The current financial crisis in the United States raises a fundamental question: are these crises good or bad for long term growth? Some economists believe that crises have negative consequences for long run growth because of increased volatility and wealth destruction. Others believe that crises are opportunities to learn, reform and improve economic and political institutions. This view tends to see crises as a natural and potentially desirable phenomenon in the process of development, which allows important reforms to take place.
Our view is that economic crises do not occur in an institutional vacuum. Crises are, in essence, periods in time when important decisions are made. Whether these will be instrumental for long-term growth or not depends on the type of political institutions prevailing at the time of a crisis, and on the kind of political compromises that this institutional set-up delivers. In particular, irrespective of the causes that lead to a crisis (i.e., bad policy, or bad luck), policy responses will be shaped by the incentives and constraints faced by the key political actors during the time of crisis.
What type of political institutions help most during crises is controversial. Democracy, for example, could help by ensuring that checks-and-balances exist on arbitrary decisions that might impose unduly costs on some sectors for the benefit of small interest groups. On the other hand, more democracy and public debate could mean that governments are unable to make quick decisions needed to mitigate the duration and negative impact of the crisis. Consider, for example, how long it has taken for President Obama to negotiate with the US Congress his proposed fiscal stimulus plan. This political tinkering, some could argue, might end up prolonging the painful consequences of the crisis.
In a recent paper we explore this issue heads-on. Using data from a panel of 80 countries in the past three decades, we explore how various political institutions affect the impact of financial crises on long-term growth. Our results provide evidence that stronger democratic institutions can greatly mitigate the negative effects of crises on long-term growth, while autocratic governments typically amplify the negative outcome of crisis. Results appear closely linked to how decisions are made during times of crises, as evidenced by the fact that higher levels of government constraints (that limit discretionary policy decisions typically linked to vested short-term interests) have a strong positive impact on growth through their interaction with crises. In addition, we find that a more regulated political participation process, which provides a more structured political discussion during times of crisis, has similar beneficial effects.
Our results suggests that, if history is of any guidance, there are good chances that the current financial crisis in the United States might end up being looked back years from now as a positive event: a period in time when important reforms were implemented that improved the workings of the financial system and, as a result, boosted long term growth. Of course, this is of little comfort for those who are now suffering the immediate consequences of the crisis, but it is still a signal for hope that a brighter future lies ahead. The institutional environment in the United States, one of the strongest democracies in the world, increases the chances for a positive result. As the crisis spills into other countries where the democratic tradition is not so well engrained, the outcome is more uncertain. In these cases, more likely than not, special interest groups will tend to co-opt policy responses and the crisis will end up reducing the chances for sustainable long run growth.