The New Political Macroeconomics
During the past two decades research into the various forms of interaction
between politics and macroeconomics has become a major growth area giving
rise to a field known as the ‘new political macroeconomics’ (Alesina,
1995; Alt and Alesina, 1996; Alesina and Rosenthal, 1995; Alesina et al.
1997; Drazen, 2000a). This research area has developed at the interface of
macroeconomics, social choice theory and game theory. Of particular interest
to macroeconomists is the influence that political factors have on such issues
as business cycles, inflation, unemployment, growth, budget deficits and the
conduct and implementation of stabilization policies (Snowdon and Vane,
1999a).
As we will discuss in Chapter 10, modern politico-economic models,
initially developed in the 1970s by Nordhaus (1975), Hibbs (1977) and Frey
and Schneider (1978a), view the government as an endogenous component of
the political and economic system. The conventional normative approach, in
sharp contrast, regards the policy maker as a ‘benevolent social planner’
whose only objective is to maximize social welfare. The normative approach
is concerned with how policy makers should act rather than how they do act.
Alesina (1994) has highlighted two general political forces that are always
likely to play a crucial distorting role in the economy. The first factor is the
incumbent policy maker’s desire to retain power, which acts as an incentive
to ‘opportunistic’ behaviour. Second, society is polarized and this inevitably
gives rise to some degree of social conflict. As a result ideological considerations
will manifest themselves in the form of ‘partisan’ behaviour and actions.
Nordhaus’s model predicts self-interested opportunistic behaviour, irrespective
of party allegiance, before an election. When these political
motivations are mixed with myopic non-rational behaviour of voters and
non-rational expectations of economic agents, a political business cycle is
generated which ultimately leads to a higher rate of inflation in a democracy
than is optimal. In the Hibbs model ‘left’-inclined politicians have a greater
aversion to unemployment than inflation, and ‘right’-inclined politicians have
the opposite preference. The Hibbs model therefore predicts a systematic
difference in policy choices and outcomes in line with the partisan preferences
of the incumbent politicians.
Both of these models were undermined by the rational expectations revolution.
By the mid-1970s models which continued to use adaptive expectations or
were reliant on a long-run stable Phillips curve trade-off were coming in for
heavy criticism. The scope for opportunistic or ideological behaviour seemed
to be extremely limited in a world dominated by rational ‘forward-looking’
voters and economic agents who could not be systematically fooled. However,
after a period of relative neglect a second phase of politico-economic models
emerged in the mid-1980s. These models capture the insights emanating from
and including the rational expectations hypothesis in macroeconomic models.
Economists such as Rogoff and Sibert (1988) have developed ‘rational opportunistic’
models, and Alesina has been prominent in developing the ‘rational
partisan’ theory of aggregate instability (Alesina, 1987, 1988; Alesina and
Sachs, 1988). These models show that while the scope for opportunistic or
ideological behaviour is more limited in a rational expectations setting, the
impact of political distortions on macroeconomic policy making is still present
given the presence of imperfect information and uncertainty over the outcome
of elections (Alesina and Roubini, 1992). As such this work points towards the
need for greater transparency in the conduct of fiscal policy and the introduction
of central bank independence for the conduct of monetary policy (Alesina
and Summers, 1993; Alesina and Gatti, 1995; Alesina and Perotti 1996a;
Snowdon, 1997).
More recently several economists have extended the reach of the new
political macroeconomics and this has involved research into the origin and
persistence of rising fiscal deficits and debt ratios, the political economy of
growth, the optimal size of nations, the economic and political risk involved
with membership of fiscal unions and the political constraints on economic
growth (Alesina and Perotti, 1996b, 1997a; Alesina et al., 1996; Alesina and
Spolare, 1997, 2003; Alesina and Perotti, 1998; Acemoglu and Robinson,
2000a, 2003). With respect to achieving a reduction in the fiscal deficit/GDP
ratio, Alesina’s research has indicated that successful fiscal adjustment is
highly correlated with the composition of spending cuts. Unsuccessful adjustments
are associated with cuts in public investment expenditures whereas
in successful cases more than half the expenditure cuts are in government
wages and transfer payments (Alesina et al., 1997). In addition, because
fiscal policy is increasingly about redistribution in the OECD countries,
increases in labour taxation to finance an increase in transfers are likely to
induce wage pressure, raise labour costs and reduce competitiveness (Alesina
and Perotti, 1997b). Research into the optimal size of nations has indicated
an important link between trade liberalization and political separatism. In a
world dominated by trade restrictions, large political units make sense because
the size of a market is determined by political boundaries. If free trade
prevails relatively small homogeneous political jurisdictions can prosper and
benefit from the global marketplace (Alesina and Spolare, 2003). Work on
the implications of fiscal unions has also indicated the potential disadvantages
of larger units. While larger jurisdictions can achieve benefits in the
form of a centralized redistribution system, ‘these benefits may be offset
(partially or completely) by the increase in the diversity and, thus, in potential
conflicts of interests among the citizens of larger jurisdictions’ (Alesina
and Perotti, 1998).
In recent years the ‘politicisation of growth theory’ (Hibbs, 2001) has led
to a burgeoning of research into the impact on economic growth of politics,
policy, and institutional arrangements. Daron Acemoglu and his co-authors
have made a highly influential contribution to the debate relating to the
‘deeper’ institutional determinants of economic growth and the role of politi
cal distortions as barriers to progress (see Acemoglu, 2003a; Snowdon, 2004c).
Acemoglu’s recent research highlights the importance of ‘political barriers to
development’. This work focuses on attitudes to change in hierarchical societies.
Economists recognize that economic growth is a necessary condition for
the elimination of poverty and sustainable increases in living standards. Furthermore,
technological change and innovation are key factors in promoting
growth. So why do political élites deliberately block the adoption of institutions
and policies that would help to eliminate economic backwardness?
Acemoglu and Robinson (2000a, 2003) argue that superior institutions and
technologies are resisted because they may reduce the political power of the
élite. Moreover, the absence of strong institutions allows autocratic rulers to
adopt political strategies that are highly effective at defusing any opposition
to their regime. As a result economic growth and development stagnate.
During the past two decades research into the various forms of interaction
between politics and macroeconomics has become a major growth area giving
rise to a field known as the ‘new political macroeconomics’ (Alesina,
1995; Alt and Alesina, 1996; Alesina and Rosenthal, 1995; Alesina et al.
1997; Drazen, 2000a). This research area has developed at the interface of
macroeconomics, social choice theory and game theory. Of particular interest
to macroeconomists is the influence that political factors have on such issues
as business cycles, inflation, unemployment, growth, budget deficits and the
conduct and implementation of stabilization policies (Snowdon and Vane,
1999a).
As we will discuss in Chapter 10, modern politico-economic models,
initially developed in the 1970s by Nordhaus (1975), Hibbs (1977) and Frey
and Schneider (1978a), view the government as an endogenous component of
the political and economic system. The conventional normative approach, in
sharp contrast, regards the policy maker as a ‘benevolent social planner’
whose only objective is to maximize social welfare. The normative approach
is concerned with how policy makers should act rather than how they do act.
Alesina (1994) has highlighted two general political forces that are always
likely to play a crucial distorting role in the economy. The first factor is the
incumbent policy maker’s desire to retain power, which acts as an incentive
to ‘opportunistic’ behaviour. Second, society is polarized and this inevitably
gives rise to some degree of social conflict. As a result ideological considerations
will manifest themselves in the form of ‘partisan’ behaviour and actions.
Nordhaus’s model predicts self-interested opportunistic behaviour, irrespective
of party allegiance, before an election. When these political
motivations are mixed with myopic non-rational behaviour of voters and
non-rational expectations of economic agents, a political business cycle is
generated which ultimately leads to a higher rate of inflation in a democracy
than is optimal. In the Hibbs model ‘left’-inclined politicians have a greater
aversion to unemployment than inflation, and ‘right’-inclined politicians have
the opposite preference. The Hibbs model therefore predicts a systematic
difference in policy choices and outcomes in line with the partisan preferences
of the incumbent politicians.
Both of these models were undermined by the rational expectations revolution.
By the mid-1970s models which continued to use adaptive expectations or
were reliant on a long-run stable Phillips curve trade-off were coming in for
heavy criticism. The scope for opportunistic or ideological behaviour seemed
to be extremely limited in a world dominated by rational ‘forward-looking’
voters and economic agents who could not be systematically fooled. However,
after a period of relative neglect a second phase of politico-economic models
emerged in the mid-1980s. These models capture the insights emanating from
and including the rational expectations hypothesis in macroeconomic models.
Economists such as Rogoff and Sibert (1988) have developed ‘rational opportunistic’
models, and Alesina has been prominent in developing the ‘rational
partisan’ theory of aggregate instability (Alesina, 1987, 1988; Alesina and
Sachs, 1988). These models show that while the scope for opportunistic or
ideological behaviour is more limited in a rational expectations setting, the
impact of political distortions on macroeconomic policy making is still present
given the presence of imperfect information and uncertainty over the outcome
of elections (Alesina and Roubini, 1992). As such this work points towards the
need for greater transparency in the conduct of fiscal policy and the introduction
of central bank independence for the conduct of monetary policy (Alesina
and Summers, 1993; Alesina and Gatti, 1995; Alesina and Perotti 1996a;
Snowdon, 1997).
More recently several economists have extended the reach of the new
political macroeconomics and this has involved research into the origin and
persistence of rising fiscal deficits and debt ratios, the political economy of
growth, the optimal size of nations, the economic and political risk involved
with membership of fiscal unions and the political constraints on economic
growth (Alesina and Perotti, 1996b, 1997a; Alesina et al., 1996; Alesina and
Spolare, 1997, 2003; Alesina and Perotti, 1998; Acemoglu and Robinson,
2000a, 2003). With respect to achieving a reduction in the fiscal deficit/GDP
ratio, Alesina’s research has indicated that successful fiscal adjustment is
highly correlated with the composition of spending cuts. Unsuccessful adjustments
are associated with cuts in public investment expenditures whereas
in successful cases more than half the expenditure cuts are in government
wages and transfer payments (Alesina et al., 1997). In addition, because
fiscal policy is increasingly about redistribution in the OECD countries,
increases in labour taxation to finance an increase in transfers are likely to
induce wage pressure, raise labour costs and reduce competitiveness (Alesina
and Perotti, 1997b). Research into the optimal size of nations has indicated
an important link between trade liberalization and political separatism. In a
world dominated by trade restrictions, large political units make sense because
the size of a market is determined by political boundaries. If free trade
prevails relatively small homogeneous political jurisdictions can prosper and
benefit from the global marketplace (Alesina and Spolare, 2003). Work on
the implications of fiscal unions has also indicated the potential disadvantages
of larger units. While larger jurisdictions can achieve benefits in the
form of a centralized redistribution system, ‘these benefits may be offset
(partially or completely) by the increase in the diversity and, thus, in potential
conflicts of interests among the citizens of larger jurisdictions’ (Alesina
and Perotti, 1998).
In recent years the ‘politicisation of growth theory’ (Hibbs, 2001) has led
to a burgeoning of research into the impact on economic growth of politics,
policy, and institutional arrangements. Daron Acemoglu and his co-authors
have made a highly influential contribution to the debate relating to the
‘deeper’ institutional determinants of economic growth and the role of politi
cal distortions as barriers to progress (see Acemoglu, 2003a; Snowdon, 2004c).
Acemoglu’s recent research highlights the importance of ‘political barriers to
development’. This work focuses on attitudes to change in hierarchical societies.
Economists recognize that economic growth is a necessary condition for
the elimination of poverty and sustainable increases in living standards. Furthermore,
technological change and innovation are key factors in promoting
growth. So why do political élites deliberately block the adoption of institutions
and policies that would help to eliminate economic backwardness?
Acemoglu and Robinson (2000a, 2003) argue that superior institutions and
technologies are resisted because they may reduce the political power of the
élite. Moreover, the absence of strong institutions allows autocratic rulers to
adopt political strategies that are highly effective at defusing any opposition
to their regime. As a result economic growth and development stagnate.
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