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1.9 The New Political Macroeconomics

During the past two decades research into the various forms of interaction

between politics and macroeconomics has become a major growth area giving

rise to a field known as the ‘new political macroeconomics’ (Alesina,

1995; Alt and Alesina, 1996; Alesina and Rosenthal, 1995; Alesina et al.

1997; Drazen, 2000a). This research area has developed at the interface of

macroeconomics, social choice theory and game theory. Of particular interest

to macroeconomists is the influence that political factors have on such issues

as business cycles, inflation, unemployment, growth, budget deficits and the

conduct and implementation of stabilization policies (Snowdon and Vane,


As we will discuss in Chapter 10, modern politico-economic models,

initially developed in the 1970s by Nordhaus (1975), Hibbs (1977) and Frey

and Schneider (1978a), view the government as an endogenous component of

the political and economic system. The conventional normative approach, in

sharp contrast, regards the policy maker as a ‘benevolent social planner’

whose only objective is to maximize social welfare. The normative approach

is concerned with how policy makers should act rather than how they do act.

Alesina (1994) has highlighted two general political forces that are always

likely to play a crucial distorting role in the economy. The first factor is the

incumbent policy maker’s desire to retain power, which acts as an incentive

to ‘opportunistic’ behaviour. Second, society is polarized and this inevitably

gives rise to some degree of social conflict. As a result ideological considerations

will manifest themselves in the form of ‘partisan’ behaviour and actions.

Nordhaus’s model predicts self-interested opportunistic behaviour, irrespective

of party allegiance, before an election. When these political

motivations are mixed with myopic non-rational behaviour of voters and

non-rational expectations of economic agents, a political business cycle is

generated which ultimately leads to a higher rate of inflation in a democracy

than is optimal. In the Hibbs model ‘left’-inclined politicians have a greater

aversion to unemployment than inflation, and ‘right’-inclined politicians have

the opposite preference. The Hibbs model therefore predicts a systematic

difference in policy choices and outcomes in line with the partisan preferences

of the incumbent politicians.

Both of these models were undermined by the rational expectations revolution.

By the mid-1970s models which continued to use adaptive expectations or

were reliant on a long-run stable Phillips curve trade-off were coming in for

heavy criticism. The scope for opportunistic or ideological behaviour seemed

to be extremely limited in a world dominated by rational ‘forward-looking’

voters and economic agents who could not be systematically fooled. However,

after a period of relative neglect a second phase of politico-economic models

emerged in the mid-1980s. These models capture the insights emanating from

and including the rational expectations hypothesis in macroeconomic models.

Economists such as Rogoff and Sibert (1988) have developed ‘rational opportunistic’

models, and Alesina has been prominent in developing the ‘rational

partisan’ theory of aggregate instability (Alesina, 1987, 1988; Alesina and

Sachs, 1988). These models show that while the scope for opportunistic or

ideological behaviour is more limited in a rational expectations setting, the

impact of political distortions on macroeconomic policy making is still present

given the presence of imperfect information and uncertainty over the outcome

of elections (Alesina and Roubini, 1992). As such this work points towards the

need for greater transparency in the conduct of fiscal policy and the introduction

of central bank independence for the conduct of monetary policy (Alesina

and Summers, 1993; Alesina and Gatti, 1995; Alesina and Perotti 1996a;

Snowdon, 1997).

More recently several economists have extended the reach of the new

political macroeconomics and this has involved research into the origin and

persistence of rising fiscal deficits and debt ratios, the political economy of

growth, the optimal size of nations, the economic and political risk involved

with membership of fiscal unions and the political constraints on economic

growth (Alesina and Perotti, 1996b, 1997a; Alesina et al., 1996; Alesina and

Spolare, 1997, 2003; Alesina and Perotti, 1998; Acemoglu and Robinson,

2000a, 2003). With respect to achieving a reduction in the fiscal deficit/GDP

ratio, Alesina’s research has indicated that successful fiscal adjustment is

highly correlated with the composition of spending cuts. Unsuccessful adjustments

are associated with cuts in public investment expenditures whereas

in successful cases more than half the expenditure cuts are in government

wages and transfer payments (Alesina et al., 1997). In addition, because

fiscal policy is increasingly about redistribution in the OECD countries,

increases in labour taxation to finance an increase in transfers are likely to

induce wage pressure, raise labour costs and reduce competitiveness (Alesina

and Perotti, 1997b). Research into the optimal size of nations has indicated

an important link between trade liberalization and political separatism. In a

world dominated by trade restrictions, large political units make sense because

the size of a market is determined by political boundaries. If free trade

prevails relatively small homogeneous political jurisdictions can prosper and

benefit from the global marketplace (Alesina and Spolare, 2003). Work on

the implications of fiscal unions has also indicated the potential disadvantages

of larger units. While larger jurisdictions can achieve benefits in the

form of a centralized redistribution system, ‘these benefits may be offset

(partially or completely) by the increase in the diversity and, thus, in potential

conflicts of interests among the citizens of larger jurisdictions’ (Alesina

and Perotti, 1998).

In recent years the ‘politicisation of growth theory’ (Hibbs, 2001) has led

to a burgeoning of research into the impact on economic growth of politics,

policy, and institutional arrangements. Daron Acemoglu and his co-authors

have made a highly influential contribution to the debate relating to the

‘deeper’ institutional determinants of economic growth and the role of politi32

cal distortions as barriers to progress (see Acemoglu, 2003a; Snowdon, 2004c).

Acemoglu’s recent research highlights the importance of ‘political barriers to

development’. This work focuses on attitudes to change in hierarchical societies.

Economists recognize that economic growth is a necessary condition for

the elimination of poverty and sustainable increases in living standards. Furthermore,

technological change and innovation are key factors in promoting

growth. So why do political élites deliberately block the adoption of institutions

and policies that would help to eliminate economic backwardness?

Acemoglu and Robinson (2000a, 2003) argue that superior institutions and

technologies are resisted because they may reduce the political power of the

élite. Moreover, the absence of strong institutions allows autocratic rulers to

adopt political strategies that are highly effective at defusing any opposition

to their regime. As a result economic growth and development stagnate.