The Political Economy of Debt and Deficits

The Political Economy of Debt and Deficits
During the mid-1970s several OECD countries accumulated large public
debts. This rise in the debt/GNP ratios during peacetime among a group of
relatively homogeneous economies is unprecedented and difficult to reconcile
with the neoclassical approach to optimal fiscal policy represented by the
‘tax smoothing’ theory. While countries such as Greece, Italy and Ireland had
accumulated public debt ratios in excess of 95 per cent in 1990, other countries
such as Germany, France and the UK had debt ratios in 1990 of less than
50 per cent (Alesina and Perotti, 1995b).
In order to explain the variance of country experience and the timing of the
emergence of these rising debt ratios, Alesina and Perotti (1995b) argue that
an understanding of politico-institutional factors is ‘crucial’. In explaining
such wide differences Alesina and Perotti conclude that the two most significant
factors are:
1. the various rules and regulations which surround the budget process; and
2. the structure of government; that is, does the electoral system tend to
generate coalitions or single party governments?
In the face of large economic shocks weak coalition governments are
prone to delaying necessary fiscal adjustments. While a ‘social planner’ would
react quickly to an economic shock, in the real world of partisan and opportunistic
politics a ‘war of attrition’ may develop which delays the necessary
fiscal adjustment (see Alesina and Drazen, 1991). Persson and Tabellini (2004)
have investigated the relationship between electoral rules, the form of government
and fiscal outcomes. Their main findings are that: (i) majoritarian
elections lead to smaller government and smaller welfare programmes than
elections based on proportional representation; and (ii) presidential democracies
lead to smaller governments than parliamentary democracies.
Research by Alesina and Perotti (1996b, 1997a) also indicates that the
‘composition’ of a fiscal adjustment matters for its success in terms of its
sustainability and macroeconomic outcome. Two types of adjustment are
identified: Type 1 fiscal adjustments rely on expenditure cuts, reductions in
transfers and public sector wages and employment; Type 2 adjustments depend
mainly on broad-based tax increases and cuts in public investment.
Alesina and Perotti (1997a) find that Type 1 adjustments ‘induce more lasting
consolidation of the budget and are more expansionary while Type 2 adjustments
are soon reversed by further deterioration of the budget and have
contractionary consequences for the economy’. Hence any fiscal adjustment
that ‘avoids dealing with the problems of social security, welfare programs
and inflated government bureaucracies is doomed to failure’ (see Alesina,
2000). Type 1 adjustments are also likely to have a more beneficial effect on
‘competitiveness’ (unit labour costs) than policies which rely on distortionary
increases in taxation (see Alesina and Perotti, 1997b).