Rational Political Business Cycles

Rational Political Business Cycles
Recent work in the political business cycle tradition has shown that some of
the insights of Nordhaus (1975) can survive even in a model with rational
expectations, providing there is asymmetric information between voters and
policy makers. In other words, voters need not be myopic in order for politicians
to generate political business cycles. Optimal policies are only likely in
a world of political competition when there is unanimity about social objectives
and symmetric information between agents, voters and politicians. Since
these conditions are unlikely ever to hold, politicians have the opportunity to
follow non-optimal policies. Providing there is some element of imperfect
information, so that forward-looking voters are not fully informed about
some characteristics of the political and economic environment, incumbents
have the opportunity of creating ‘a temporary illusion of prosperity’ (Alesina,
1989) in order to gain favour with the electorate.
In the rational opportunistic models proposed by Cukierman and Meltzer
(1986), Rogoff and Sibert (1988), Rogoff (1990) and Persson and Tabellini
(1990), electoral cycles are created in policy variables such as government
spending, taxes and monetary growth, and such cycles are made possible by
temporary information asymmetries. Although rational voters aim to choose
politicians who they believe can deliver the highest utility, they lack information
on the competence of different policy makers. Voters acquire information
on competence by observing outcomes. Therefore before elections the incumbents
engage in a ‘signalling process’ which aims to persuade voters that
the politicians in power are competent. Such signalling is always observed in
the UK during the Chancellor of the Exchequer’s annual budget speech,
especially just before an election.
Rogoff and Sibert define competence as the ability to reduce waste in the
budget process; that is, competent governments can produce more public
goods and transfers for a given amount of tax revenue. Incumbents have the
potential to create a temporary fiscal boost (or fail to impose necessary tax
increases), which is popular with voters. Because the budgetary process is so
complicated the inevitable post-election tax increases needed to finance the
pre-election boost are not foreseen even by rational voters, due to their
incomplete information. Rather than generating a regular inflation–unemployment
cycle as in the Nordhaus model, rational political business cycle
theories predict the manipulation of various policy instruments before and
after the election. The temptation of incumbents to cut taxes and increase
spending before an election in order to appear competent clearly generates
departures from optimality. Hence opportunistic behaviour survives in rational
opportunistic models, although such models give rise to a different set
of empirical predictions compared to the original Nordhaus model. In particular,
because of rational expectations, any cycles resulting from the
manipulation of monetary and fiscal policies will be predicted to be less
regular and of shorter duration.
Finally, we should note that developing-country governments appear to
behave in a similar way to their counterparts in richer countries. In a study of
35 developing countries Schuknecht (1996) found ‘considerable evidence’ in
favour of election-generated fiscal policy cycles although the opportunities
for self-interested political behaviour are less in more open economies.