Financial stability and politics

The conventional wisdom is that financial crises are caused by private sector firms taking excessive risk, where the job of the authorities is therefore to monitor and control that risk. There are problems with this approach, such as the measurability of risk, but that is not my topic today.

Politics is a central driver of financial crises. By politics I mean the broad sense — government policy, elections, regime change, geopolitical conflict, sanctions and the political bargains that shape how financial systems are structured and regulated.

Consider the most extreme case, when a country transitions from capitalism to communism, the financial system is not just destabilised — it is eliminated. Russia after 1917, the Eastern European states after 1945, China after 1949, Cuba after 1959, and Cambodia and Vietnam after 1975.

War is another. The financial collapses in Germany and Japan during and after the Second World War. More recently, the financial systems of Iraq, Libya, Syria and Ukraine, just to mention a few.

The financial crisis of 1914, perhaps the most severe systemic crisis ever, was triggered by a political assassination and then driven by domestic political decisions.

Admittedly, revolutions and world wars are a bit beyond the remit of any financial regulator. We can hardly expect the central bank to have a contingency plan for the abolition of capitalism. Let's set those aside and look only at the crises the authorities might plausibly have prevented.

The 2008 crisis was shaped by decades of US housing policy and the political choices that sustained it, as argued by Calomiris and Haber in Fragile by Design (2014). The reason the dangerous instruments and banking practices that culminated in the crisis in 2008 were allowed to build up and could not be prevented was almost entirely political pressure. And interestingly, it was the far right and the far left in the US Congress that came together in applying the pressure.

In Iceland in 2008, the UK government used anti-terrorism legislation to freeze Icelandic bank assets, even going so far as designating the Icelandic Central Bank as a terrorist entity — instantly triggering a financial crisis. While also harming the UK financial system and economy, it was necessarily for political reasons. Argentina cycles endlessly between populist excesses that culminate in crises. Lebanon's decades of sectarian power-sharing and political dysfunction produced a complete financial collapse in 2019. Sri Lanka's political mismanagement led to sovereign default in 2022. In Venezuela, the political programme of Chavez and Maduro effectively destroyed the financial system. Zimbabwe's hyperinflation was a direct consequence of Mugabe's political choices.

In Europe, the sovereign debt crisis was driven by political choices in the design of the euro and the politics of the Greek bailout negotiations. The Liz Truss mini-budget in 2022 crashed the gilt market. It is entirely possible that one of Trump's announcements, perhaps on tariffs, could trigger a financial crisis.

The question is not whether politics drives financial instability — it obviously does — but whether the authorities responsible for financial stability can do anything about it. Robert Macrae and I argued in our 2016 blog The fatal flaw in macropru: It ignores political risk that they cannot, and that this is macropru's fatal flaw.

This creates a paradox. Financial regulators derive their legitimacy from the political system and cannot credibly analyse political risk without appearing to challenge democratic processes. The Bank of England learned that lesson to its cost when the then-governor Mark Carney made pronouncements about the economic impact of Brexit in the run-up to the vote.

A central banker who publicly warns that an election outcome might destabilise markets is no longer seen as a neutral technocrat, however well meaning. Financial regulators cannot regulate the conduct of their political masters. The only choice is to stay quiet and allow the systemic risk arising from politics.

None of this means we should abandon financial regulation. But we should be honest about what financial policy can and cannot do. It is a tool for adjusting capital buffers and lending standards. It is not, and cannot be, a comprehensive framework for financial stability. As long as we pretend otherwise, we are building a system that will fail when needed most.