The Financial Crisis as a Crisis of Democracy: Towards Prudential Regulation Through Public Reasoning

Abstract

This paper analyzes the impact of the 2007-2010 financial crisis on our understanding of democracy and uses insights from political theory, namely the concept of public reasoning, in order to strengthen prudential regulation. The financial crisis could be understood as a challenge to our understanding of democracy. Before the crisis there was a widespread conviction that democracies were not only morally superior to authoritarian forms of government, but were also better positioned to deal with severe economic and financial turmoil. Systemic events that exceed purely cyclical ups and downs were believed to be confined to the less democratic parts of the world. The crises in Asia and the post-soviet states of the 1990s seemed to confirm this.

The recent financial crisis, however, has been a crisis in and of the West, while some authoritarian regimes have done much better. It raises the question whether democracy really produces outcomes that are superior to those of other forms of governance and create a just society. Three answers are possible. First, the belief in the greater resilience and stability of democracies might be wrong and democracy might be part of the problem, giving too much deference to special interests. Second, issues of democracy and financial stability might be unrelated and one form of government might be just as good as another for the goal of financial stability. Third, the crisis might have been the result of democracy deficits on the domestic or international level.

To explore this question, I start with Amartya Sen’s comparative theory of democracy that combines output and input oriented aspects. Sen considers “public reasoning” as the key mechanism through which democracies achieve better outcomes than authoritarian regimes. The paper then analyzes some of the causes of the crisis that have been identified in the literature. It shows that each of these causes can be understood as a lack of public reasoning. I claim that there is an intrinsic relationship between the prudential regulation of financial markets and public reasoning. Public reasoning is destined to optimize decision-making under conditions of uncertainty, which is exactly what prudential regulation is about. This insight has important consequences for the design of the regulatory architecture and the interpretation and application of domestic and international law relating to financial market regulation. Enabling public reasoning should be the guideline for both in policy-making and legal interpretation.

Keywords: financial crisis, financial stability, democracy, authoritarian, public reasoning, prudential regulation, decision-making

JEL Classification: F02, F10, F20, F30, F40