Political economy of debts and deficits (2): Theoretical overview

After a brief intermission it's time to continue with the PE of debts and deficits. In today's post I will present a theoretical overview focusing on the common-pool problem and political instability.

According to Persson and Tabellini (2000) high debt and deficit levels appear to be correlated with specific political and institutional features: high debts are characteristics of countries ruled by either coalition or unstable governments. This seems to suggest that institutional factors as well as political factors play an important role in public debt policy. They present a detailed overview of the political economy models of public debts[1]. They survey the literature and present two main types of models explaining the problem of deficits and debt in an economy, from which I will in the following blog post derive the main hypotheses explaining the rising debt levels since the 1970s onward.

Source

Common-pool problem

They focus first on the effects of interest groups and the so-called common-pool problem: smaller groups prefer overspending since each group will internalize the benefits of its own public good but it will internalize only a fraction of the marginal cost of higher taxes (this argument goes back to Olson’s theory of interest groups [2]). In other words one group captures all the benefits from the public good received, while the cost is shared across the entire society via higher taxation, or if unfeasible according to the tax smoothening hypothesis, via higher borrowing.

In systems with dispersed political power government size increases primarily because of powerful interest groups which tend to bias the majority of the government spending towards themselves. This will in effect create even higher incentives to borrow and increase the size of government under the persistent pressure from interest groups demanding budgetary concessions and giving political support in return (via campaign contributions for example; see Mueller, 2009, ch. 20). Such a dynamic common-pool problem leads to myopic (short-sighted) policies, and new research has shown it too can be linked with rising inequality.

In this case higher spending and borrowing are caused by a flawed budget process in which each group (whether geographically or ideologically determined) is given a too high decision-making authority over the budgetary procedure. 

Institutional reforms can be used to solve this problem by centralizing decision-making (or perhaps via reforming the electoral system to make majority governments rather than coalition governments). If a single party fully controls all spending decision it would appropriately internalize costs of overspending and overborrowing. However this too can be abused. Theoretically such a group can seek to allocate the entire spending towards itself (the moral hazard problem of political agency models), which would imply that the allocation across groups is extremely uneven, even though the allocation of spending would be Pareto optimal.

Institutional checks and balances could solve this problem. Increased transparency of the budget process in addition to closer public scrutiny at both the national and a local level lowers the incentives for overborrowing. In addition fiscal rules are arguably the most successful way of lowering the debt burden and closing the deficit (if implemented correctly, i.e. if the punishments for breaking the rules are enforceable and credible). This however refers to the issue of how well defined the basic institutions are within a country. 

If a particular political system leads to inefficiently myopic policies, normative arguments speak in favor of institutional constraints such as balanced budget rules. But since the failure involved has a political origin, a balanced budget constraint must be constitutionally (or supernationally) enforced, for there will always be a simple legislative majority in favor of repealing it. A balanced budget constraint may impose other distortions, however. It has been noticed that many EU states have cut public investments to cope with the constraints on budget deficits imposed by the Stability Pact. The parties in power will be reluctant in cutting funding to their own “constituencies”, i.e. support groups. But again the role of institutions is crucial in solving this problem.

Empirical evidence [3] points out to certain features of the budget process which decrease the likelihood of debt problems in countries. One is the extent to which power is centralized in the hands of the Prime Minister or the Treasurer, while another is whether the budget is subject to transparent sequential decision making. Naturally this too is linked to the strength of domestic institutions, where countries with strong institutions will be less subject to abuse of centralized political power.

Furthermore, Kontopoulos and Perotti (1997, 1999) use a panel data set including both public spending and debt issuance in 20 OECD countries from 1960 to 1995. They relate a country’s spending and debt to the type and structure of government in that country and find that spending and debt issuance correlate positively and significantly with two features: the number of coalition partners in government, and the number of ministries in government. 

Political instability

In addition to the common-pool problem a politically unstable system can also increase public debts to above sustainable levels. This argument revolves partially around the idea that debt can be used strategically between two interchanging parties (the US case). But this can easily be extended to a country with well-defined permanent coalitions (e.g. where liberals usually collide with conservatives, while the greens usually collide with social democrats).

The party (or coalition) deciding on public policy in the current period is aware that with some probability it will not hold office in the next period. This may induce too much borrowing, because the costs in terms of future spending cuts are not fully internalized. An incumbent government may also want to choose debt issuing strategically for another reason, however, namely to influence its likelihood of reelection.

The empirical prediction is that countries experiencing political polarization (i.e., sharp disagreement between the majority and the opposition) and political instability (i.e., frequent government turnovers) should accumulate more debt. A more precise prediction is that a lower perceived probability of reelection should cause any government to issue more debt.

If we introduce probabilistic (as opposed to deterministic) voting models, which assign probabilities of winning with respect to specific support gained by a political party within a particular group (geographically, economically, or ideologically speaking) the party with the fewer swing voters (i.e. the party with more ideologically unified voters) accumulates more debt.

This implies that if a government is supported by a unified ideological base big enough to secure its reelection, it worries less about the negative effects of its overborrowing. The party in power creates a big enough “constituency” that will ensure its reelection. In electorates where ideological issues override the economic ones during political campaigns voters are less likely to control the budgetary transparency of the party in power. Ideological battles will polarize the electorate and as a consequence lead to more debt.

                                                       
[1] Persson and Tabellini (2000) Political Economics. Explaining Economic Policy. MIT Press. Chapter 13.
[2] Olson, Mancur (1971) Theory of Collective Action. Harvard University Press
[3] E.g. Alesina, Hommes, Hausmann, and Stein 1996