Recent events in Europe provide ample evidence that the political aftershocks of financial crises can be severe. This column uses a new dataset that covers elections and crises in 20 advanced economies going back to 1870 to systematically study the political aftermath of financial crises. Far-right parties are the biggest beneficiaries of financial crises, while the fractionalisation of parliaments complicates post-crisis governance. These effects are not observed following normal recessions or severe non-financial macroeconomic shocks.
.. Our first main finding is that politics takes a hard right turn following financial crises. On average, far-right votes increase by about a third in the five years following systemic banking distress, as shown in Figure 1. This pattern is visible in the data both before and after WWII and is robust when controlling for economic conditions and different voting systems. The gains of extreme right-wing parties were particularly pronounced after the global crises of the 1920s/1930s and after 2008.
.. The second key finding is that governing becomes more difficult after financial crises. Government majorities shrink and parliaments tend to fragment, confirming the findings of Mian et al (2012).
.. Parliaments become more fractionalised and the number of parties rises (lower panel). All this is bad news for effective governance in the post-crisis period – at a time when decisive political action may be most needed.
.. How persistent are these effects? We find that the first five years are critical and most effects slowly taper out afterwards. A decade after the crisis hits, most political outcome variables are no longer significantly different from the historical mean.
.. This raises the question – why are financial crises different? One explanation is that financial crises may be perceived as endogenous, ‘inexcusable’ problems resulting from policy failures, moral hazard and favouritism. In contrast, non-financial crises could be seen as ‘excusable’ events, triggered by exogenous shocks (e.g. oil prices, wars). A second potential explanation is that financial crises may have social repercussions that are not observable after non-financial recessions. For example, it is possible that the disputes between creditors and debtors are uglier or that inequality rises more strongly. Lastly, financial crises typically involve bailouts for the financial sector and these are highly unpopular, which may result in greater political dissatisfaction.
.. The typical political reaction to financial crises is as follows: votes for far-right parties increase strongly, government majorities shrink, the fractionalisation of parliaments rises and the overall number of parties represented in parliament jumps. These developments likely hinder crisis resolution and contribute to political gridlock. The resulting policy uncertainty may contribute to the much-debated slow economic recoveries from financial crises.In the light of modern history, political radicalisation, declining government majorities and increasing street protests appear to be the hallmark of financial crises. As a consequence, regulators and central bankers carry a big responsibility for political stability when overseeing financial markets. Preventing financial crises also means reducing the probability of a political disaster.