Financial Crises and Political Crises

Why are some financial crises associated with political crises and some are not? Does political instability cause financial fragility or the other way around? What are the implications of political distortions for policy

in countries experiencing financial turmoil? This paper studies these and other questions in a formal model of debt, default, and financial crisis. A key assumption is that the default decision is made by a government that

has superior information than the public about the social costs of default. Citizens, however, can dismiss the government, and overrule its default decision, at the cost of a political crisis. If there is a divergence between the

objectives of the government and its people, political crisis may emerge in equilibrium. For this to be the case, the foreign debt must be large enough,and international reserves low. When this political equilibrium is seen as

a part of a larger investment problem, I show that there are equilibria in which crises are "only financial," and equilibria in which default and political crises occur. In some cases, both kinds of equilibria coexist and, in this sense, a loss of confidence by foreign lenders can exacerbate the likelihood of a political crisis. If so, international intervention in financial markets may ensure financial and political stability at little cost. Policy

analysis is delicate, however, and may require linking financial policies to political outcomes.

For more information, contact Antonio Merlo.