There is a broad consensus among economists that financial crises are costly, as evidenced by the Asian currency crisis in 1997 and other systemic crises during the 1990s (Hawkins 1999; Klingebiel and Laeven 2002). However, there is little agreement on the cause of financial fragility, not to mention the policy prescriptions for financial stability. A perennial heated controversy is the role of government versus the market in promoting and maintaining financial stability. Against the background of frequent outbreaks of financial crises following the global trend of financial liberalization over the past quarter of a century, many economists have pointed to financial liberalization as an important source of financial instability. For example, Jomo (1998) argues that the Malaysian crisis in 1997 was due to financial liberalization rather than excessive regulation. Empirically, such a view is to some extent supported by certain studies that show that financial liberalization has induced excessive risk taking by financial institutions and ultimately precipitated financial crises (Demirguc-Kunt and Detragiache 2001, 2005; Noy 2004).
Since the Asian crisis, many economists and policymakers have called for stronger regulation of financial markets. A popular view is that global financial markets are now beyond the control of governments and that financial crises are the consequence (Strange 1998, 2002). Adherents of that view call for tighter state control over financial markets.
The literature on financial instability has been expanding rapidly over the last decade, and the literature on the relationship between the state and the market has an even longer history. In this article, I employ categorical data analysis techniques to examine whether there are statistically significant associations among financial crises, liberalization, and government size. If there are associations, I proceed to ask: Does financial liberalization have a significant impact on financial stability? And, more important, does a large government avert financial crises? Does the impact of one factor, say financial liberalization on financial stability depend on the other factor (i.e., the size of government), and vice versa? The answer to that question can potentially shed light on the role of the state versus the market in promoting and maintaining financial stability. The main conclusion of this article is that the popular belief that financial crises are due to governments being outgrown by markets cannot be substantiated by the data.
Financial Deregulation, Government Size, and Financial Stability
To examine the relationship between financial deregulation, government size, and financial instability during the past three decades, I employ contingency table analysis and log-linear models. Financial instability is regarded as a response variable, whereas financial deregulation and government size are treated as factors or explanatory variables.
A country is defined as having experienced financial instability if it had at least one systemic banking crisis or borderline case during the period under study. Caprio and Klingebiel (1996, 1999, 2000) documented countries with systemic crises or borderline cases during the past three decades. For countries that experienced more than one financial crisis during the period under study, the following criteria apply: (1) when there is a systemic crisis and a borderline case for a country the systemic crisis will be selected; (2) when financial crises for a country are the same in terms of severity the choice will depend on the availability of data on financial deregulation and government size; and (3) when financial crises fall into the same category of severity and data availability is not a problem the country's latest financial crisis will be chosen.
After a country's status regarding financial instability has been determined, I consider the changes in that country's government size and in the extent of its financial regulation over a long period--say, a decade or more, depending on data availability--prior to the outbreak of the financial crisis. …