Partisan Financial Cycles

Abstract

Financial cycles of boom and bust are as old as finance itself – a fact that has led some observers to infer that human nature may be a fundamental cause of financial cycles. But “politics” also influences financial cycles by way of government policies and regulations. I argue that policies and regulations vary predictably with the partisan character of the government, creating a partisan-policy financial cycle in which conservative, pro-market governments preside over financial booms while left-wing governments are elected to office after crashes. My sample consists of all bank-centered financial crises to hit advanced countries since World War II, including the current “Subprime” crises – a total of 27 cases. I find that governments in power prior to major financial crises are more likely than the average OECD country to be right-of-center in political orientation. I also find that these governments are more likely than the OECD average to be associated with policies that predict crises: large fiscal and current account deficits, heavy borrowing from abroad, and lax bank regulation. However, once a major financial crisis occurs, the causal arrow flips and government partisanship becomes a consequence of crises. I find that the electorate moves to the left after a major financial crisis, and this leftward shift is associated with changes in government partisanship in that direction.