Snowdon & Vane Modern Macroeconomics

in order to protect their economic rents (Parente and Prescott, 2000). In contrast, Daron Acemoglu and James Robinson in a series of papers advocate a ‘political losers’ hypothesis’ as an alternative and more plausible explanation of why there emerge institutional barriers to development (see, for example, Acemoglu and Robinson, 2000a).

10.17Political Barriers to Economic Growth

Economists have a good idea of the broad requirements that are needed for economic growth, or rather they at least know what not to do! And yet many governments continue to choose to maintain what everyone knows to be disastrous policies and institutions that inhibit or even destroy incentives, productivity growth and entrepreneurial activity. Such regimes are also characterized by excessive corruption (Aidt, 2003). Since policies and institutions seem to be ‘first-order’ determinants of the economic performance of countries, why don’t governments learn from their mistakes and switch to better policies? What explains the persistent and repeated adoption and maintenance of inefficient institutions and proven bad policies (Robinson, 1998)? This is clearly one of the most important contemporary questions in political economy. Is there a rational choice explanation that does not have to assume that dysfunctional political leaders, such as Mobutu in Zaire, are simply mad or irrational and ideologically blind to reason?

Acemoglu (2003b) and Acemoglu and Robinson (2000a, 2000b, 2000c, 2001, 2003) provide a political perspective on the origin and persistence of economic backwardness. Their main line of argument runs as follows:

1.the introduction of new technology that will enhance economic efficiency and economic growth will also influence the distribution of political power;

2.groups who feel that their political power will be eroded as a result of the introduction of new technology will deliberately block such change even if it is to the overall benefit of society;

3.although new technology will increase future output, and hence the revenue of the politically powerful groups, the incumbent élite also fear that new technology will enhance the power of competing groups thereby threatening the future of the élite;

4.therefore there is a trade-off facing any élite between the potential rents that can be earned from allowing technological progress and the threat to the élite’s monopoly of political power;

5.serious commitment problems prevent the élite from supporting growthenhancing technological, institutional and policy changes and then redistributing a part of the gains to themselves;

6.external threats may shock an élite into accepting change, for example, the programme of ‘defensive modernization’ adopted in Japan in the late nineteenth century following the Meiji restoration in 1868.

Using this framework, Acemoglu and Robinson examine the history of political change and industrialization in the USA, Britain, Germany, AustriaHungary (the Hapsburg Empire), and Russia. They argue that where political élites are subject to competition they are forced to accept change or be replaced. Where an élite is deeply entrenched they are also likely to accept change more readily. However, where an élite is insecure they will block change. In the case of both Russia and Austria-Hungary unconstrained absolute monarchies resisted the forces of industrialization because they feared that this would lead to a loss of political power. In contrast, in the USA, where political competition is guaranteed by the constitution and the opportunity to extract rents is restricted by the separation of powers, change was encouraged and promoted. In Britain, where the landed aristocracy that made up the élite were ‘sufficiently entrenched’, incremental political change accompanied the Industrial Revolution. A similar story characterizes the German experience in the latter part of the nineteenth century.

Many of the worst cases of development failure have involved countries that have suffered from the personal rule of ‘kleptocrats’ who use their political power as a means to control assets and expropriate the wealth of their citizens on a massive scale, usually for their own (their families’ and their close supporters’) consumption and glorification. The best-known kleptocratic regimes include those of Trujillo (Dominican Republic, 1930–61), the Duvaliers (Haiti, 1957–86), Mobutu (Zaire, 1965–97), Amin (Uganda, 1971–9), the Somozas (Nicaragua, 1936–79) and Marcos (the Philippines, 1965–86). As Acemoglu et al. (2003b) point out, one of the most puzzling features of kleptocracies is their longevity. Why don’t the oppressed majority overthrow the kleptocrat? Acemoglu et al. suggest that this longevity is the result of ‘weakly institutionalised polities’ that allow the kleptocrat to operate a ‘divide and rule strategy’. The kleptocrat is able to survive by intensifying the collective action problem, thereby destroying the coalition against him by bribing the pivotal groups (Bates, 1981, 2001). In turn, the feasibility of a divide and rule strategy is enhanced if the kleptocrat has easy access to natural resource rents (oil, diamonds, copper and so on) and foreign aid flows (see Easterly, 2003; Sala-i-Martin and Subramanian, 2003). Kleptocractic regimes are also more likely to appear in low-income per capita countries where bribes are more attractive to pivotal groups.

Where ethnic diversity is a feature of a country, the kleptocrat will use this as a basis for divide and rule, with certain ethnic groups receiving bribes in order to buy off their opposition. Mauro (1995) links political instability to

ethno-linguistic fractionalization and the impact that this has on the quality of institutions. Easterly and Levine (1997) also trace much of sub-Saharan Africa’s poor economic performance to political instability related to ethnic diversity (see also Collier, 2001; Alesina et al., 2003).

10.18The Size of Nations

Since the late 1990s several economists have been using the tools of modern economic analysis to explore the determinants of the size of nations (see Alesina and Spolare, 1997, 2003; Bolton and Roland, 1997; Alesina et al., 2000, 2005). Although historians and other social scientists have studied this issue, economists ‘have remained on the sidelines’. Of particular interest to economists is the observation of Alesina et al. (2005) that there has been a dramatic increase in the number of nations since the end of the Second World War. In 1948 there were 74 countries, 89 in 1950, and 192 in 2001. They also note that the world ‘now comprises a large number of relatively small countries: in 1995, 87 of the countries of the world had a population of less than 5 million, 58 had a population of less than 2.5 million, and 35 less than 500 thousands’. The proliferation of countries has also led to too many separate currencies (Alesina and Barro, 2002; Alesina et al., 2002). During this same period the second age of globalization has emerged and the share of international trade in world GDP has ‘increased dramatically’ (Snowdon, 2002a, 2003c). Is there a connection? Alesina et al. (2005) make the following important points:

1.political borders are made by humans and are not exogenous geographical features;

2.economists should think of the equilibrium size of nations (measured by total population) ‘as emerging from a trade-off between the benefits of size and the costs of preference heterogeneity in the population’;

3.the main benefits of size are as follows: economies of scale with respect to the production of public goods such as defence, maintenance of law and order, public health and so on; greater safety from foreign aggression; internalization of cross-regional externalities; better income insurance to regions subject to specific shocks; transfers of income across regions to achieve greater equity among the overall population; a larger internal market increases the potential for greater specialization, as noted by Adam Smith;

4.in a world of free trade, country size, as measured by population, is no longer a determinant of market size;

5.it therefore follows that ‘the benefits of country size decline as international economic integration increases’;

6.the benefits of international economic integration increase the smaller is a country;

7.economic integration and political disintegration are positively correlated;

8.the costs of size include administrative and congestion costs, but much more important are problems associated with the heterogeneity of preferences of individuals, which obviously increase with the size of a nation;

9.using ethno-linguistic fractionalization as a proxy for heterogeneity of preferences economists have found that ethnic diversity is inversely correlated with economic performance, the quality of governance, and economic and political freedom (see Alesina et al., 2003);

10.as international economic integration increases, the trade-off between the benefits of size of a nation and the costs in terms of heterogeneity of preferences shifts in favour of small nations.

This work has important implication for the future of the European Union (EU). EU enlargement clearly increases the heterogeneity of preferences and economic integration lowers the benefits of country size, thereby reducing the costs of independence for small countries. As Alesina et al. (2005) note, ‘many have argued that Europe will (and perhaps should) become a collection of regions loosely connected within a European confederation of independent regions’.

Research by economists on the determinants of the size of nations is in its infancy. However, many interesting relationships remain to be explored, including the interconnection between international integration, democracy, the size of nations and international conflict.

10.19Conclusion

Since the late 1980s there has been a major revival of political economy utilizing the tools of modern economic analysis. A common theme running throughout this ‘new political economy’ is the need to integrate the political process into mainstream economics. In the midto late 1970s the seminal contribution of Nordhaus (1975) reawakened interest in the idea of political business cycles, an idea which can be traced back to the work of Schumpeter and Kalecki. However, for a period following the rational expectations revolution, interest in politico-economic models lost momentum. The theoretical shortcomings and inconclusive empirical results of the non-rational opportunistic and partisan models led to a temporary demise of this line of research. On the empirical front Alt and Chrystal (1983) declared that ‘no one could read the political business cycle literature without being struck by the lack of

supporting evidence’. While interest in the politico-economic approach ebbed, new classical theorists were busy following through the policy implications of rational expectations market-clearing models. The emphasis in these models on policy ineffectiveness and rationality was initially interpreted as being inconsistent with politically motivated policy manipulations. Nevertheless, new rational politico-economic models have been successfully developed which incorporate features such as asymmetric/imperfect information, noncontingent nominal wage contracts and uncertainty over election results. The policy-making process does not consist of a benevolent dictator taking advice from economists in order to maximize social welfare; rather it consists of a complex game played out by various competing groups whose interests do not coincide.

While the importance given to political influences in causing aggregate instability in industrial democracies remains highly controversial, few commentators would challenge the view that politicians, faced with a regular election cycle, will tend to develop short time horizons. The desire to be re-elected or regain office may lead politicians to pursue or promise an economic policy package which creates aggregate economic instability. If this line of argument is accepted, then it follows that what is needed is an institutional framework which creates an environment conducive to the more frequent implementation of sustainable economic policies geared to longer-term objectives. The dilemma faced in industrial democracies is how to constrain the over-zealous short-term discretionary actions of politicians through institutional reform without threatening the basic principles of democratic government. Trying to find a solution to this dilemma will ensure that the relationship between economic and electoral cycles will remain a rich and fertile area of research for macroeconomists.

Not only have economists enhanced our understanding of aggregate instability by adding a political dimension to their models; they have also explored the deeper determinants of growth miracles and disasters. In doing so they have highlighted the important constraint on economic growth imposed by ‘bad’ institutions and policies. Recent research has explored the interaction of politics and economics, yielding new insights into the political economy of economic growth and development, and the impact of international economic integration on the size of nations. These are certainly areas where much more research is required (see Chapter 11).

Just as economic forces cannot be ignored by political scientists, the message coming from the research discussed in this chapter is that economists interested in positive models of economic policy ‘cannot and should not ignore the political arena’ (Alesina, 1988).

ALBERTO ALESINA

Alberto Alesina was born in 1957 in Broni, Italy and obtained his Laurea from the Università Bocconi, Milan in 1981 and his PhD from Harvard University in 1986. His main posts have included: Assistant Professor of Economics at Carnegie-Mellon University (1986–8); Assistant Professor of Economics and Government (1988–90) and Associate Professor of Political Economy (1990–93) at Harvard University. Since 1993 he has been Professor of Economics and Government at Harvard University.

Professor Alesina is best known for his contributions, in terms of both theoretical analysis and empirical investigation, to the various forms of interaction between politics and macroeconomics; and his influential work on politico-economic cycles, the origin and implications of fiscal deficits, and the relationship between political stability and economic growth. Among his best-known books are: Partisan Politics, Divided Government and the Economy

(Cambridge University Press, 1995), co-authored with H. Rosenthal; Political Cycles and the Macroeconomy (MIT Press, 1997), co-authored with N. Roubini; and The Size of Nations (MIT Press, 2002), co-authored with E. Spolare. His most widely read articles include: ‘Macroeconomic Policy in a Two-Party System as a Repeated Game’, Quarterly Journal of Economics (1987); ‘Political Cycles in OECD Economies’, Review of Economic Studies (1992), co-authored with N. Roubini; ‘Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence’, Journal of Money,

Credit, and Banking (1993), co-authored with L. Summers; ‘Distributive Politics and Economic Growth’, Quarterly Journal of Economics (1994), coauthored with D. Rodrik; and ‘The Political Economy of the Budget Surplus in the US’ , Journal of Economic Perspectives (2000).

We corresponded with Professor Alesina in March/April 1997.

Background Information

How did you become interested in economics and where did you study as an undergraduate and postgraduate student?

In high school I was very interested in socio-political problems. I thought that economics was the most rigorous of the social sciences. As an undergraduate I studied at Università Bocconi in Milan, Italy [1976–81] and took both my Masters degree and PhD at Harvard University [1982–6].

Which papers and/or books have influenced your research interests?

I have been much more influenced by ‘facts’ rather than by specific papers or books and have always been very interested in the policy-making process. The basic fact which has always impressed me is how different actual policy making is from the predictions of models which assume social planners and a representative consumer. I always noted how in politics discourse is about redistributive conflicts while in most macroeconomic models distributive issues are absent.

Is there any aspect of the Italian economy and/or political system that stimulated your interest in the link between economics and politics?

Yes: the inability of government after government in Italy to address serious fiscal problems has been an important influence. More generally, thinking about Italy made me wonder about the relationship between political fragmentation and economic performance.

Do you regard yourself as belonging to any identifiable school of thought in macroeconomics?

No.

Keynes and Keynesianism

Was Keynes naive in assuming that economic policy should be, and would be, carried out in the public interest?

If we can characterize Keynes’s view as such, I would say yes, although I think that your question oversimplifies his view.

The idea that aggregate demand policy matters because of lack of complete price flexibility.

The Political Business Cycle

Prior to Michal Kalecki [1943] were there other economists who anticipated the possibility of a political business cycle?

Not that I know of.

To what extent could the deep UK recession of 1979–82 be viewed as being politically induced? For example, it can be argued that the then Prime Minister, Margaret Thatcher, used high unemployment in order to restore the health of British capitalism, a development consistent with Kalecki’s model.

Thatcher’s recession was the result of the need for disinflation. I am not sure that unemployment is needed ‘in order to restore the health of capitalism’. Unemployment is in part a cyclical phenomenon, in part the result of supply-side rigidities. This latter influence is particularly strong in the European economies.

How important are macroeconomic variables for voting behaviour?

In the USA, the rate of GNP growth is extremely important, inflation and unemployment somewhat less so. In other countries the evidence is less clear cut, in part due to differences in the electoral systems. In general, the state of the economy is very important for elections but how this effect manifests itself may vary dramatically from one country to another.

Nordhaus’s [1975] model is intuitively very appealing. What do you regard to be its main strengths and weaknesses?

Its main strength is that it makes a simple powerful point which is easily testable. Its main weaknesses are that it is based on the assumption of extremely naive behaviour, and also has very weak empirical support.

How can voters (principals) ensure that their agents (the politicians) refrain from opportunistic behaviour which creates economic inefficiencies?

Mainly with the threat of voting them out of office.

Non-Rational Partisan Theory

What do you regard to be the important contributions of Hibbs [1977] to the development of politico-economic models?

Hibbs played an important role by introducing ideological–partisan differences and moved attention away from models in which it was assumed that all politicians have identical motivations.

How strong is the evidence that inflation is more harmful to higher income than lower income groups?

The evidence on this is not very strong. How harmful inflation is depends on the level of inflation and various institutional arrangements, such as indexation.

For the post-war period as a whole, is the empirical evidence supportive of the partisan view that left-of-centre governments favour and achieve lower unemployment than right-of-centre governments? Have left-of-centre administrations also been associated with higher inflation than right of centre administrations?

To some extent yes. However, the success of left-wing governments in reducing unemployment has only been temporary. After taking into account structural breaks such as the break in exchange rate regime in the early 1970s, the oil shocks and so on, it is true that left-of-centre governments have been associated with higher inflation than those right of centre.

Rational Expectations and Business Cycle Models

Do you attribute the decline of interest in politico-economic explanations of the business cycle between the late 1970s and mid-1980s to theoretical developments associated with Robert Lucas and the rational expectations revolution or was empirical failure a more important factor?

I think that the ‘rational expectations revolution’ was a much more important contributing factor to the decline of interest in such models. Furthermore, empirical ‘failures’ have not stopped economists investigating this matter further in the 1990s.

An important criticism of democratic markets is that voters are, in most cases, uninformed. For each voter the benefits of gaining more information will be outweighed by the costs. In this world of imperfect information is it not inevitable that politicians will engage in opportunistic fiscal behaviour prior to elections?

To some extent this is the case, but I would not overemphasize this point for several reasons. First, if this were the main explanation for budget deficits, it should apply (more or less) to every democracy. Thus one should not observe such large differences in fiscal policies in OECD democracies. Second, large deviations from efficient policies, such as huge deficits in election years, are easily observable, if not by the individual voter, then certainly by the press. Third, I do not know of any conclusive evidence which shows that larger deficits favour the re-election of an incumbent. I think that in practice what happens all the time is that in election years fiscal favours may not be very