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On the Politics of Financial Meltdowns
The Globalist
Editor’s Note: Recent economic events in the
United States have provided a not-so-subtle reminder that a financial
crisis is first and foremost a political phenomenon. Raj M. Desai
explores what the United States can learn from the political economy of
the financial crises that have roiled emerging markets.
United States have provided a not-so-subtle reminder that a financial
crisis is first and foremost a political phenomenon. Raj M. Desai
explores what the United States can learn from the political economy of
the financial crises that have roiled emerging markets.
Throughout the 1990s, instability and electioneering infused the
financial turmoil in emerging markets around the world. When Mexico
suffered a peso collapse in late 1994, the country had recently been
through assassinations, a dirty election and an armed guerilla movement
in Chiapas. During the Asian financial crises after 1997, massive
protests against IMF-led adjustment programs took place in Korea,
Indonesia and Thailand. Meanwhile, Malaysia’s Prime Minister Mahathir
railed against George Soros, famously calling speculative attacks
against Asian currencies “akin to terrorism.†The Russian financial
crisis in 1998 evaporated domestic support for Yeltsin, who thereafter
had to contend with an emboldened opposition in parliament, and a
Communist party-led general strike. In Brazil following the devaluation
of the real, a truck drivers’ strike paralyzed major highways while
ranchers, farmers, labor unions, landless peasants and leftists
descended on Brasilia to demand relief. And in Argentina at the end of
2001, a series of violent clashes between demonstrators and police
forced President De La Rúa to flee the capital.
A new IMF study examines 124 episodes of “systemic banking
distress†(defined as situations where all bank capital is wiped out)
in 102 countries. Using these data, along with available information on
governmental characteristics of these countries, there are some lessons
from the experiences of those countries.
First, crises don’t always lead to governmental collapse — but changes in government keep recovery costs down.
Several of the financial crisis episodes in the 1990s prompted
changes in government — and in a few cases, regime collapse. Korea,
Argentina and Brazil, as well as the Czech Republic, Poland and Turkey
(among other countries), all saw incumbents thrown out in elections
following currency problems. In non-democratic states such as Mexico
and Indonesia, incumbents began to lose their grip on power. Between
1994 and 2000, a series of opposition-party governors were elected in
several Mexican states, eventually paving the way for Vincente Fox’s
election and the end of 80 years of single-party rule. In Indonesia,
amid riots sparked by rising prices for rice and kerosene, Suharto’s
30-year regime came to an end in 1998. But political change is not the
norm: The data show that in less than one-third of the counted episodes
did governments change hands within three years following the onset of
the crisis.
However, countries where governments changed ended up better
off. The concentration of economic power usually means that investing
in influence to obtain privileged treatment is regarded as any normal
economic activity. In many of these crisis countries, it was common
knowledge that paying off public officials to obtain benefits —
favorable legislation, judicial rulings, regulatory forbearance — was
sometimes as lucrative as profit maximizing. But it was also,
naturally, a recipe for widespread moral hazard. Whether for grupos in
Latin America, chaebol in Korea or financial-industrial groups in
Russia, large portions of business were acquired through the
cultivation of close ties with governments. Consequently, shifting
political winds mean that those who lose power can no longer deliver
benefits to certain favored private business and financial interests.
Those groups, then, are less likely to avoid shouldering the costs of
crisis resolution.
The second lesson is that re-establishing credibility can be just as hard as re-establishing solvency.
In addition to political instability, financial collapse also
breeds policy uncertainty, something which can be more harmful to
prospects for recovery. Instability and uncertainty are not the same.
The former refers to frequent changes of government, which in extreme
circumstances can certainly harm prospects for recovery. Uncertainty,
on the other hand, can be present even where governments are stable —
and is more likely to be present under conditions of systemic financial
distress. Under financial-crisis conditions, investors, depositors and
entrepreneurs complain that financial reforms promised are broken, that
implemented policies are poorly enforced or reneged upon and are
arbitrarily interpreted — and subject to frequent and unpredictable
changes.
Many market- and country-based risks are always present and
investors will seek commensurate returns, or they will insure
themselves against these risks. These risks may be influenced by
governments but they are not typically under government control. By
contrast, risks created by policy and regulatory instability are fully
under government control and — short of expropriation — are generally
not insurable. Re-establishing credibility in governmental actions —
convincing investors that their commitments will not be eroded — can
require wide-ranging institutional reforms.
The third lesson is that governments will be unable to protect the most vulnerable.
In over two-thirds of the crises, devaluation, capital flight and
austerity measures produced wage and income declines that persisted for
more than three years. Resulting fiscal constraints, of course,
affected those households most reliant on publicly funded social
services. Although IMF lending typically included agreements to
maintain spending levels for certain basic services, these crises were
wrenching events for affected households. Who took a hit? The evidence
varies. In Latin America, crises often squeezed the poorest. In the
Asian cases it was the so-called “striving classes†— the lower-middle
income, upwardly mobile households, who were pushed back into poverty
(at least temporarily).
But governments everywhere, despite their best intentions, are
generally ill-prepared to help the hardest-hit groups, whoever they may
be. There is some evidence from crisis economies in the 1990s that,
post-crisis, tax and expenditure patterns actually became more
regressive, not less.
The fourth lesson is that backlashes do not necessarily mean a
turn to the left, but center-left governments are more likely to limit
economic collapse.
Based on the third lesson, and given that vulnerable groups
outnumber those that escape from harm, one might expect strong
anti-market backlashes to be followed by the resurgence of left-wing
movements. While it is plausible that systemic financial distress laid
the groundwork for leftist strength after several years — Latin
America’s turn to the left in the 2000s being an example — the evidence
for leftward movements in the immediate aftermath of crises is slim. In
only 32 out of 121 cases for which there is information did governments
move to the left inside three years after the crisis started.
Surprisingly, countries that were ruled by leftist parties at
the start of the crisis and/or three years afterwards suffered less of
an output collapse. On average, countries in which the executive was in
the hands of left-wing parties at any time during the crisis suffered
an output collapse of 14%, while for non-left governments' output fell
20%.
An examination of financial recovery in several countries
suggests that labor-supported parties serve as an effective check on
corporate excess. In retrospect, recovery programs that were designed
and implemented without formal support from key labor constituencies
seem to have been prone to political stalemates at later dates, when
the electoral landscape for the party in power may have changed. By
contrast, in countries such as Poland and Korea, labor-friendly
governments managed to obtain considerable support for recovery
programs up front. The pattern suggests that the Chilean crisis in the
1980s is an exception to the rule, as Chilean authorities did not
consult — and indeed excluded — both employers associations and labor
from the financial restructuring program.
The fifth lesson is that centralized asset-recovery regimes have
a poor record. It should be noted that government purchases of bad
assets was rare — used only in Mexico, Japan, Bolivia, Czech Republic,
Jamaica, Malaysia and Paraguay. Output declines and the gross fiscal
cost were approximately twice as large in these countries compared to
countries that did not opt for a centralized approach to recovery. Why
such a dismal record?
First, by removing bad assets from banks, centralized
asset-management units (AMUs) do not force institutional “learningâ€
where it is needed most — namely, in the core lending practices of
financial institutions. In the Czech Republic, for example, banks
continued to make bad loans long after most of their bad debt burdens
were removed and placed in a “hospital†bank. Second, AMUs are prone to
bureaucratic misuse and corruption and rarely die when their missions
have been completed. AMUs, once created, tend to perpetuate themselves,
usually through a coalition of bankers and bureaucrats who support
their continuation. Third, AMUs, as all state-owned agencies, are
susceptible to external political pressures, as well as
intra-governmental disputes and turf wars that limit their effectiveness.