Snowdon & Vane Modern Macroeconomics

there are no election surprises in the second half of an administration’s term of office, real variables settle down to their natural rates. However, because left-wing governments will be locked into a high-inflation equilibrium in Alesina’s model, they may feel obliged to fight inflation before the next election. President Carter found himself in such a situation in 1979–80.

We can now summarize the predictions of the rational partisan theory of the business cycle:

A1 A change to a Conservative or Republican government will be followed by a recession and rising unemployment. Once inflationary expectations have been reduced, output growth returns to its natural rate. Inflation is low as the next election approaches.

A2 A change to a Labour or Democratic government will be followed by an acceleration of inflation as the economy expands more rapidly. Unemployment will initially fall. Once inflationary expectations adjust, output growth returns to its natural rate but inflation remains high. Should a government of the left attempt to fight inflation in the run-up to the next election, it will create a recession.

A3 The stronger the ideological convictions of the two parties, the greater will be the disturbance to output and employment following a change of policy regime after an election.

A4 Unlike the Hibbs model, the rational partisan theory predicts that differences in unemployment and growth resulting from changes in government will only be a temporary phenomenon.

10.10.1Empirical evidence for rational partisan cycles

A considerable amount of empirical work has been done in recent years to test the rational partisan theory (see Alesina and Sachs, 1988; Alesina, 1989; Alesina and Roubini, 1992; Alesina and Rosenthal, 1995). These studies have found supporting evidence for temporary partisan effects on output and employment and long-run partisan effects on the rate of inflation as predicted. For the USA systematic differences have been found to occur in the first half, but not the second half, of a large number of administrations. This evidence is reported in Table 10.3. Although the rational partisan theory of Alesina and the political business cycle model of Nordhaus (1975) give similar predictions for Republican and Conservative administrations, the data in Table 10.3 do not show, on average, evidence of opportunistic behaviour. In line with the predictions of the Alesina model, ‘Every Republican administration in the post-World War II period except Reagan’s second one has started with a recession. No recessions have occurred at the beginning of Democratic administrations’ (Alesina, 1995). The deep recessions in the US and UK economies following the elections of President Reagan and Prime Minister

Note: a Oil shocks.

Source: Economic Report of the President, 1992 (cited in Alesina, 1995).

Thatcher conform very well to predictions A1 and A3 above. Prediction A2 fits very well the experience in France in the period 1981–3. During the early part of the French Socialist administration of Mitterand, expansionary policies were pursued initially, even though many other major economies were in recession. Both President Mitterand and President Carter in the USA ended their administrations trying to fight inflation, although it should be recognized that the second OPEC oil-price shock complicates matters in the case of the Carter administration.

Alesina concludes that the more recent rational versions of politico-eco- nomic models of cycles have been much more successful empirically than the earlier models of Nordhaus and Hibbs. In particular, ‘partisan effects’ appear to be ‘quite strong’ while ‘opportunistic effects’ appear to be ‘small in magni-

tude’ and seem to affect only certain policy instruments, particularly fiscal variables (see Alesina, 1995). It is also well documented that during the Reagan and Thatcher administrations the income distribution consequences of the micro and macro policies were ‘particularly partisan’. Inequality increased under both administrations (see Alesina, 1989).

10.10.2Criticisms of the rational partisan theory

There are a number of important weaknesses in the rational partisan theory. First of all, if the cyclical effects are due to the signing of wage contracts before an election, then one obvious solution is to delay the signing of contracts until the election result is known. This solution is, of course, not as applicable where the timing of elections is fixed endogenously. However, in the USA wage contracts are staggered and overlapping, which means that at least a significant proportion of wage contracts will inevitably go over the election date. A second important criticism is that, in line with other models which assume nominal wage rigidity, the Alesina model implies a countercyclical real wage which is at odds with the stylized facts of the business cycle. For theoretical purists a third criticism relates to the lack of firm microeconomic foundations in such models to explain the mechanism of nominal wage contracting. Alesina (1995) describes this as the ‘Achilles heel’ of the rational partisan theory. A fourth line of criticism originates from the most recent generation of equilibrium business cycle theories. According to real business cycle theorists, monetary policy cannot be used to produce real effects on output and employment, although they agree that monetary growth determines the rate of inflation. In real business cycle models aggregate fluctuations are determined mainly by shocks to the production function, and such shocks are endemic. The pre-electoral behaviour of politicians and postelectoral monetary surprises are largely irrelevant. A benign monetary policy would not bring to an end aggregate fluctuations (see Chapter 6). A fifth criticism relates to hysteresis effects. If the natural rate properties of rational partisan models do not hold due to persistence effects following an aggregate demand disturbance, the political business cycle may be turned ‘upside down’ (see Gartner, 1996). A sixth criticism relates to the empirical evidence. In an extensive survey Carmignani (2003) concludes that monetary policy is not the source of political cycles in real variables (see also Drazen, 2000a, 2000b). Finally, some theorists argue that partisan and opportunistic models are not incompatible and a more complete model should incorporate both influences (see Frey and Schneider, 1978a, 1978b; Schultz, 1995). It is to this latter criticism that we now turn.

10.11Opportunistic and Partisan Behaviour: A Synthesis

We have seen in our earlier discussion that opportunistic theories of the political business cycle assume that politicians are only office-motivated. Their macroeconomic policies are designed to win elections. Partisan theories stress ideological considerations and reject the assumption made in opportunistic theories that all parties will follow the same policies. Partisan theory rejects policy convergence. An alternative hypothesis is to follow the suggestion of Frey and Schneider (1978a, 1978b) that political parties behave in an opportunistic way when their chances of re-election are perceived to be low. Governments can use independent surveys to assess their popularity. When a party is ‘popular’ and confident of winning the next election, it can afford to indulge in ideological policies. Frey and Schneider (1978a) suggest that ‘a government’s lead over the opposition is determined by both the state of the economy and the election cycle’. This latter feature is the tendency of the incumbents to become less popular between elections (see also Alesina and Rosenthal, 1995). Incumbent politicians want to be re-elected in order to implement their ideological programmes, but may face an incentive structure which varies at each election. Because the temptation to use opportunistic policies is strongest when governments do not feel confident they can win the next election, opportunistic behaviour will be an increasing function of the incumbents’ political insecurity. Such an approach can account for the lack of systematic evidence in support of opportunistic behaviour. Where political security is an important factor opportunistic policy manipulations should be observed before some elections but not all (see Schultz, 1995).

When considering the use of policy manipulations which have as their objective the maximization of re-election prospects, incumbents need to consider the marginal benefits and marginal costs of such policies. The marginal benefits of opportunistic behaviour, in the form of extra votes, are greatest when the government has a large popularity deficit. However, policy manipulations also generate extra costs to the incumbents in the form of loss of reputation, and this could damage long-term partisan support (see Schultz, 1995). Schultz argues that ‘by engineering a pre-election boom, governments already open themselves up to charges of irresponsibility and opportunism’. However, ‘when governments feel insecure in the current election, they can ill afford the luxury of being far-sighted and hence they discount the future quite heavily’. From these observations Schultz formulates the following hypothesis: ‘The degree to which the government manipulates the economy prior to an election will be negatively correlated with its lead in public opinion polls at the time.’ Given the potential costs of policy manipulations, it is also the case that governments should only respond to popularity deficits close to the next election. Schultz tested this hypothesis for the manipulation

of UK government transfer payments, which have significant and instantaneous effects on real disposable income. Schultz found that, with the exception of the October 1974 election, there is a clearly discernible negative correlation between growth of real transfers and the pre-election poll lead of the incumbents. These results are suggestive. The strength of the political business cycle effect in generating opportunistic behaviour will differ from one election to the next ‘because the government’s incentives also differ from one election to the next’ (Schultz, 1995). Clearly more research is needed in this area. Table 10.4 summarizes the main features of the five main politicoeconomic models of aggregate fluctuations.

In his survey of what economists have learned from 25 years of research into the political business cycle, Drazen (2000b) concludes with a ‘clear message’ that:

monetary surprises are an unconvincing force for political cycles, either opportunistic or partisan; research should concentrate on fiscal policy as the driving force, especially for opportunistic cycles. Political monetary cycles are more likely the effect of accommodation of fiscal impulses, that is, are passive while fiscal policy is active in trying to affect election outcomes.

10.12Politics, Time Inconsistency, Credibility and Reputation

Following the incorporation of the rational expectations hypothesis into macroeconomic models, the theoretical literature on economic policy has been dominated by the game-theoretic approach. Policy makers are seen to be engaged in a complicated dynamic game with private sector economic agents (who are also voters). This literature was stimulated by the seminal paper of Kydland and Prescott (1977), who raised the general problem of time inconsistency of policy (see Chapter 5). According to Kydland and Prescott, governments that are free from rules (pre-commitment) so that they can use discretionary policies will be unable to persuade rational agents that they will stick to low-inflation policies. Agents know that if they lower their inflation expectations the government will have an incentive to cheat and, by creating an inflation surprise, increase employment temporarily. However, because rational agents are aware of the policy makers’ incentives, the time-consistent policy involves an inflationary bias. If a government has discretion, lowinflation declarations are time-inconsistent and are not credible. Therefore a credible policy announcement can be defined as one which is time-consistent. Solutions to the time-inconsistency problem include contractual arrangements, delegation of decisions and institutional and legal constraints (see Drazen, 2000a).

As we have already seen, in industrial democracies subject to regular democratic elections, politicians have an incentive to deviate from optimal

policies and create an inflation surprise. In the Nordhaus model there is an incentive to expand the economy before an election in order to gain votes. This is possible in the Nordhaus model because the policy makers never lose credibility due to the assumption of non-rational economic agents and myopic voters. In models with rational expectations and forward-looking voters, policy makers are under pressure to establish their credibility and reputation (see Blackburn and Christensen, 1989). By reputation in this context economists are referring to ‘the actions that policymakers are expected to take’ (Drazen, 2000a). In a game-theoretic context the reputation of a player will depend on the way they have played and reacted to events in the past. Rational agents will only believe politicians who make ex ante policy announcements which are also optimal to implement ex post. However, rational agents have imperfect information about the real motives of politicians as opposed to their pre-election promises. Therefore private sector agents will need to analyse carefully the various signals that politicians give out. In this scenario it may be difficult for voters to distinguish ‘hard-nosed’ (inflationaverse) from ‘wet’ (inflation-prone) politicians since the latter will always have an incentive to masquerade as ‘hard-nosed’ (see Backus and Driffill, 1985).

Alesina (1987) has shown that the prediction of the median voter theorem, that in a two-party system there will be policy convergence, is time-inconsist- ent. In the period before an election both parties find it in their interest to announce convergent policies on the assumption that this will appeal to the median voter. Ideological issues take back stage in order to maximize reelection prospects. However, because there is no mechanism for holding an elected government to its promises, these announced convergent policies must be time-inconsistent. After the election the influence of partisan considerations will predominate as the elected politicians re-optimize and follow a programme which best fits their ideological stance. Thus the time-consistent equilibrium involves no policy convergence and the two parties ‘follow their most preferred policy’ (Alesina and Tabellini, 1988). This inevitably creates too much volatility in policy making which, in turn, causes politically induced business cycles.

It follows from the above analysis that only those pre-election announcements and promises which are consistent with a party’s ideology should be taken seriously by voters. Once elected, politicians will tend to follow a more partisan strategy. This may prove to be a particular problem for parties of the left that declare themselves to be ‘tough on inflation’. Given the underlying assumptions of the Hibbs (1977) and Alesina (1987) models that politicians on the left give a high priority to reducing unemployment, voters may well look with suspicion at pronouncements claiming an aversion to inflation. Inflation-prone parties have an incentive to masquerade as ‘hard-nosed’ on

this objective. Rational voters are likely to interpret such signalling as the ‘dissembling actions of an impostor’ (Blackburn, 1992). An implication of this is that ‘a low inflation policy announced by a government concerned with unemployment would not be credible; indeed if expected inflation was low, this government would create an inflation surprise in order to reduce unemployment’ (Alesina, 1989).

These issues were very pertinent in the UK in the run-up to the 1997 election. The ‘New’ Labour Party, led by Tony Blair, declared that it intended to be ‘tough on inflation’ and that it also aimed to achieve much lower unemployment. In terms of Alesina’s model, the statement on inflation is clearly time-inconsistent. However, to give credibility to its anti-inflation rhetoric, on winning the 1997 election, new Labour immediately granted operational independence to the Bank of England (see Snowdon, 1997).

10.13Policy Implications of Politico-Economic Models: An Independent Central Bank?

In introducing ‘The New Monetary Policy Framework’ for the UK economy on 6 May 1997, which established ‘operational independence’ for the Bank of England, Chancellor Gordon Brown, in an official statement, provided the following rationale for the government’s strategy (Brown, 1997, emphasis added):

We will only build a fully credible framework for monetary policy if the longterm needs of the economy, not short-term political considerations guide monetary decision-making. We must remove the suspicion that short-term party political considerations are influencing the setting of interest rates.

Chancellor Brown’s decision to grant much greater independence to the Bank of England had its origins in a 1992 Fabian Society paper entitled ‘Euro Monetarism’, written by Ed Balls, Brown’s economic adviser. As a former student of Larry Summers at Harvard, Balls was familiar with the empirical work on central bank independence produced by Alesina and Summers (1993). In a visit to the USA in March 1997, Shadow Chancellor Brown and his economic adviser met both Alan Greenspan and Larry Summers. And so was born the strategy to go for immediate greater central bank independence if elected.

The general debate on the relative merits of rules versus discretion in the conduct of fiscal and monetary policy was given a new stimulus by the research surveyed in Chapters 5 and 7. Since the non-optimal use of monetary and fiscal instruments lies at the heart of the various strands of the political business cycle literature, most of this work points towards the desirability of establishing a policy regime which curtails the incentives policy

makers have to engage in destabilizing policies. The new classical contributions of Kydland and Prescott (1977) and Barro and Gordon (1983a), which highlighted time-inconsistency, credibility and reputational issues, have provided extra weight to the case for monetary rules associated with the work of Friedman (1968a). The politico-economic literature has also shown how strong partisan or opportunistic behaviour can generate a non-optimal outcome for aggregate variables. However, in order to make policy rules credible, some sort of enforcement mechanism is required. For this reason many economists in recent years have argued in favour of institutional reform involving the establishment of an independent central bank (see Goodhart, 1994a, 1994b). The assumption lying behind this argument is that such an institution (at least in principle) is capable of conducting monetary policy in a manner free from opportunistic and partisan influences. In addition, fiscal policy will also be subject to a harder budget constraint, providing the independent central bank is not obliged to monetize deficits (see Alesina and Perotti, 1995a). Greater central bank independence was also one of the objectives contained in the Maastricht Treaty, which sought to bring about some fundamental changes in national banking legislation in anticipation of European monetary union (see Walsh, 1995a, 1995b).

The case for central bank independence is usually framed in terms of the inflation bias present in the conduct of monetary policies. Such an inflation bias is evident from the relatively high rates of inflation experienced in industrial countries in the 1970s and early 1980s. Because a majority of economists emphasize monetary growth as the underlying cause of sustained inflation (see Lucas, 1996), it follows that prolonged differences in countries’ rates of inflation result from variations in their rates of monetary expansion. Any plausible explanation of these ‘stylized facts’ must therefore include an understanding of central bank behaviour (Walsh, 1993). In particular, we need to identify the reasons why monetary policy is conducted in a way that creates a positive average rate of inflation which is higher than desirable. There are several reasons why monetary authorities may generate inflation. These include political pressures to lower unemployment in order to influence re-election prospects, partisan effects as emphasized by Hibbs and Alesina, dynamic inconsistency influences and motivations related to the financing of deficits. The last is particularly important in economies with inefficient or underdeveloped fiscal systems (see Cukierman, 1994).

The theoretical case for central bank independence in industrial democracies relates to a general acceptance that the long-run Phillips curve is vertical at the natural rate of unemployment. This implies that although monetary policy is non-neutral in the short run, it has little effect on real variables such as unemployment and output in the long run. With no exploitable long-run trade-off, far-sighted monetary authorities ought to select a position on the

vertical Phillips curve consistent with a sustainable objective of price stability (see Goodhart, 1994b; Cukierman, 1994).

The empirical case for central bank independence is linked to cross-coun- try evidence which shows that for advanced industrial countries there is a clear negative relationship between central bank independence and inflation (see Grilli et al., 1991; Cukierman, 1992; Alesina and Summers, 1993; Eijffinger and Keulen, 1995; Eijffinger, 2002a). It should be noted, however, that this negative correlation does not prove causation and fails to hold for a larger sample of countries which includes those from the developing world (see Jenkins, 1996). Poor countries with shallow financial markets and unsustainable budget deficits are unlikely to solve their inflation problems by relying on the creation of an independent central bank (Mas, 1995). However, at least as far as advanced industrial democracies are concerned, the theoretical and empirical work suggests that monetary constitutions should be designed to ensure a high degree of central bank autonomy.

Although the success of the independent German Bundesbank in delivering low inflation over a long period of time inspired other countries to follow its example, it is also clear that some important problems emerge with the measurement, form and consequences of central bank independence. First, the whole question of independence is one of degree. Although before May 1997 the Federal Reserve had much more independence than the Bank of England, it is clear that legal independence does not (and cannot) completely remove the influence of ‘monetary politics’ (see Mayer, 1990; Havrilesky, 1993; Woolley, 1994). For example, Chappell et al. (1993) show how partisan influences on the conduct of monetary policy can arise through presidential appointments to the Board of Governors of the Federal Reserve. Through these ‘political’ appointments and other forms of presidential signalling (moral suasion) the Federal Reserve’s monetary policy making can never be totally independent of political pressures. Nevertheless, considerable research effort has been made in recent years to measure the extent of central bank independence in a large number of countries (see Cukierman, 1992; Eijffinger and Keulen, 1995; Healey, 1996). According to Cukierman, four sets of indices can be used to identify the degree of independence of a central bank:

(i) legal indices; (ii) questionnaire-based indices; (iii) the turnover of central bank governors; and (iv) the political vulnerability of the bank. However, such studies and their implications have come in for considerable criticism (see Jenkins, 1996).

In discussing the form of central bank independence, Fischer (1995a, 1995b) introduces the distinction between ‘goal independence’ and ‘instrument independence’. The former implies that the central bank sets its own policy objectives (that is, political independence) while the latter refers to independence with respect to the various levers of monetary policy (that is,