Snowdon & Vane Modern Macroeconomics

economic independence). Using this framework the Bank of England was granted instrument (economic) independence but not goal (political) independence in May 1997. The distinction between goal and instrument independence can be used to illustrate the difference between the two main models of independent central banks which have been developed in the theoretical literature. The first model is based on Rogoff’s (1985) ‘conservative central banker’. In this model an inflation-averse conservative central banker is appointed who ensures that inflation is kept low in circumstances where it would otherwise be difficult to establish a pre-commitment to low inflation. Rogoff’s inflation-averse central banker has both goal and instrument independence. The result is lower average inflation but higher output variability. The second model, associated with Walsh (1995b), utilizes a principal–agent framework and emphasizes the accountability of the central bank. In Walsh’s contracting approach the central bank has instrument independence but no goal independence, and the central bank’s rewards and penalties are based on its achievements with respect to inflation control. However as Walsh (1995a) notes:

An inflation-based contract, combined with central bank independence in the actual implementation of policy, achieves optimal policy outcomes only if the central bank shares social values in trading off unemployment and inflation. When the central bank does not share society’s preferences, the optimal contract is no longer a simple function of inflation; more complicated incentives must be generated to ensure that the central bank maintains low average inflation while still engaging in appropriate stabilization policies.

While the New Zealand Federal Reserve Bank, which was set up following the 1990 reforms, resembles the principal–agent model, the German Bundesbank, before EMU, comes close to the conservative central banker of the Rogoff model. In Fischer’s (1995a) view, the important conclusion to emerge from this literature is that ‘a central bank should have instrument independence, but should not have goal independence’.

In recent years many countries have set about reforming the institutions of monetary policy. Such countries include those of the former ‘Eastern bloc’ of communist economies as well as those from Latin America and Western Europe. Most have adopted some variant of the principal–agent approach whereby the central bank is contracted to achieve clearly defined goals, provided with the instruments to achieve these desired objectives, and held accountable for deviating from the chosen path (see Bernanke and Mishkin, 1992; Walsh 1995a). In the New Zealand model the central bank governor is accountable to the finance minister. This contrasts with the German Bundesbank, which was held accountable to the public. In both Canada and the UK, emphasis has been placed on inflation targeting. Failure to meet inflation targets involves a loss of

reputation for the central bank. In the case of the UK, the approach adopted since 1992 has involved inflation targeting combined (since May 1997) with operational independence for the Bank of England (see Chapter 7).

One of the main theoretical objections to central bank independence is the potential for conflict that this gives rise to between the monetary and fiscal authorities (see Doyle and Weale, 1994). An extensive discussion of the problems faced by policy makers in countries where monetary and fiscal policies are carried out independently is provided by Nordhaus (1994). In countries where this has led to conflict (for example in the USA during the period 1979–82) large fiscal deficits and high real interest rates have frequently resulted. According to Nordhaus this leads to a long-run rate of growth which is too low. The tight monetary–easy fiscal mix is hardly surprising given the predominant motivations driving the ‘Fed’ and the ‘Treasury’ in the USA. Whereas independent central banks emphasize monetary austerity and low stable rates of inflation, the fiscal authorities know that increased government expenditure and reduced taxes are the ‘meat, potatoes and gravy of politics’ (Nordhaus, 1994). In this scenario the economy is likely to be locked into a ‘high-deficit equilibrium’. Self-interested politicians are unlikely to engage in deficit reduction for fear of losing electoral support. These coordination problems which a non-cooperative fiscal–monetary game generates arise inevitably from a context where the fiscal and monetary authorities have different tastes with respect to inflation. At the end of the day these problems raise a fundamental issue. Should a group of unelected individuals be allowed to make choices on the use of important policy instruments which will have significant repercussions for the citizens of a country? In short, does the existence of an independent central bank threaten democracy (see Stiglitz, 1999a)? What is clear is that independence without democratic accountability is unacceptable (Eijffinger, 2002b).

There is now an extensive literature related to the issue of central bank independence. The academic literature has pointed to the various reasons why industrial democracies have developed an inflation bias in which governments are allowed discretion in the operation of fiscal and monetary policies. In contrast to Rogoff (1985), Alesina and Summers (1993) point to the empirical evidence which, for advanced industrial countries, shows that inflation is negatively correlated with the degree of central bank independence without this having significant adverse effects on real growth and employment in the long run. Central bank independence seems to offer a ‘free lunch’! However, this issue is made more complicated by the causes of output variability. Alesina and Gatti (1995) distinguish between two types of variability which can contribute to aggregate instability. The first is economic variability resulting from different types of exogenous shocks to aggregate demand and/or supply. The second type is political or policy-induced and has

been the subject of this chapter. Rogoff’s conservative central banker does not react much to ‘economic shocks’. However, Alesina and Gatti (1995) argue that an independent central bank will reduce policy-induced output variability. Hence the ‘overall effect of independence on output induced variability is, thus, ambiguous’. It follows that in cases where policy-induced variability exceeds that resulting from exogenous shocks, a more independent central bank can reduce inflation and the variance of output, a result consistent with the Alesina and Summers (1993) data. To the critics, central bank independence is no panacea and the Alesina–Summers correlations do not prove causation (Posen, 1995). In addition, the numerous domestic and international policy coordination problems which independence can give rise to could outweigh the potential benefits. In the face of powerful ‘economic’ shocks a conservative and independent central bank may not be superior to an elected government.

10.14The Political Economy of Debt and Deficits

During the mid-1970s several OECD countries accumulated large public debts. This rise in the debt/GNP ratios during peacetime among a group of relatively homogeneous economies is unprecedented and difficult to reconcile with the neoclassical approach to optimal fiscal policy represented by the ‘tax smoothing’ theory. While countries such as Greece, Italy and Ireland had accumulated public debt ratios in excess of 95 per cent in 1990, other countries such as Germany, France and the UK had debt ratios in 1990 of less than 50 per cent (Alesina and Perotti, 1995b).

In order to explain the variance of country experience and the timing of the emergence of these rising debt ratios, Alesina and Perotti (1995b) argue that an understanding of politico-institutional factors is ‘crucial’. In explaining such wide differences Alesina and Perotti conclude that the two most significant factors are:

1.the various rules and regulations which surround the budget process; and

2.the structure of government; that is, does the electoral system tend to generate coalitions or single party governments?

In the face of large economic shocks weak coalition governments are prone to delaying necessary fiscal adjustments. While a ‘social planner’ would react quickly to an economic shock, in the real world of partisan and opportunistic politics a ‘war of attrition’ may develop which delays the necessary fiscal adjustment (see Alesina and Drazen, 1991). Persson and Tabellini (2004) have investigated the relationship between electoral rules, the form of government and fiscal outcomes. Their main findings are that: (i) majoritarian

elections lead to smaller government and smaller welfare programmes than elections based on proportional representation; and (ii) presidential democracies lead to smaller governments than parliamentary democracies.

Research by Alesina and Perotti (1996b, 1997a) also indicates that the ‘composition’ of a fiscal adjustment matters for its success in terms of its sustainability and macroeconomic outcome. Two types of adjustment are identified: Type 1 fiscal adjustments rely on expenditure cuts, reductions in transfers and public sector wages and employment; Type 2 adjustments depend mainly on broad-based tax increases and cuts in public investment. Alesina and Perotti (1997a) find that Type 1 adjustments ‘induce more lasting consolidation of the budget and are more expansionary while Type 2 adjustments are soon reversed by further deterioration of the budget and have contractionary consequences for the economy’. Hence any fiscal adjustment that ‘avoids dealing with the problems of social security, welfare programs and inflated government bureaucracies is doomed to failure’ (see Alesina, 2000). Type 1 adjustments are also likely to have a more beneficial effect on ‘competitiveness’ (unit labour costs) than policies which rely on distortionary increases in taxation (see Alesina and Perotti, 1997b).

10.15Political and Economic Instability: Are They Related?

A further related area of research in the politico-economic sphere concerns the relationship between political and economic stability (see Carmignani, 2003). There are good reasons to believe that economic performance will suffer if a country is politically unstable. Frequent riots, politically motivated violence and revolution inevitably have a negative impact on a country’s economic performance. As Keynes always highlighted, uncertainty has a depressing effect on investment and productive entrepreneurship.

Alesina’s partisan theory predicts that instability will increase the greater the partisan effects because widely divergent policies create uncertainty and destabilize expectations. It is also unlikely that reputational considerations will be important to a government which feels that it has little chance of being re-elected. In this situation an incumbent has an ‘incentive to follow particularly shortsighted policies, since it is not concerned with a future in which it is likely to be out of office’ (Alesina, 1989).

A further destabilizing influence on policy arising from political instability derives from the inability of fragile coalition governments to carry through the tough but necessary economic policies crucial for long-run stability. Alesina (1989) finds a positive correlation between an index of political instability and Okun’s misery index (inflation + unemployment) for the period 1973–86. An exception in his 20-country sample is the UK, which managed to combine relatively poor economic performance during this pe-

riod despite having a high degree of political stability. In Alesina and Drazen’s (1991) analysis of why necessary stabilization policies are frequently delayed, they consider a situation where two parties with different ideologies engage in a war of attrition as they each attempt to pass on the burden of fiscal reform to the other party’s supporters. The resultant delay and government inaction in the reform process leads to debt accumulation and crisis before one of the parties is forced to accept a larger share of the fiscal burden. As Drazen (2000a) notes, ‘the failure to adopt socially beneficial economic reforms or their adoption only after long delays is a leading example of the divergence between the simple textbook models of economic policymaking and real world experience’.

Considerable cross-country evidence now exists which indicates that seigniorage (the inflation tax) is positively related to the degree of political instability. In a study of 79 developed and developing countries for the period 1971–82, Cukierman et al. (1992) found evidence in support of their hypothesis that ‘more unstable countries rely relatively more on seigniorage to finance the government budget than do stable and homogenous societies’. These conclusions are also supported by Edwards (1994), who found that the incentive to use inflationary finance is closely related to the volatility of the political system. In the extreme, hyperinflation may erupt (see Capie, 1991; Siklos, 1995; Fischer et al., 2002).

10.16The Political Economy of Economic Growth

One of the most important adverse effects of political instability is its negative impact on economic growth. In Chapter 11 we discuss several strands in the new growth literature that focus on the deeper determinants of growth, including politics and institutions. Drazen (2000a) argues that the political economy of growth literature is a natural extension of the research on the political economy of income redistribution and in this chapter we review some recent research into the links between inequality, economic growth, dictatorship and democracy (see Alesina and Perotti, 1994; Alesina and Rodrik, 1994; Persson and Tabellini, 1994; Alesina and Perotti, 1996c; Benabou, 1996; Deininger and Squire, 1996; Aghion et al., 1999; Barro, 2000; Forbes, 2000; Lundberg and Squire, 2003).

In exploring the connection between inequality and economic growth we first of all need to distinguish between the ‘old’ view and the ‘new’ view. The old view dominated thinking in development economics throughout the 1960s and 1970s and is captured in the work of economists such as Arthur Lewis (1954) and Richard Nelson (1956). The old view is dominated by ‘capital fundamentalism’; that is, capital accumulation is the key to economic growth. Capital fundamentalism is associated in particular with the wide acceptance

and use of the Harrod–Domar growth model within the development literature and development institutions such as the World Bank (see Easterly, 1999, 2001a, and Chapter 11). In order to foster high rates of accumulation, in the absence of substantial inflows of foreign capital, a country must generate the necessary resources through high rates of domestic saving. It was assumed that inequality of income would produce this result since the rich were assumed to have a higher propensity to save than the poor (see Kaldor, 1955). This view is encapsulated in the following statement by Harry Johnson (1958):

There is likely to be a conflict between rapid growth and an equitable distribution of income; and a poor country anxious to develop would be probably well advised not to worry too much about the distribution of income.

Another reason why inequality may lead to faster growth is linked to the idea of investment indivisibilities, that is, the setting up of new industries frequently involves very large sunk costs. Meeting these costs in poorly developed countries with inadequate financial markets requires the concentration of wealth. Finally, it was also argued that without adequate incentives, investment rates would remain insufficient to generate sustained growth

That there was a trade-off between growth and equity dominated early postSecond World War development thinking. In addition, the ‘Kuznets hypothesis’ suggested that as countries develop, inequality will initially increase before declining (see Kuznets, 1955). Hence the relationship between inequality and GDP per capita shows up in both time series and cross-sectional data as an inverted U-shaped relationship. Barro’s (2000) empirical results confirm that the Kuznets curve remains a ‘clear empirical regularity’.

As economic development spread across the world during the latter half of the twentieth century it became clear that there was an increasing number of successful development stories where outstanding rates of economic growth were achieved without those countries exhibiting high degrees of income inequality, namely the Asian Tigers. In addition many countries, for example in Latin America, with high inequality had a poor record of economic growth. Hence, during the last decade there has been a change in thinking on this issue. Several economists have begun to emphasize the potential adverse impact of inequality on growth, an idea that had already been propounded by Gunnar Myrdal (1973). Aghion et al. (1999) conclude that the old view that inequality is necessary for capital accumulation and that redistribution damages growth ‘is at odds with the empirical evidence’.

Various mechanisms have been suggested as possible causes of a negative association between inequality and subsequent growth performance (see Alesina and Perotti, 1994). The credit market channel highlights the limited access to finance that the poor have in order to invest in human capital formation. Since in this environment most people have to rely on their own resources to finance

education, a reduction in inequality could increase the rate of human capital formation and economic growth. A second ‘fiscal’ channel highlights the distortions and disincentive effects of taxation introduced under political pressure to reduce high inequality. Redistribution of income, by raising the tax burden on potential investors, reduces investment and consequently economic growth (Alesina and Rodrik, 1994; Persson and Tabellini, 1994). A third channel suggests that high inequality leads to a larger number of agents engaging in rent seeking, corruption and criminal activities. These activities threaten property rights and the incentive to invest. Glaeser et al. (2003) develop a model where inequality adversely influences economic outcomes by threatening property rights due to the subversion of legal, political and regulatory institutions by a rich, powerful élite. The answer to this problem is not to replace ‘King John redistribution’ with ‘Robin Hood distribution’, that is, not to replace an old corrupt oligarchy with a bureaucratic socialist oligarchy. Rather, the solution lies in institutional reform. According to Olson (2000), there are two key requirements for any society to prosper: first, the establishment of secure and well-defined individual rights with respect to private property and impartial enforcement of contracts, as capitalism is first and foremost a legal system; and second, the ‘absence of predation of any kind’. The empirical evidence suggests that there ‘is no society in the post-war world that has fully met the two foregoing conditions’. But clearly some economies have come much closer to the ideal than others and this is generally reflected in their long-term economic performance (Olson, 1996). Gyimah-Brempong’s (2002) empirical analysis of corruption, economic growth and inequality in Africa finds that corruption is positively related to income inequality and hurts the poor more than the rich. To understand the political roots of economic success is a crucial research area for social scientists because, as Table 10.5 indicates, sub-Saharan Africa’s ‘Subjective indictors of governance’ make depressing reading. Fajnzylber et al. (2002) have also shown that violent crime is positively correlated to inequality and their results are robust after controlling for the overall level of poverty. Furthermore, Alesina and Perotti (1996c) show that inequality promotes social and political unrest and the threat of violence and revolution reduces growthenhancing activities. These conclusions are empirically ‘quite solid’ (see also Alesina et al., 1996).

Albert Hirschman (1973) also drew attention to the impact of inequality on growth via what he labelled ‘the tunnel effect’, which consists of the following basic propositions:

1.in the early stages of development and growth there is a high tolerance for growing inequalities;

2.this tolerance erodes through time if the low income groups fail to benefit from the growth process;

Notes:

aUNDP, Human Development Report, 2002.

bChambers Political Systems of the World, Edinburgh: Chambers.

cUNDP (2002). In the scoring range –2.5–2.5, higher is better. The highest scores for each category are:

Switzerland for Voice and accountability (1.73); Switzerland for Rule of law (1.91);

Singapore for Government effectiveness (2.16); Finland for the Corruption index (2.25).

The UK scores 1.46, 1.61, 1.77 and 1.86 respectively for each category.

3.in the long run persistent and growing inequalities in a developing country are likely to lead to ‘development disasters’ as internal tensions, fuelled by inequality, lead to political instability.

Hirschman argues that individuals assess their individual welfare in relative terms, that is, by comparing their own income with that of others. Even if the

poor make some modest gains in terms of real income, the fact that other groups make spectacular progress will lead to feelings of relative deprivation. Hirschman uses the analogy of motorists stuck in a traffic jam in a two-lane tunnel, both lanes heading in the same direction. If the traffic is stationary in both lanes, drivers will initially show patience in the hope that soon the blockage will be removed. If the one lane of traffic then begins to move, those who are not yet moving initially have their hopes raised. Soon they to expect to be on their way. So initially the ‘tunnel effect’ is strong and the drivers who are not moving wait patiently for their turn to move. But if one lane of traffic continues to move, and at an ever-increasing pace, while the other lane remains blocked, very soon the drivers in the static lane will become furious at the injustice they are being subjected to and they will be prepared to engage in ‘foul play’, dangerous acts of driving and maybe even in severe violence (road rage) towards the drivers in the unblocked lane. In other words, as long as the ‘tunnel effect’ lasts, everyone feels better off even though it involves increased inequality. But once the ‘tunnel effect’ wears off there is potential for revolution and demand for political change. That change may take place with or without violent disruption. This seems to be an accurate description of the experience of several developing countries.

A fourth channel is one that derives from Murphy et al.’s (1989b) reinvigorated version of the ‘Big Push’ theory. Here the idea is that successful industrialization requires a large market in terms of domestic demand in order to make increasing-returns technologies profitable. A high degree of income inequality, by suppressing domestic demand, inhibits the development of an economic environment conducive to facilitating a ‘Big Push’ on economic development.

The various mechanisms whereby inequality impacts on economic growth are illustrated in Figure 10.6. As Alesina and Perotti (1996c) recognize, some of these channels work in opposing directions. The distortionary effect of taxes on the incentive to invest operating through the fiscal channel will tend to reduce growth, but at the same time may also reduce social tensions and thereby reduce the threat of political instability. ‘Therefore the net effect of redistributive policies on growth has to weigh the costs of distortionary taxation against the benefits of reduced social tensions’.

Is there any way of linking the old view to the new view of the impact of inequality on growth? In an interview Acemoglu suggests the following possibility (see Snowdon, 2004c):

One way of linking the ‘old inequality is good for growth’ story with the newer stories that ‘inequality is bad for growth’ is as follows. Think of a model where in the early stages of development, by giving resources and political power to the same group, this leads to higher rates of investment. But suppose also, that in a dynamic world these people who are rich and powerful are no longer the ones

Credit market imperfections: the poor forego investment in human capital

Inequality promotes redistribution: tax distortions reduce work effort and

entrepreneurship Reduced economic

growth

Inequality promotes rent seeking, crime and political instability

‘Big Push’ theory: industrialization requires a large domestic market and inequality represents an obstacle

Figure 10.6 How inequality may adversely affect growth

who can take advantage of the changing economic opportunities. The entrenched groups with political power become an unproductive oligarchy resistant to change. They utilise their economic and political power to block the entry of new more dynamic groups of people. This reverses the relationship between inequality and growth. The high inequality countries are those that begin to stagnate. Of course this is conjecture squared [laughter]. But it is a story that is consistent with the history of the Caribbean economy.

It is becoming increasingly clear from economists’ research that institutional failures frequently prevent a country from adopting the most productive technologies. Some economists have suggested an ‘economic losers’ hypothesis’ whereby powerful interest groups resist the adoption of new technology