Regulatory Cycles: A Political Economy Model

Abstract

Financial regulatory policy in the U.S. has been conspicuously pro-cyclical over the last two decades. The 2000s financial boom coincided with a period of financial deregulation and the post-crisis response, a massive scaling up of regulation, was largely implemented during an economic downturn. Many argued that these regulatory waves were excessive. More recently, there are strong signs of a move toward deregulation, at a time of a booming economy and stock market. A closer look at historical financial boom-bust cycles suggests that, in fact, pro-cyclicality in financial regulation is a common and recurring pattern. This paper combines a signaling model of elections with a simple financial regulation model to study how public opinion, financial innovation, and policy-makers incentives shape financial regulation. While changes in voters' perceptions of financial innovation alone can generate a pro-cyclical pattern, we show that this cyclicality can be significantly amplified by politicians' electoral incentives: Both over-regulation and under-regulation can naturally arise in equilibrium, and small changes in public opinion can induce large regulatory shifts.