Snowdon & Vane Modern Macroeconomics

1947–72 and concluded that ‘given both casual and formal evidence of economic behaviour, and the historical record in the countries examined, it is clear that a political business cycle is a significant factor in the operation of some capitalist economies’ (Nordhaus, 1975, emphasis added). Later, Nordhaus (1989) argued that there can be no monocausal explanation of the political influences on economic cycles, but in his view the impact of ideological considerations remained secondary to opportunistic behaviour.

Perhaps the best example of opportunistic behaviour was observed towards the end of the first term of Richard Nixon’s Presidency in the USA. The deliberately induced 1970–71 recession was quickly reversed by expansionary policies in the run-up to the 1972 election. According to Tufte (1978), Nixon ensured that all social security recipients received a letter in the period just before the 1972 presidential election. With each letter was a cheque containing a social security benefits increase of 20 per cent. Apparently Nixon was concerned that his defeat by Kennedy in 1960 was due to the failure of President Eisenhower to reflate the economy. It is therefore hardly surprising that Richard Nixon has been described by Rogoff (1988) as the ‘all time hero of political business cycles’.

Given the potentially serious nature of this phenomenon, Nordhaus suggested a number of possible remedies which included increasing the information available to voters and entrusting monetary policy to an independent central bank (see section 10.13).

10.7The Hibbs Partisan Model

In the Nordhaus model there is policy convergence in that all governments behave in the same opportunistic way, and all voters are assumed to have identical preferences over inflation and unemployment. An alternative approach is to view voters and politicians as ideological or partisan. Politicians view winning elections as a means of putting into action their partisan programme and heterogeneous voters will clearly have different preferences over inflation and unemployment. Hibbs (1977) examined the post-war patterns of economic policies and outcomes in 12 advanced capitalist democracies for the period 1945–69 in order to test the proposition that leftand rightwing governments have different preferences with respect to the trade-off between inflation and unemployment. In particular, Hibbs argues that his evidence supports the proposition that left-wing governments prefer a lower

˙

U, higher P outcome than right-wing governments. We can represent this difference in preferences in terms of differences in loss functions. Equations (10.8) and (10.9) show the loss (cost) functions in terms of unemployment and inflation for two parties, a right-wing party = CR, and a left-wing party = CL (see Alesina, 1987).

Hence there is evidence supporting the Hibbs model that systematic differences exist in the policy choices and outcomes of partisan governments. Hibbs argues that this is in line with the subjective preferences of the classbased political constituencies of rightand left-wing political parties.

10.8The Decline and Renaissance of Opportunistic and Partisan Models

The 1970s were a turbulent time for the capitalist democracies as the ‘Golden Age’ of low inflation, low unemployment and above average growth came to an end. The stagflation crisis of the 1970s also brought to an end the Keynesian consensus which had dominated macroeconomic theory and policy making in the quarter-century following the Second World War. In the wake of the monetarist counter-revolution, Lucas inspired a rational expectations revolution in macroeconomics. By the mid-1970s models which continued to use the adaptive expectations hypothesis were coming in for heavy criticism from new classical theorists, as the hypothesis implies that economic agents can make systematic errors. In market-clearing models with rational expectations the assumption that economic agents are forward-looking makes it more difficult for the policy maker to manipulate real economic activity. There is no exploitable short-run Phillips curve which policy makers can use. Preelection monetary expansions, for example, will fail to surprise rational agents because such a manoeuvre will be expected.

The rational expectations hypothesis also implies that voters will be for- ward-looking and will not be systematically fooled in equilibrium. According to Alesina (1988), ‘the theoretical literature on political business cycles made essentially no progress’ after the contributions of Nordhaus (1975), Lindbeck (1976) and MacRae (1977) because of the ‘devastating’ effect of the rational expectations critique. The Nordhaus model involves an exploitable short-run Phillips curve trade-off combined with myopic voters. Once the rational expectations hypothesis is introduced, however, voters can be expected to recognize the incentives politicians have to manipulate the economy for electoral profit. Given that US presidential elections are held on a regular four-year basis, it is difficult to believe that rational voters and economic agents would allow themselves to be systematically duped by the macroeconomic manipulations of self-interested politicians. Moreover, it is difficult to reconcile the predictions of the Nordhaus model with situations where monetary policy is conducted by an independent central bank, unless government can in some way pressurize the central bank to accommodate the incumbent government’s preferred monetary policy (on this see Havrilesky, 1993; Woolley, 1994). However, Blinder, in discussing this issue, denies that political pressure was an issue during his period as Vice Chairman at the US Federal

Reserve, 1994–6. In his experience the political influence on monetary policy was ‘trivial, next to zero’, although he agrees that this was not the case during the Richard Nixon–Arthur Burns era (see Snowdon, 2001a).

The Hibbs model also has major theoretical shortcomings, especially with respect to the stability of the Phillips curve trade-off implicit in his analysis. Remarkably, Hibbs makes no mention of the expectations-augmented Phillips curve in his 1977 paper even though the Friedman–Phelps theory was a decade old and by then a well-established idea, even among Keynesians (see Gordon, 1975, 1976; Blinder, 1988b, 1992a; Laidler, 1992a). The assumption of rationality also has implications for the Hibbs model. Since the output and employment effects of expansionary and contractionary demand management policies are only transitory in new classical models, the identification of partisan influences on macroeconomic outcomes will be harder to detect (see Alesina, 1989). Alt (1985) concluded that partisan effects are not permanent but occur temporarily after a change of government.

In addition to the theoretical shortcomings of the early political business cycle literature, the Nordhaus model also failed to attract strong empirical support, with the econometric literature yielding inconclusive results (see Mullineux et al., 1993). While McCallum (1978) rejected the implications of the Nordhaus model for US data, Paldam (1979) could only find weak evidence of a political business cycle in OECD countries. Later studies, such as those conducted by Hibbs (1987), Alesina (1988, 1989), Alesina and Roubini (1992), Alesina and Roubini with Cohen (1997) and Drazen (2000a, 2000b), also find little evidence of a political business cycle in data on unemployment and GNP growth for the US and other OECD economies. This also applies where the timing of elections is endogenous (see Alesina et al., 1993). More favourable results for the Nordhaus model are reported by Soh (1986), Nordhaus (1989), Haynes and Stone (1990) and Tufte (1978), who found some evidence of preelection manipulation of fiscal and monetary policy for the USA. In addition, Drazen (2000a) distinguishes between empirical predictions that focus on policy outcomes (inflation, unemployment, growth) and those that focus on policy instruments (taxes, government expenditure interest rates) and concludes that ‘the evidence for opportunistic manipulation of macroeconomic policies is stronger than for macroeconomic outcomes’. With respect to policy outcomes there is more support for the opportunistic political business cycle theory coming from post-electoral inflation behaviour than can be found in the preelectoral movement of real GDP and unemployment. Drazen also concludes that the evidence in favour of opportunistic manipulation of policy instruments is much stronger for fiscal policy than it is for monetary policy.

A significant problem for partisan theories in general is the argument and evidence presented by Easterly and Fischer (2001) that low inflation helps the poor more than the rich. Inflation acts as a financial tax that hits the poor

disproportionately because they tend to hold more of their wealth in cash relative to their income than the rich, whereas the rich are more likely to have access to various financial instruments that allow them to hedge against inflation. In addition the poor obviously depend more on minimum wages and state-determined income payments that are not always indexed to protect against the effects of inflation (see Snowdon, 2004b). Easterly and Fischer present evidence drawn from an international poll of over 30 000 respondents from 38 countries and the responses indicate that the poor themselves are more strongly averse to inflation than those with higher incomes. This undermines a key assumption of Hibbs’s model that the rich are more inflation-averse than the poor.

By the mid-1980s the politico-economic literature had reached a new ebb. Zarnowitz (1985), in his survey of business cycle research, devotes one footnote to the idea of an electoral cycle and refers critically to the ‘strong’ and ‘questionable’ assumptions of such models as well as the lack of supporting evidence. The same neglect is also a feature of Gordon’s (1986) edited survey of The American Business Cycle.

Following a period of relative neglect, the literature on the relationship between politics and the macroeconomy underwent a significant revival since the mid-1980s (see Willet, 1988). Economists responded to the rational expectations critique by producing a new generation of rational politico-economic models. Like the first phase in the 1970s, the second phase of politicoeconomic models consisted of opportunistic and partisan versions of the interaction between politics and the macroeconomy. In the next two sections we examine the main features of rational political business cycle models and the rational partisan theory.

10.9Rational Political Business Cycles

Recent work in the political business cycle tradition has shown that some of the insights of Nordhaus (1975) can survive even in a model with rational expectations, providing there is asymmetric information between voters and policy makers. In other words, voters need not be myopic in order for politicians to generate political business cycles. Optimal policies are only likely in a world of political competition when there is unanimity about social objectives and symmetric information between agents, voters and politicians. Since these conditions are unlikely ever to hold, politicians have the opportunity to follow non-optimal policies. Providing there is some element of imperfect information, so that forward-looking voters are not fully informed about some characteristics of the political and economic environment, incumbents have the opportunity of creating ‘a temporary illusion of prosperity’ (Alesina, 1989) in order to gain favour with the electorate.

In the rational opportunistic models proposed by Cukierman and Meltzer (1986), Rogoff and Sibert (1988), Rogoff (1990) and Persson and Tabellini (1990), electoral cycles are created in policy variables such as government spending, taxes and monetary growth, and such cycles are made possible by temporary information asymmetries. Although rational voters aim to choose politicians who they believe can deliver the highest utility, they lack information on the competence of different policy makers. Voters acquire information on competence by observing outcomes. Therefore before elections the incumbents engage in a ‘signalling process’ which aims to persuade voters that the politicians in power are competent. Such signalling is always observed in the UK during the Chancellor of the Exchequer’s annual budget speech, especially just before an election.

Rogoff and Sibert define competence as the ability to reduce waste in the budget process; that is, competent governments can produce more public goods and transfers for a given amount of tax revenue. Incumbents have the potential to create a temporary fiscal boost (or fail to impose necessary tax increases), which is popular with voters. Because the budgetary process is so complicated the inevitable post-election tax increases needed to finance the pre-election boost are not foreseen even by rational voters, due to their incomplete information. Rather than generating a regular inflation–unem- ployment cycle as in the Nordhaus model, rational political business cycle theories predict the manipulation of various policy instruments before and after the election. The temptation of incumbents to cut taxes and increase spending before an election in order to appear competent clearly generates departures from optimality. Hence opportunistic behaviour survives in rational opportunistic models, although such models give rise to a different set of empirical predictions compared to the original Nordhaus model. In particular, because of rational expectations, any cycles resulting from the manipulation of monetary and fiscal policies will be predicted to be less regular and of shorter duration.

Finally, we should note that developing-country governments appear to behave in a similar way to their counterparts in richer countries. In a study of 35 developing countries Schuknecht (1996) found ‘considerable evidence’ in favour of election-generated fiscal policy cycles although the opportunities for self-interested political behaviour are less in more open economies.

10.10Rational Partisan Theory

As noted earlier, Hibbs (1977), in his partisan theory of macroeconomic policy choices, argued that parties of the left will systematically select combinations of unemployment and inflation which differ from those preferred by right-wing parties. Following the rational expectations revolution, theo-

rists questioned the ability of policy makers to influence real economic activity using aggregate demand management policies. Alesina, in a series of publications, has shown that the partisan theory of political business cycles can survive in models incorporating rational expectations providing (i) voters are uncertain about election outcomes, and (ii) uncontingent labour contracts are signed for discrete periods and are not subject to renegotiation after the election result is declared (see Alesina, 1987, 1988, 1989). In Alesina’s model economic agents cannot enter into state-contingent nominal wage contracts that provide insurance against electoral risk. Central to the rational partisan theory is the idea that the political systems of many industrial democracies are polarized. Alesina rejects the traditional view of politicians’ behaviour associated with Downs (1957) that vote-maximizing politicians in a two-party system will generate a convergence of policies, as both parties choose the policies favoured by the median voter (see also Minford and Peel, 1982). In the partisan theory politicians are ideological and adopt different policies when in power. ‘There is no presumption that in a multi-party system with self-interested politicians one should observe policy convergence’ (Alesina, 1989). In the case of the USA, empirical work has shown that although the degree of polarization has varied throughout American history, the Republican and Democratic parties have never fully converged (Alesina and Rosenthal, 1995). This in part reflects the fact that a presidential candidate has to appeal to the median voter in his/her own party in order to win the nomination. ‘Since the platform adopted in the primary is a constraint on the choice of platform for the presidential elections, even self-interested politicians may have to choose polarized policies’ (Alesina, 1989). Alesina follows Wittman (1977) and Hibbs (1977) and emphasizes the ideological preferences of politicians who aim to please their supporters by implementing policies which are likely to lead to a redistribution of income in their favour. Hence the rational partisan theory shows how parties follow different macroeconomic strategies because of their impact on the redistribution of income. It is assumed that voters are well aware of these ideological differences between the parties. In this framework macroeconomic policies create shortrun aggregate disturbances because rational voters are uncertain about election results. When Republicans or Conservatives are elected, economic agents are confronted in the period immediately following the election with a deflationary shock, that is, inflation is lower than expected. When Democratic and Socialist governments are elected, the opposite occurs. There is a larger than expected ‘inflation surprise’. It is the combination of election outcome uncertainty combined with ideological differences between the two parties that leads to aggregate instability in Alesina’s model. If a common macroeconomic policy could be agreed between the two political parties aggregate fluctuations would be reduced.

The ‘eclectic’ macroeconomic framework adopted by Alesina is based on Fischer’s (1977) well-known rational expectations model which includes a labour market where nominal wage contracts are signed and extend for considerable time periods (see Chapter 7). The ‘neutrality’ result or ‘policy ineffectiveness proposition’ associated with Lucas (1972a) and Sargent and Wallace (1975) depends on perfect (instantaneous) wage and price flexibility as well as agents having rational expectations (see Chapter 5). Fischer (1977) demonstrated that the crucial assumption for new classical results is instantaneous market clearing. With nominal wage contracts, an element of price stickiness is introduced into the model and in a non-market-clearing setting policy effectiveness is restored with monetary policy having real effects on aggregate output and employment. When ideological politicians use monetary policy in such a setting a rational partisan business cycle is generated.

How does this come about? Consider equations (10.10)–(10.13) below.

Ignoring capital accumulation, equation (10.10) shows that the rate of output growth (yt) depends on the natural rate of growth of output (yNt) and posi-

˙

tively on the difference between the rate of inflation (Pt ), and nominal wage

˙

growth (Wt ), that is, the path of real wages. (By Okun’s Law unemployment and output are assumed to be inversely related and the natural rate of output growth is that which is compatible with the natural rate of unemployment.) Alesina uses output growth rather than the level of output since this is the variable that empirical research uses to capture partisan effects on the economy. If we assume that non-indexed nominal wage contracts lasting one period (for example, two years) are drawn up with the objective of maintaining a real wage consistent with natural output growth, we derive equation (10.11),

which shows that nominal wage growth is set equal to the current expected

˙ e rate of inflation (Pt ) :

Unlike the situation in the Nordhaus and Hibbs models, agents form their expectations rationally. The rational expectations hypothesis is given in equation (10.12):

Here E is the mathematical expectations operator and It–1 indicates the information which has been accumulated by economic agents up to the end of time period t–1. By combining (10.10) and (10.11) we arrive at equation

(10.13), which tells us that output growth will deviate from its natural rate if there is an inflation surprise, that is, an unexpected change in monetary policy:

In rational partisan models it is assumed that the incumbent politicians have the ability to control the rate of inflation by monetary policy. Since party preferences with respect to the extent of aversion to inflation differ, with the right being assumed to be more averse than the left, an election which brings about a change of government will lead to an inflation surprise, causing output to deviate from its natural growth path. Agents have rational expectations but are uncertain about forthcoming election results. Because agents sign nominal wage contracts before the election result is known, the rate of inflation forthcoming after the election can differ from the rational expectation of inflation formed by wage negotiators in the pre-election period. Consider the following possible sequence of events. Suppose the current administration is a party of the left (Democrats in the USA, Labour in the UK). Following Hibbs (1977), we can assume that left-wing governments have a reputation for wanting to lower unemployment. Wage negotiators, if they assume that the incumbents will win the election, will sign nominal wage contracts which have built into them a high expected rate of inflation. Even if the right-wing party looks like winning the election, risk-averse negotiators will probably sign contracts involving inflation expectations higher than would have been the case if agents knew for certain that the right would win. If a Conservative (inflation-averse) government replaces the left-wing incumbents, they will begin to tighten monetary policy in order to reduce inflation, thus creating a surprise which has not been built into the wage contracts. As a result, following an election victory by a Republican or Conservative party, the Alesina rational partisan theory predicts a recession in output growth and a rise in unemployment as inflation declines. The opposite sequence of events would follow a change in government from right to left (Maloney et al., 2003). In the period following an election, left-wing governments expand the economy and reduce unemployment. Eventually, when inflationary expectations adjust to the new situation, output growth returns to the natural rate but the economy is locked into an equilibrium with high inflation. The election of parties of the left will, according to Alesina’s model, be followed by a cyclical pattern which is the opposite of that predicted by the Nordhaus model. In both cases expectations are assumed to adjust to the actual rate of inflation in the second half of a term of office, and from equation (10. 13) we can see that output growth will settle back to its natural rate for both rightand left-wing governments during this period of the electoral cycle. Since