Working Paper

Financial Crises, Political Constraints, and Policy Responses

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We analyze the political environment in the wake of financial crises and try to infer its implications on decision making and economic policies.

Concretely, we investigate if a shift in the ideology of the government or changes of political constraints drive the implementation of economic policies around periods of financial stress. To this end, we apply a simultaneous equations approach to evaluate governments’ responses to financial crises, given the impact of crises on the political and social environment. This method allows us to disentangle the direct effects from financial crises on public policy from the indirect effects induced by political and social changes. The proposed policy response model is able to take into account the possibility of a selection bias. The direct and indirect effects from financial crises on the political process are shown, where the indirect effect is defined as the impact of financial crises on the political orientation and political constraints. Furthermore, results suggest that changes in the political environment during financial crises do affect policy responses, although the effect is highly heterogeneous across different types of crises.