The Case for Optimism amid the Crisis

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.

7 Responses to "The Case for Optimism amid the Crisis"

  1. sage   February 20, 2009 at 4:54 pm

    you spanish speaking guys must be extremely naive to believe that special interest groups in the US are not actively co-opting US govt. policy options. i wonder who is funding your commentary…..

    • Anonymous   February 21, 2009 at 11:24 am

      I think you got it wrong. what they are saying is that in the end those groups wont be as successful as in autoritarian developing countries.

    • Guest   February 22, 2009 at 11:29 pm

      I think Sage needs to go back to the basics and re-read Federalist paper #10, Madison’s argument about how competing factions under a democratic system will prevent any one faction from having too much influence on some policy decision.

  2. Eduardo Cavallo   February 21, 2009 at 4:23 pm

    Sage: you did not get the point. Of course there are interest groups that try to co-opt policy responses everywhere. But what the empirical work suggests, is that they are more likely to succeed in countries where the check-and-balances of democracy are not present.

  3. Anonymous   February 22, 2009 at 6:18 am

    In the conclusion of your paper you say:”This paper has several important policy mplications. First, if a country’s democratic institutions are strong, it may welcome crises as opportunities to learn and improve the policy stance. On the other hand, if institutions are weak, crises may not beuseful to promote growth-enhancing reforms. More likely than not, special interest might co-opt policy responses and crises will only end up hurting the public at the expense of more powerful interest groups. We view this as an important take-away for theproponents of the moral-hazard view, who argue that countries should “suffer” crises to learn from their mistakes.”Could you expand a little more on what you mean by that last sentence and its implications with regard to financial institutions in the U.S.?

    • Eduardo Cavallo   February 23, 2009 at 9:38 am

      Thanks. The believers in the moral hazard view argue for the non-involvement of the international comunity in crisis resolutions in developing countries under the premise that countries should suffer the consequences of past excesses in order to learn from their mistakes. Our results suggests that this learning process is less likely to take place in countries with no democratic tradition.