Snowdon & Vane Modern Macroeconomics

example, on 20 January 1997 the Shadow Chancellor of the Exchequer, Gordon Brown, promised the electorate that ‘New Labour’ would not increase tax rates if elected. On 21 January 1997 Tony Blair promised not to reverse the Conservative Party’s industrial relations legislation of the 1980s. Does this imply that polarization is less important than it used to be?

In the case of the UK we shall have to wait and see! However, on the more general issue of increasing party convergence, in Political Cycles and the Macroeconomy [1997] we conclude that ‘the idea that political parties are becoming more alike when it comes to macroeconomic management is somewhat exaggerated’. Our view is that while the macroeconomic problems of the 1970s and early 1980s ‘have probably made politicians on both sides of the political spectrum more cautious in terms of macroeconomic management, they have not completely eliminated ideological differences’. Furthermore, we also point out that ‘both left-wing and right-wing governments in the next decade will have to face issues of fiscal retrenchment’ and that ‘partisan conflicts are very likely to explode on how to achieve this goal’.

In your rational partisan models [1987, 1989] you appear to adopt an eclectic approach to your theoretical framework based on a variant of the ‘monetary surprise’ rational expectations model associated with Fischer [1977]. Lucas and other new classical theorists now appear to attach more importance to real shocks as an explanation of post-war macroeconomic fluctuations. Does this not undermine the basis of models based on monetary shocks?

I do not like the view that macroeconomic fluctuations are due to either supply or demand shocks. First, an economy can be subjected to both types of shock. Second, real business cycle models have certainly not been an empirical success. The rational partisan theory does not imply that real shocks do not exist. In fact in empirical testing one may want to control for supply shocks.

What are the essential predictions of the rational partisan theory and have they been supported by empirical work?

The basic idea of the model is that, given the sluggishness in wage adjustments, changes in the inflation rate associated with changes in government create temporary deviations of real economic activity from its natural level. At the beginning of a right-wing government output growth is below its natural level and unemployment is above its natural level. The opposite is predicted for left-wing governments. After expectations, prices and wages adjust, output and employment return to their natural level and the level of economic activity should be independent of the party in office. However, the rate of inflation should remain higher throughout the term of a left-wing

government. These implications of rational partisan theory are consistent with the empirical evidence particularly for a subset of countries with bipartisan systems or with clearly identifiable movements from left to right and vice versa. The rational partisan theory is less applicable, and in fact tends to fail in countries with large coalition governments with frequent government collapses.

In the UK the Conservative Party gained power in the four elections between 1979 and 1992. President Clinton has also been re-elected. What does the rational partisan theory predict will be the effect of the repeated re-election of a particular party?

Strictly speaking, it depends on how unexpected is the re-election. If the Conservative Party had been sure to win in the previous four elections, not much should have happened to the economy. Inflation should have continued to remain low and growth (ceteris paribus) should have been stable. President Clinton was probably less sure of being re-elected. In this case the model predicts that growth should slightly increase in the USA.

What is likely to happen according to your model if a left-of-centre party gains office at the peak of an economic expansion?

According to the model, the left-of-centre party will do as much as possible to avoid a recession, including increasing inflation. If we speak of the UK in 1997, one has to consider other issues which may influence the outcome, such as European Monetary Union. This kind of issue is clearly not considered in the model.

What are the main policy implications of your model for the conduct of macroeconomic policy and the design of political institutions?

The model in its stripped-down version is ‘positive’ rather than ‘normative’, thus it does not have any direct policy implications. However, the model can be used in a normative direction. Let me give a couple of examples to illustrate the point. First, the model suggests that independent central banks, by insulating monetary policy from partisan influences, can reduce the extent of both monetary and real variability. This point is formally derived in my paper with Roberta Gatti [1995]. Second, as for political institutions, the model points towards a trade-off. Proportional electoral systems which result in coalition governments lead to ‘compromise’ and policy moderation. This reduces partisan fluctuations and polarization, but may induce deadlocks in policy making, particularly with respect to fiscal issues. Majoritarian systems leading to two-party systems have the opposite feature, namely more policy polarization but no policy deadlocks. Extreme versions of the two systems are unlikely to be optimal although I regard the

risk of excessive ‘governing by coalition’ to be a particularly significant problem in the European context.

Which is likely to create the most instability: exogenous or endogenous timing of elections?

Endogenous elections undoubtedly generate more frequent elections. Whether that creates more or less instability is less obvious. Italy is a perfect example. One may argue that in the post-war period Italy has been very unstable because it has had numerous government changes and many early elections. On the other hand, one may argue that at least until the early 1990s nothing much ever changed, because the same parties and individuals were always in office.

What are the main weaknesses of the rational partisan theory?

I guess I am not the right person to ask that particular question, but elsewhere [1995] I have pointed out that the Achilles’ heel of the rational partisan theory is that the mechanism of wage formation is postulated exogenously rather than derived from optimal individual behaviour.

Would you agree that rational voters will make their voting decision based on information relating to both the past performance of a political party as well as expected future performance?

Past information has to be used to form expectations about the future. Even voters who are forward-looking have to look backward to form expectations. The question ‘are voters backward or forward-looking?’ is very misleading. Furthermore, I find the research on this point often both confused and confusing. A different, more useful, question is whether the voters use ‘efficiently’ the past information that they have to form expectations about the future. In other words, the question is whether voters use ‘rationally’ their past information. This is a difficult but well-posed question, which is similar to questions raised in finance.

To what extent do opportunistic behaviour and partisan behaviour depend on the confidence of an incumbent administration that it will be re-elected? Is it the case that the more confident an administration is of re-election, the more likely it is to behave ideologically?

Possibly, perhaps likely. I have not seen a ‘rational’ model making this point. Bruno Frey and Freidrich Schneider back in 1978 made this point in their ‘non-rational’ models.

General Macroeconomic Issues

How influential has the literature relating to time inconsistency, credibility and reputation been to the development of politico-economic models?

In my case these contributions have been very influential. I think that this literature has been an important driving force behind the new wave of po- litico-economic models in the 1990s, although it is fair to say that now this literature has a life of its own.

Why do governments create inflation?

One important reason is to try to reduce unemployment. A second reason relates to the financing of budget deficits. Also, when inflation becomes entrenched in the system it is costly to reduce it. These reasons may apply differently to different countries, and at different points in time.

What is the relationship between political and economic instability? How has the UK managed to combine political stability with a relatively poor economic performance in the post-war period? How does this compare to the Italian experience?

The UK has been ‘stable’ but very polarized. Conservative and Labour governments have had very different programmes. On the other hand Italy has had the opposite problem, namely frequent government changes but with always the same people ending up in office. The result for Italy has been a lack of fiscal discipline. However, concepts such as political stability and polarization are difficult to measure in practice.

Should central banks have goal independence as well as instrument independence? What is your view of the contracting approach suggested by Carl Walsh?

Legislatures should set, once and for all, price stability (defined as low inflation, between 0 and 3 per cent) as the sole goal of monetary policy. Central banks should do whatever they want to achieve that goal. I do not know whether you want to call this instrument or goal independence. Carl Walsh [1995a] has produced a good paper but I would like to see further work in a more political direction. For example, how does Walsh’s contracting approach deal with the fact that in the real world we have partisan and opportunistic politicians, rather than benevolent social planners?

Are you in favour of monetary and fiscal rules?

My answer to the previous question covers my views on monetary rules. Personally I am against balanced budget rules for national governments but in favour of such rules for sub-national governments.

Does reducing inflation from moderate rates, say from 10 per cent to 5 per cent, bring any significant real economic benefits in the form of improved performance with respect to employment and economic growth?

If inflation remained stable forever at say 10 per cent, with perfect certainty and everything adjusted, it wouldn’t matter very much. But higher inflation results in more variable and less predictable inflation, which is costly. Thus, on balance I believe that there are benefits in reducing inflation.

Where do you stand on the issue of European Monetary Union? For countries like Italy and the UK do the costs of Monetary Union not outweigh the benefits?

The benefits of Monetary Union have been oversold. There are clearly both pros and cons to such an arrangement. Italy has benefited from the Maastricht target, otherwise it would have done even less to put its ‘house in order’. However, this is not sufficient reason to join a monetary union. Although a full answer to this question would require a whole article, my feeling is that the economic arguments in favour of European Monetary Union are quite weak.

In your view what are the most important lessons and policy implications to arise from recent research into the interaction of politics and the macroeconomy?

First procedures, namely how policies are determined. This matters for the outcome. Second, when thinking about ‘optimal institution building’ one should not ignore conflicts of interests. Third, models based on ‘social planners’ cannot completely explain the empirical evidence and may be misleading or useless if used for policy prescriptives.

What kind of political system is most conducive to macroeconomic stability?

For an OECD economy I would choose an electoral system with a majoritarian emphasis. The American system of presidential–legislative checks and balances has also worked quite well. Different electoral systems imply different choices in the trade-off between moderation and gridlock. An English system is probably at the extreme of the ‘no moderation but no gridlock’ scale. The current Italian system is at the opposite end. Perhaps the US system is a happy medium.

At the moment what research are you currently engaged in and what in your opinion are the important areas of research which macroeconomists should concentrate on in the future?

I am working on three main areas. The first area is the issue of the political economy of major fiscal adjustments where I have already published several

papers with Roberto Perotti. I am also interested in what determines the number and shapes of countries, that is, economic theories of secessions and mergers and their relationship with factors such as geography and trade and so on. For example, see my paper with Enrico Spolare [1997]. Third, I am also researching into the effect of socio-ethnic fragmentation on the choice of fiscal policy in US cities and localities. Personally, I find issues relating to fiscal policy more intriguing than those associated with monetary policy, especially as we know less about the former than the latter. I think that the political economy of social security reforms and, more generally, reforms of the welfare state will be the number one item in the policy agenda of OECD countries during the next decade. The research of economists needs to keep up with important events.

minants of living standards that have captivated the research interests of both economists, economic historians and other social scientists during the twentieth century.

11.2 The ‘Great Divergence’

Nothing in human history compares with the impact that the Industrial Revolution has had on the living conditions for the world’s population. Sustained growth of both total GDP and GDP per capita date from the great transformation unleashed by this event. While economic historians continue to debate the origins, timing and quantitative aspects of the Industrial Revolution, there is no doubt that during the last 250 years the main consequence of this event has been a distinctive regime change as the world economy began to experience a new epoch of what Kuznets (1966) called ‘modern economic growth’. It should also be noted that modern economic growth and capitalism are synonymous, for as Baumol (2002) writes:

what is clear to historians and laypersons alike is that capitalism is unique in the extraordinary growth record is has been able to achieve in its recurring industrial revolutions that have produced an outpouring of material wealth unlike anything previously seen in human history.

Baumol’s point had been recognized by Karl Marx and Friedrich Engels over 150 years earlier in their Communist Manifesto of 1847 when they observed that ‘the bourgeoisie has created more massive and more colossal productive forces than have all preceding generations together’.

In contrast to most of human history, the modern epoch has been characterized by a population explosion, rising life expectancy, rapid urbanization, diversified patterns of employment and steadily rising income per capita for the world as a whole (Easterlin, 1996). However, because the Industrial Revolution and economic growth have spread unevenly across the world, the modern era of human history has also witnessed the emergence of unprecedented global inequality. Since the beginning of the nineteenth century the world economy has experienced what Pomeranz (2000) calls the ‘Great Divergence’ and Pritchett (1997) refers to as ‘Divergence, Big Time’. International differences in living standards, measured by real income per capita, are enormous even after making adjustments to the estimates that take into account variations in purchasing power and household production.

The ‘Great Divergence’ of income per capita is a modern phenomenon. Before the nineteenth century, for the vast majority of the economies and peoples of the world, the process of economic growth was ‘sporadic and inconsistent’. It was not until the second half of the twentieth century that growth spread to many living in the Third World. As Table 11.1 shows, living