Political and Economic Instability: Are They Related?

Political and Economic Instability: Are They Related?
A further related area of research in the politico-economic sphere concerns
the relationship between political and economic stability (see Carmignani,
2003). There are good reasons to believe that economic performance will
suffer if a country is politically unstable. Frequent riots, politically motivated
violence and revolution inevitably have a negative impact on a country’s
economic performance. As Keynes always highlighted, uncertainty has a
depressing effect on investment and productive entrepreneurship.
Alesina’s partisan theory predicts that instability will increase the greater
the partisan effects because widely divergent policies create uncertainty and
destabilize expectations. It is also unlikely that reputational considerations
will be important to a government which feels that it has little chance of
being re-elected. In this situation an incumbent has an ‘incentive to follow
particularly shortsighted policies, since it is not concerned with a future in
which it is likely to be out of office’ (Alesina, 1989).
A further destabilizing influence on policy arising from political instability
derives from the inability of fragile coalition governments to carry through
the tough but necessary economic policies crucial for long-run stability.
Alesina (1989) finds a positive correlation between an index of political
instability and Okun’s misery index (inflation + unemployment) for the period
1973–86. An exception in his 20-country sample is the UK, which
managed to combine relatively poor economic performance during this pe556
Modern macroeconomics
riod despite having a high degree of political stability. In Alesina and Drazen’s
(1991) analysis of why necessary stabilization policies are frequently delayed,
they consider a situation where two parties with different ideologies
engage in a war of attrition as they each attempt to pass on the burden of
fiscal reform to the other party’s supporters. The resultant delay and government
inaction in the reform process leads to debt accumulation and crisis
before one of the parties is forced to accept a larger share of the fiscal burden.
As Drazen (2000a) notes, ‘the failure to adopt socially beneficial economic
reforms or their adoption only after long delays is a leading example of the
divergence between the simple textbook models of economic policymaking
and real world experience’.
Considerable cross-country evidence now exists which indicates that seigniorage
(the inflation tax) is positively related to the degree of political
instability. In a study of 79 developed and developing countries for the period
1971–82, Cukierman et al. (1992) found evidence in support of their hypothesis
that ‘more unstable countries rely relatively more on seigniorage to
finance the government budget than do stable and homogenous societies’.
These conclusions are also supported by Edwards (1994), who found that the
incentive to use inflationary finance is closely related to the volatility of the
political system. In the extreme, hyperinflation may erupt (see Capie, 1991;
Siklos, 1995; Fischer et al., 2002).