Friday, 28 September 2012

Reforming democracies

From about a month ago, Buttonwood wrote a good piece at the Economist, addressing this important issue:
"Modern governments play a much larger role in the economy than the ancient Greeks or the founding fathers could have imagined. This makes political leaders a huge source of patronage, in the form of business contracts, social benefits, jobs and tax breaks. As the late political scientist, Mancur Olson, pointed out, these goodies are highly valuable to the recipients but the cost to the average voter of any single perk will be small. So beneficiaries will have every incentive to lobby for the retention of their perks and taxpayers will have little reason to campaign against them. Over time the economy will be weighed down by all these costs, like a barnacle-encrusted ship. The Greek economy could be seen as a textbook example of these problems." [my emphasis]
And if I may add, not only the Greek economy, I can think of a lot of examples that fit this unfortunate scenario.
"One reason was the fear that democratic rule would lead to ruin. Plato warned that democratic leaders would “rob the rich, keep as much of the proceeds as they can for themselves and distribute the rest to the people”. James Madison, one of America’s founding fathers, feared that democracy would lead to “a rage for paper money, for an abolition of debts, for an equal division of property and for any other improper or wicked projects”. Similarly John Adams, the country’s second president, worried that rule by the masses would lead to heavy taxes on the rich in the name of equality. As a consequence, “the idle, the vicious, the intemperate would rush into the utmost extravagance of debauchery, sell and spend all their share, and then demand a new division of those who purchased from them.” 
Even with all these issues, democracies still have an advantage over dictatorships and all other forms of government in creating, sustaining and distributing wealth. The problem is in the between-country institutional differences and rules in the society that make some democracies more extractive than others, even when they both conduct a fair election. 

Should the solution to this problem be to surrender fiscal policy and redistribution to an unelected body of technocrats, like we do with monetary policy and the central banks? After all, the reason monetary policy was taken away from the full power of politicians was precisely the same argument surrounding current debates on fiscal policy and corresponding corruption and cronyism. Politicians used central banks to print money in order to reduce the country's debt. This power was taken away from them by making central banks independent. Now, they are again abusing their powers through skewed forms of fiscal redistribution, serving to interest groups, logrolling etc. 

I'm currently reading a new book by De Mesquita and Smith (two of the four authors of the excellent "Logic of Political Survivor"), called "The Dictator's Handbook: Why Bad Behavior is Always Good Politics". The aim of the book is to discover and portray the self-interested motives of politicians and what they do to usurp and maintain power, the single most important aim of their political career and motivation.

Needless to say, for a political economist, this is an argument I fully align with. I find it remarkable how the authors look at democratic rulers and dictators under the same loop, where both seem to be using similar methods to reach and stay in power. Use of violence is the big and crucial difference, but the idea of building an essential coalition of supporters and relying on this small group of to rule over a large group (the available voters, i.e. the population) is actually no different in Third World countries and Western democracies. However, the authors do point out that democrats find it harder than dictators to stay in power for a long amount of time. In my paper I model how even in democracies rulers can stay in power for longer periods of time provided that they curtail their rent-extraction - the argument is a bit different than the book's thesis, as De Mesquita and Smith seem to think that rulers don't even need to reduce rent-extraction; they only need to maintain their steady support from the essential group that keeps them in power. 

To see this more precisely, De Mesquita and Smith find a striking example of a town in California, called Bell (pop. 35,000). There they had a 'major' (city manager) called Robert Rizzo who governed this town for 17 years. In this time he managed to push a balanced budget every time. However he also managed to pay himself a salary of $800,000 per year (in comparison, the US President earns $400,000), even though the majority of citizens are rather poor. They were poor because Rizzo levied high taxes on the people to pay for his cronies and for keeping himself in power. His winning strategy was to form a group of loyal council members to whom he also gave large salaries by assigning them as board members in city companies. They were happy with their also huge earnings and knew that they will keep getting this by keeping Rizzo in power. As for the elections, even thought they were always fair and subject to the US electoral system, Rizzo and his councilmen were winning since the amount of those who voted was low, and among them it was much easier to pick those who can be influenced to vote the "right" way. 

A story like this happening in America? In the middle of California? Impossible! Now, I'm not saying that things like these happen all around the country. Also the strength of the US institutional system punished the corruption and criminal activities that happened in this town (perhaps a bit late, but justice did prevail). But even the fact that it could happen is worrying and is sending a troublesome picture of how a democracy can be altered to serve self-interest of politicians. 

The next question is how do we reform this? Is the aforementioned fiscal council the proper solution? Or could these bureaucrats be as easily corruptible as politicians. After all fiscal policy isn't the same as monetary policy. Redistribution of the budget to special interest group doesn't have a strong, visible, and immediate negative effect on the economy. Printing money does. 

Perhaps the solution is in the classical problem of rules vs. discretion in policy-making. Charles Wyplosz has a good new paper on this topic. Perhaps if we had strong rules that would guide budgetary redistribution there would be much less scope for interest groups and corruption. If this is true for monetary policy (John Taylor persistently points to the benefits of rules in monetary policy that lower policy uncertainty and lower business cycle volatility - see this paper for example), why wouldn't it be applicable for fiscal policy as well? I'm basically up for any solution that would limit the power of politicians, reduce the influence of various interest groups, and reduce the uncertainty of economic policy decision-making. 


  1. What every Republic needs are strong constitutional rules that actively forbid the government from a number of economic disasters such as tariffs, setting wages or prices, wealth transfers to corporations for any reason. And a firm upward limit on growth of any social safety net.

    Only by taking away the power of government can you reduce the lure of corruption.

    1. I agree, these are exactly the types of rules I would favour over any type of discretion from politicians or government officials.

  2. I would never opt for handing decisions on fiscal policy over to unelected bureaucrats, simply because budget redistribution decisions are much different than monetary policy. For one, I think it's only fair for those who get affected by redistribution (all those on welfare and all public sector workers) to have a democratic voice in who should be handling the budget and how. After all their lives directly depend on this.
    How many people should depend on the government is a completely different issue, which should always be led by efficiency.