Crises and government: Some empirical evidence

I. INTRODUCTION In September of 2008, the world seemed to fall apart. What seemed like economic slowdown in 2007 deteriorated into financial crisis, first in the United States and then in Europe and elsewhere. Since then, it has been hard to scan the headlines without reading about an economic crisis of some sort, somewhere. From 2008 to 2010, worldwide there were 21 sovereign debt crises, 28 currency crises, and a staggering 46 banking crises. (1) Governments often intervene into markets and implement policies intended to halt or mitigate crises. Recent interventions include the United Kingdom's 2008 bank rescue package, the 2009 American Recovery and Reinvestment Act (ARRA), and the European Union's 2008 stimulus plan. These interventions were all associated with increases in government expenditures and the scope of government decision making and control. Are they exceptional or the rule? If they are the rule, are the increases in government size and scope temporary expedients or are they permanent? We address these questions using data for up to 70 countries on economic crises from the 1960s through 2010. We estimate the relationship between crises and changes in the size and scope of government over both 5- and 10-year horizons. Unlike previous studies that consider banking crises, we also consider sovereign debt, currency, and inflation crises. Rahm Emanuel, then chief of staff to U.S. President-Elect Barack Obama, was quoted as saying: "You never want a serious crisis to go to waste." (2) His point (at least as widely interpreted) was that a crisis "creates a sense of urgency[;] actions that once appeared optional suddenly seem essential" (Seib 2008). In other words, a crisis facilitates political actions that, from the policymaker's perspective, would have been desirable regardless. Presumably, then, these political actions are not temporary expedients. Economists have also argued that temporary crises are likely to result in permanent expansions of government. Higgs (1987) argues that, during a crisis, individuals' confidence in the efficiency of markets is shaken. The demand for government intervention increases as a result. Increasing the scope for government, in particular, can require a relaxing of constitutional constraints that tend to persist beyond the crisis period. Furthermore, people become accustomed to the more extensive government. For these reasons, Higgs argues that while expansion of government may recede after the crisis, it is unlikely to return to precrisis levels. There is a ratchet effect and the expansion of government has a permanent component. Alternatively, Pitlik and Wirth (2003, 565) argue that it is "commonly shared wisdom among economists and political scientists [...] that crises promote the adoption of market-oriented reforms." (3) Pitlik and Wirth cite a number of examples in support of this view, including the reforms of Latin American countries at the beginning of the 1980s and the reforms of transition economies in the wake of the Soviet Union's demise. (4) According to this view, crises represent "moments of clarity" for politicians; realizations that bad policies need to be abandoned to avoid economic collapse (Harberger 1993; Williamson and Haggard 1994). Crises will result in a decrease in the size and scope of government. Relatedly, Alesina and Drazen (1991) and Drazen and Grilli (1993) argue that particular reforms impose costs on particular special interests, and that conflicts over the distribution of such costs delay reforms generally. Economies become "sclerotic," to use Olson's (1982) term. However, during a crisis, the more widely spread costs (i.e., those associated with the continuation of bad policies) increase. This increases the likelihood that reforms occur. Furthermore, there is a third possibility: crises lead to political polarization and, as a result, gridlock. This hampers both reforms and expansions of government. …