Monday, 7 July 2014

Political economy of debts and deficits (4): Hypotheses explaining debt accumulation

The fourth (and final) part of the PE of debts and deficits closes with the last three hypotheses explaining debt accumulation in the past 40 years in many industrial economies. In the end it includes the suggested literature used in all four posts: Intro, Theory, Hypotheses pt 1.

4. Models of distributional conflicts

Theories about distributional conflicts suggest that delays in addressing the deficit issue reflect war of attrition among parties that cannot agree on the distribution of the fiscal burden required for consolidation. Such situations could occur particularly in weak coalition governments that do not share the same distributional agenda.

For example, when an external shock influences the government budget so as to increase the deficit, the social planner government (a standard benchmark assumption in political economy models) would immediately choose to close it either via revenue increases or spending cuts (he would enact a stabilization effect), but a coalition government would engage into a series of trade-offs between what is the optimal policy response: which group(s) should bear a higher burden in terms of spending cuts and/or tax hikes? Each coalition member will attempt to protect the interests of their own voter group (their ideological or economic “constituency”). Naturally the party which caves in to the pressure will be the looser (in terms of both reputation and voter support). No one wants to accept such a position.

In such cases, parties might postpone the decision to address debt until a crisis finally forces them to act. The more unequal is the distribution of stabilization costs among social groups the later is the expected time of stabilization (the policy reaction).

Here again political stability comes to the fore, as empirical research suggests that more durable governments are more prone to be fiscally conservative. These models tend to have the highest empirical support for their underlying assumptions, since it can indeed be verified that unstable, coalition governments on average result in larger deficits and higher debt levels.

5. Models of geographically dispersed interests

Models of geographically dispersed interests are a realization of the common pool problem where the groups are geographically dispersed rather than socio-economically. These are typical pork-barrel spending models, where in majoritarian political systems political representatives (Congressmen) overestimate the benefits of public projects in their own districts (constituencies) relative to the costs of financing which are distributed nation-wide. The total effect will be an oversupply of local public goods (“bridges to nowhere”).

Such models don’t explain the deficit problem directly, but they do explain the overinflated size of government spending which indirectly increases the deficit. However empirically local pork-barrel spending only marginally affects the national budget, but this does differ from country to country, depending on the level of centralization. In general such models don’t explain the accumulation of debt so much as they do the increase of inefficient spending and potential local government corruption.

6. Models emphasizing the role of budget institutions

The last and recently most popular stream of literature has focused on the effects of different institutional characteristic of government and budgetary procedures on budget outcomes.

Budgetary procedures (or budgetary institutions) represent all the rules and regulations according to which budgets are drafted, approved and implemented. Since they tend to vary between countries they could provide an explanation for varying fiscal policy outcomes. They can have an influence on policy outcomes if they are more difficult to change than the budget law itself. If a country has enforceable and transparent fiscal rules and conducts fiscal policy according to these rules instead of discretion, it will generally exhibit lower deficits and lower public debt levels.

Empirical research suggests that budgetary procedures that give larger authority to Prime Ministers or Ministers of finance do better in terms of lower deficits and debts than systems with more dispersed authority. Furthermore procedures that increase transparency also lead to more prudent fiscal policies.

In terms of electoral institutions Persson and Tabellini (2000) find that majoritarian electoral systems (the two-party US or UK system) are more fiscally conservative than proportional systems (European electoral systems). This can however be linked to the persistence of strong, centralized governments on one hand and weak coalition governments on the other hand. The hypotheses above clearly explain why such weak coalition governments are more fiscally irresponsible than one-party governments. Persson and Tabellini (2000) also find that presidential systems tend to be less fiscally wasteful and have lower deficits and lower budgets in general than parliamentary systems. This can be explained via the relative agenda-setting power given to the President, which isn’t a characteristic of parliamentary systems. In addition parliamentary systems are also more prone to coalitions and the common-pool problem.

If we accept the assumption that policy outcomes are influenced by politico-institutional variables then in order to improve policy making one has to intervene at an institutional level. One can either change budgetary formation legislation via implementing new fiscal rules, or by changing electoral laws so as to increase political accountability and decrease the incentives for wastefulness.

One of the most commonly advocated reforms of the budget process is the introduction of a balanced budget law, or more generally, regulations which limit the discretion of governments in running deficits. A potential cost of such strict rules is the loss of flexibility in reacting to exogenous shocks. This can be averted by introducing a cyclically adjusted budget rule. However , as mentioned above, in each case politicians will rather cut investment spending or hit at social groups with lack of political power rather than to undermine their support groups.

However, most of these results linking various electoral or budgetary rules to government size and consequently debts and deficits need to be taken with a pinch of salt. The direction of causality can be reversed. Perhaps countries which tend to be fiscally irresponsible design these types of institutions. In addition most of the empirical findings of institutional hypothesis model bound down to the essential differences between an Anglo-Saxon laissez-fair economic model and the European welfare state economic model. Perhaps the difference in debt levels and government size lie in other factors like voter preferences, culture, or some historical trails, and not just mere differences in electoral institutions.

Literature

For those more interested in the topic I recommend the following literature.

Alesina, A. and G. Tabellini (1990) A positive theory of fiscal deficits and government debt. Review of Economic Studies 57, no. 3: 403-414.
Alesina, A. and R. Perotti (1994) “The Political Economy of Budget Deficits”.
Alesina, A. and R. Perotti (1996) “Budget Deficits and Budget Institutions”.
Alesina, A. and N. Roubini (1997) Political Cycles and the Macroeconomy. MIT Press.
Brennan, G., and Buchanan, J. (1980) The Power to Tax: Analytical Foundations of a Fiscal Constitution. Cambridge University Press.
Hibbs (1977) “Political Parties and Macroeconomic Policy” American Political Science Review, Volume 71, Issue 4 (Dec., 1977), 1467-1487
Mueller (2009) Public Choice III. Cambridge University Press.
Nordhaus (1975) “The Political Business Cycle” Review of Economic Studies 42, 169–90.
Olson, Mancur (1971) Theory of Collective Action. Harvard University Press
Peltzman, Sam (1994) “Voters as Fiscal Conservatives“ Quarterly Journal of Economics, 108(2), 327-61.
Persson, T. and L. Svensson (1989) “Why a Stubborn Conservative Would Run a Deficit: Policy with Time-Inconsistent Preferences”. Quarterly Journal of Economics 104(2): 325-45
Persson, T. and G. Tabelini (1990) Macroeconomic Policy, Credibility and Politics. London: Harwood.
Persson, T. and G. Tabellini (2000) Political Economics. Explaining Economic Policy. MIT Press.
Rogoff, K. (1990). Equilibrium Political Budget Cycles. American Economic Review, 80(1). 21-36.

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