Political regimes and financial crises
| Published date | 01 September 2023 |
| Author | Rashad Hasanov,Prasad Sankar Bhattacharya |
| Date | 01 September 2023 |
| DOI | http://doi.org/10.1111/sjpe.12341 |
1Department of Economics, ADA University,
Baku, Azerbaijan
2Department of Economics, Faculty of
Business and Law, Deakin University,
Burwood, Victoria, Australia
Correspondence
Prasad Sankar Bhattacharya, Department
of Economics, Faculty of Business and Law,
Deakin University, Burwood, VIC, Australia.
Email: prasad.bhattacharya@deakin.edu.au
Abstract
This study investigates how democratic or autocratic
regimes, their transitions, and durations, affect the proba-
bility of experiencing financial crises. The empirical strat-
egy employs novel instruments and Lewbel's method to
address potential endogeneity concerns. The results reveal
that democratic transition reduces the probability of crises
by around seven percent, whereas autocratic switchovers
enhance the crises likelihood by twelve percent. The find-
ings remain robust in presence of a number of heterogeneity
checks, with alternative measures of crises indicators, and
employing different proxy for democratic transition. Thus,
institutions in transition countries could play important role
in managing such financial upheavals.
KEYWORDS
duration, financial crises, political regime, transition
JEL CLASSIFICATION
E62, G01, P16, P48
ORIGINAL ARTICLE
Political regimes and financial crises
Rashad Hasanov1 | Prasad Sankar Bhattacharya2
DOI: 10.1111/sjpe.12341
Received: 28 September 2020 Accepted: 20 October 2022
1 | INTRODUCTION
The key aim of the paper was to analyze the relationship between political regimes and financial crises across coun-
tries. We investigate the effect of political regimes, viz., democracy and autocracy, and most importantly, their tran-
sitions and durations, on the probability of experiencing financial crises. Until 2007–2008, there was a belief that
advanced economies were less vulnerable to such financial disasters than emerging market economies (Reinhart
& Rogoff, 2011). However, the US subprime lending catastrophe and the European debt crises proved that this
presumption was incorrect. These financial upheavals affected advanced economies first and then quickly spread
285
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits
use and distribution in any medium, provided the original work is properly cited, the use is non-commercial and no modifications or
adaptations are made.
© 2022 The Authors. Scottish Journal of Political Economy published by John Wiley & Sons Ltd on behalf of Scottish Economic Society.
Scott J Polit Econ. 2023;70:285–318. wileyonlinelibrary.com/journal/sjpe
through other developing countries. Thus, following below-trend output growth in 2008, the global economic activity
dropped by 1.8% in 2009. This was the largest contraction in the world GDP since World War II.
The large body of extant literature on the causes and consequences of crises have mainly analyzed economic
determinants (Demirguc-Kunt & Detragiache, 1998; Kaminsky & Reinhart, 1999; Lane, 2012; Reinhart & Rogoff, 2009).
Recently, researchers focused on the broader aspects of economic and political institutions in explaining financial
crises. Shimpalee and Breuer (2006) argue, while currency crises are initiated by large-scale capital outflows, it begs
the question: “What causes large-scale capital outflows?” Herrera et al. (2014) show political conditions facilitate
banking crises via excessive credit growth. Alsharif and Bhattacharyya (2019) find that democratic institutions better
manage the impact of natural resource windfall like oil discovery by focusing on export and employment diversification.
However, very few studies analyze the intricate relationship between political regimes and financial instability.
There are compelling empirical and theoretical grounds for expecting significant effects of regime types on the proba-
bility of experiencing any crisis. Authoritarian and democratic regimes differ in many ways like the choice of economic
policies, attitude toward electorates, individual liberties, transparency and political participation. For example, demo-
cratic governments are expected to serve diverse interest groups, while authoritarian leaders would implement
economic policies benefiting a few clienteles. Hence, authoritarian leaders are more likely to compromise long-term
growth objectives if political or personal ties are involved, as was evidenced in Indonesia (Horowitz & Heo, 2001).
In the same vein, a strand of the literature argues that democratic governments are more committed to avoid
financial crises to elude being punished. Schultz and Weingast (2003) posit that democracies are expected to be more
committed to paying back their debt due to higher political costs. Consequently, breaking international agreements
and obligations would result in the loss of constituency and a lower chance of re-election. Given such predicaments,
democratic regimes could better negotiate the lending conditions and even plausibly pay lower interest rates than
their autocratic counterparts. This is termed as the “democratic advantage” hypothesis.
We investigate regime transitions and durations as there is some implicit conjecture from the extant literature
on what would be likely consequences of such transitions. From a theoretical perspective, the important difference
between autocracies and democracies is in regard to the conduct of economic policy linked with the time horizon of
the incumbent government. Easterly (2002) argues that if autocracies only expect to stay in power for a short period,
they will value the future less than democracies; hence, they have little incentive to implement economic stabilization
programs. This could have possible negative ramifications in future.
Looking at the empirical evidence, Giordano and Tommasino (2011) show that some sovereign borrowers are
more prone to default as it is the outcome of political struggle among different groups of citizens and the default is
less likely to occur if domestic debtholders are politically strong. Van Rijckeghem and Weder (2009) explores a large
number of political and macroeconomic variables using a nonparametric technique to predict safety from default
and concludes that in the presence of effective checks and balances (which could be associated with democracies
and parliamentary systems) and strong economic fundamentals, the probability of a sovereign debt crisis is very low.
On the contrary, certain features of democratic regimes may also expose them to economic vulnerabilities. For
example, political constraints and prevailing political conditions may usher in unsustainable macroeconomic poli-
cies. Concerned about being punished by the electorate, democratic governments could implement unnecessary
but popular economic policies to sustain popularity. Koesel et al. (2015) find that democratic leaders worried about
delivering economic growth are keener to pursue policies that create important preconditions for currency crises.
Similarly, Lipscy (2018) finds that democracies are twice more prone to banking crises than autocracies given the
political compulsions of democratic regimes.
Regime durations in autocracies could also usher in good outcomes. For autocratic regimes, regime tenure
and high political stability keep countries away from default in the presence of strong liquidity. Kohlscheen (2010)
provides evidence in favor of parliamentary democracies and coalition governments. Saiegh (2009) concludes that
coalition governments are less crisis-prone than single-party governments.
In light of the above discussions, this paper investigates the finer nuances between political regime types and the
probability of experiencing financial crises. To be specific, the study examines how being in an autocracy, democracy
HASANOV ANd BHATTACHARYA
286
or transitioning between these regimes affects the probability of experiencing a major financial crisis. Transitioning
from one regime to another matters as this points to inherent stability of regimes. The stability of political regimes
would then lead to different economic decision makings and policy management, which in turn may lead to finan-
cial crises or mitigate such vagaries as highlighted in the brief literature review before. In our empirical analysis, the
financial crises indicator takes the value 1 if at least one of the three major crises, viz, banking, sovereign debt or
currency crises occurs in a given year; else it takes the value 0.1
This study advances the understanding of regime types and financial crises in the following important ways.
First, our paper is novel to analyze the effects of being in transition from a non-democratic to a democratic state and,
vice versa, the effects of reverse transition from a democratic to an authoritarian regime. The focus on transition and
reverse transition makes sense as these are linked with inherent stability of the political regimes (Sanhueza, 1999).
We define transition from autocracy to democracy by creating a dummy for transition countries and code it 1 for
the next five years after the changeover takes place. To illustrate, if an authoritarian country becomes democratic
in a given year (i.e., Polity score increases from the [−10]–0 interval to 0–[10]), we consider it in transition for the
next five years. The reverse transition is defined in a similar way. The stability matters as stable regimes would usher
in credibility and commitment in decision making which would lead to long-run investment and subsequent growth.
This in turn would diminish the likelihood of crisis.
Second, in addition to considering the effects of political regimes, per se, we examine the effect of the tenure of
political regimes on financial crises. Van Rijckeghem and Weder (2009) focuses only on debt crisis and concludes that
regime tenure (or duration of regime) is an important factor in preventing autocratic countries from defaulting. In the
same vein, Clague et al. (1996) find that the tenure of autocratic regimes and duration of democratic regimes hasten
economic growth through protection of property rights and associated economic incentives channel. Thus, one can
expect that tenure of regimes would have important bearing on crises onsets.
Third, the potential endogeneity problem is treated in a sophisticated manner. We employ two novel instruments
to proxy for the political regime or Polity measure. These are (i) the cumulative impact of leaders' or head of states
death due to natural causes as in Jones and Olken (2005) and (ii) the cumulative impact of leaders or heads of states
exit from power due to irregular causes from the Archigos 4.1 dataset by Goemans et al. (2009). The basic intuition
for such instruments is the fact that countries political regimes are intertwined with the fate of the political leaders
as sudden change of leaders due to natural death or other irregular removals lead to dramatic shift in political trajec-
tories of countries which have significant ramifications afterward as identified in the extant literature (Bhattacharya
et al., 2019; Jones & Olken, 2005). The focus is on the cumulative impact as we would like to exploit these impromptu
changes having long-lasting effect on the political regimes. In addition, there could be multiple instances of leaders'
natural deaths like in Morocco (1961, 1991) and Uruguay (1965, 1967) as well as change of leaders in office due to
irregular causes (Honduras and Greece). The irregular reasons for leaving office from Archigos 4.1 dataset include
“Removed by Military, without Foreign Support,” “Removed in Military power struggle short of coup,” “Removed by
Rebels, with Foreign Support,” and “Assassination by Unsupported Individual.” The instruments are used together as
employing either one only would lead to underestimating the true impact of these sudden switchovers.
Fourth, extensive heterogeneity checks and robustness analysis are carried out to validate the main
endogeneity-corrected results. To begin with, we look at heterogenous impacts by dropping time trends, dropping
exogenous controls and excluding all fixed effects and time trends one by one from the main endogeneity-corrected
specification. Then, an alternative measure of democratic transition from Albertus and Mendalo (2018) is employed
where all democratic transitions are accounted for rather than focusing on five years of transition as in the main
specification. Our findings are bolstered using this alternative proxy for democratic transition. In the third check of
robustness, we use two different continuous variables as outcomes, viz., (a) yield spread over United States Treasury
1 A number of crises indicators are used in the empirical studies. Lipscy (2018) uses banking crises onset as a binary dependent variable based on data
from Reinhart and Rogoff (2009). On the other hand, quite a few papers (Tagkalakis, 2013; Waelti, 2015) employ the crises indicators as explanatory
variables as their focus are on the impact of crisis on other dependent variables like financial reforms, aid flows or on fiscal positions to name a few.
HASANOV ANd BHATTACHARYA287
Get this document and AI-powered insights with a free trial of vLex and Vincent AI
Get Started for FreeStart Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting