Elections, Special Interests, and Financial Crisis

A large literature concludes that democracy has ambiguous effects on public policy and that political checks and balances exacerbate crisis. The analysis in this article finds that although democracies are no less likely to experience banking crises, in the event of financial crisis, competitively elected governments intervene more rapidly in insolvent banks and make transfers to them that are between 10 and 20 percent of gross domestic product less than those made by nondemocratic governments. Their countries suffer far smaller growth collapses. However, political checks and balances have no effect on government responses to financial crisis. A simple model offers new explanations for these regime effects. First, for those public policies for which voter information and political credibility are particularly likely to be problematic (financial regulation), electoral accountability matters only when the consequences of failure become large and visible (financial crisis). Second, checks and balances reduce political incentives to seek rents, offsetting the delays they induce in crisis response. The analysis in this article underlines the importance of considering regime effects on political incentives to cater to special interests at the expense of broad social interests, and of avoiding aggregated and subjective measures of democracy that can obscure the identification of regime effects.This article benefited from the generous comments of George Clarke, Robert Cull, and Patrick Honohan, and from those of participants at the 6th International Conference on Finance and Development, Moscow 2005; and in seminars at the University of California, Los Angeles, Universität Basel, and the Inter-American Development Bank.