises” NBER Working Paper 16334.

Olson, M. (1965), The Logic of Collective Action. Harvard University Press.

Reinhart, C. M. and V. Reinhart (2010),"After the Fall", NBER WP 17831.

Reinhart, C. M. and K. Rogoff (2009), "The Aftermath of Financial Crises" American Economic Review P&P, 99, 466-472.

Reinhart, C. M. and K. Rogoff (2011), "From Financial Crash to Debt Crisis" American Economic Review, 101, 1676-1706

World Bank (1999), Global Economic Prospects and the Developing Countries 1998/1999. Washington DC: World Bank.


Topics: Politics and economics
Tags: crises, inequalities, reforms

Associate Professor of Economics, Finance, and Real Estate, UC-Berkeley

Associate Professor of Finance, University of Chicago Booth School of Business

Associate Professor of Economics, University of British Columbia

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