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10.9 Rational Political Business Cycles

Recent work in the political business cycle tradition has shown that some of

the insights of Nordhaus (1975) can survive even in a model with rational

expectations, providing there is asymmetric information between voters and

policy makers. In other words, voters need not be myopic in order for politicians

to generate political business cycles. Optimal policies are only likely in

a world of political competition when there is unanimity about social objectives

and symmetric information between agents, voters and politicians. Since

these conditions are unlikely ever to hold, politicians have the opportunity to

follow non-optimal policies. Providing there is some element of imperfect

information, so that forward-looking voters are not fully informed about

some characteristics of the political and economic environment, incumbents

have the opportunity of creating ‘a temporary illusion of prosperity’ (Alesina,

1989) in order to gain favour with the electorate.

In the rational opportunistic models proposed by Cukierman and Meltzer

(1986), Rogoff and Sibert (1988), Rogoff (1990) and Persson and Tabellini

(1990), electoral cycles are created in policy variables such as government

spending, taxes and monetary growth, and such cycles are made possible by

temporary information asymmetries. Although rational voters aim to choose

politicians who they believe can deliver the highest utility, they lack information

on the competence of different policy makers. Voters acquire information

on competence by observing outcomes. Therefore before elections the incumbents

engage in a ‘signalling process’ which aims to persuade voters that

the politicians in power are competent. Such signalling is always observed in

the UK during the Chancellor of the Exchequer’s annual budget speech,

especially just before an election.

Rogoff and Sibert define competence as the ability to reduce waste in the

budget process; that is, competent governments can produce more public

goods and transfers for a given amount of tax revenue. Incumbents have the

potential to create a temporary fiscal boost (or fail to impose necessary tax

increases), which is popular with voters. Because the budgetary process is so

complicated the inevitable post-election tax increases needed to finance the

pre-election boost are not foreseen even by rational voters, due to their

incomplete information. Rather than generating a regular inflation–unemployment

cycle as in the Nordhaus model, rational political business cycle

theories predict the manipulation of various policy instruments before and

after the election. The temptation of incumbents to cut taxes and increase

spending before an election in order to appear competent clearly generates

departures from optimality. Hence opportunistic behaviour survives in rational

opportunistic models, although such models give rise to a different set

of empirical predictions compared to the original Nordhaus model. In particular,

because of rational expectations, any cycles resulting from the

manipulation of monetary and fiscal policies will be predicted to be less

regular and of shorter duration.

Finally, we should note that developing-country governments appear to

behave in a similar way to their counterparts in richer countries. In a study of

35 developing countries Schuknecht (1996) found ‘considerable evidence’ in

favour of election-generated fiscal policy cycles although the opportunities

for self-interested political behaviour are less in more open economies.