Institutional and political factors behind financial crises
Human history is dotted with seismic economic events. However in the past 20 years, there’s been an increasing prevalence of financial crises and – thanks to the interconnected global economy – it seems few countries are immune.
In the 1990s it was UK/Nordic banking crises and the South East Asia currency crisis, which was then followed by the crippling 2008 global financial crisis, and in more recent times, the Eurozone sovereign debt crisis.
While follow-up research has largely focused on the macroeconomic reasons behind financial crises, Dr Rashad Hasanov took a different angle for his recently-completed doctoral thesis by concentrating on institutional and political factors.
With a deep interest in political economy, Rashad says that without enabling governments and institutions, ‘technocrat’ economists are simply not in a position to affect policy choices.
‘My thesis concentrates on the interaction of the economic theory and political and institutional factors. I try to shed light on how the interaction between two economic variables differs under one institutional environment compared to another,’ he explains.
Until the 2007–2008 global financial crisis there was a belief, Rashad says, that advanced economies were less vulnerable to financial crises than the emerging market economies.
‘However, the US subprime crisis and the following European debt crisis proved this wrong. The crisis hit advanced economies first and then quickly spread through developing countries.’
Finding a gap in the research that examines the political roots of financial crises, Rashad organised his thesis into three chapters which examine the broader array of institutional and political variables.
He says one of the easiest ways to explain his research is to use the analogy of a caged and free bird.
‘Imagine there’s an economist who has all the necessary skills to prevent a financial crisis. What happens if this economist ends up in a highly authoritarian political regime? There’s a high chance – like a caged bird – that he’ll have no impact over the economy. However if an economist ends up in a democracy there’s a much greater chance he’ll be able to have an impact. In an autocracy, the economist can feel like a caged bird – he has the ability to fly but he’s restricted,’ he says.
While the economic fate of a country depends on both economic practice and political regime, Rashad says he wanted to study how being a democracy – or an autocracy – affected the probability of financial calamity.
‘I found that the political and institutional factors play an enormous role in shaping the economic faith of the country. Although I had prior expectations about this, I never thought it would be that strong. It was also surprising to find out that the autocracies are more resilient to financial crises than democracies,’ he says.
Again using the bird analogy, Rashad says that while a wild bird is free, it’s also more exposed – and therefore more vulnerable – to the outside elements.
‘The same applies to democracies because in most of the cases their economies are open which means they’re exposed to the external threats.’
His research also found that when a country is moving from autocracy to democracy, is the time it’s most vulnerable.
‘During the first few years of transition, countries can find it difficult to embrace the economic and political changes … they can experience up to two or three financial crises. So in that respect, autocracy can be viewed as being economically safer than democracy. However my thesis does not suggest that autocracy is better than democracy. Despite being protected, are caged birds happy? Probably not,’ he says.
Rashad built his research on emerging literature surrounding the institutional aspects of financial crises and extended it by incorporating the types of political regime type, government popularity, time to elections and political constraints into standard macroeconomic models.
Originally from Azerbaijan, Rashad – like most PhD candidates – encountered a number of challenges while writing his thesis.
‘Having English as a second language means that not only do you have to read and speak English at a proficient level, but your writing skills need to be top-notch to deliver a quality PhD thesis. I think I made a lot of improvement, but I know there’s always room for more!’ he smiles.
His other challenge was tackling broad research questions that sometimes created distracting deviations.
‘However, the comments and advice from my supervisors really helped me get back on track,’ he says.
The first essay in Rashad’s thesis examines the relationship between political regime types and the probability of experiencing banking, currency or sovereign debt crisis.
‘I used data for 56 countries for the period 1960-2010 to compare autocracy and democracy, and also examined the potential impact of transitions between these political arrangements.’
Taking a two-pronged approach, the second essay investigates the factors behind banking crises within democracies.
‘First, it establishes a causal link between credit growth and banking crisis then it explains why incumbents may allow for unsustainable credit growth. In terms of credit growth, it found that growth of household credit has a bigger impact on the probability of banking crisis than the enterprise credit growth.’
The final essay focuses on the mitigation of financial crises and looks at the role of fiscal policy initiatives – such as stimulus measures – during financial crises.
‘For example, we found that an expansionary fiscal policy has a one-year lagged effect in ending financial crises, while it takes two years for the fiscal stimulus to guide countries out from economic recessions,’ he explains.
Now working full-time as a senior analyst with the Victorian State Government’s Department of Treasury and Finance, Rashad provides financial and performance-related analysis and advice across a range of departmental and government issues.
‘The research and quantitative skills that I developed during my PhD course are extremely useful in analysing data and conducting economic research. Also, having good writing skills (that I mastered during my PhD program) are extremely handy as I write briefing notes for the Treasurer and other executives on a weekly basis.’
One of the most important aspects of Rashad’s research, he explains, is in its emphasis on the role of institutional factors to ensure optimal economic policies.
‘In this regard, I believe the key implication of my study is that reforming the political system, institutions, the veto power, elections and other regime-related factors are essential in ensuring the wellbeing and prosperity of a country.’
By addressing identified gaps in the literature, Rashad’s research not only contributes to the current stockpile of financial crises knowledge but also opens up other research possibilities.
‘While my study concentrates on sovereign debt, banking and currency crises, it would be interesting to look at the effectiveness of fiscal policy during each type of crisis. I believe conducting a similar analysis – by separating fiscal stimulus into different components – would produce further important policy implications.’
Originally published on Deakin Business School Newsroom, 14 April 2017.