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10.10 Rational Partisan Theory

As noted earlier, Hibbs (1977), in his partisan theory of macroeconomic

policy choices, argued that parties of the left will systematically select combinations

of unemployment and inflation which differ from those preferred

by right-wing parties. Following the rational expectations revolution, theoThe

new political macroeconomics 539

rists questioned the ability of policy makers to influence real economic activity

using aggregate demand management policies. Alesina, in a series of

publications, has shown that the partisan theory of political business cycles

can survive in models incorporating rational expectations providing (i) voters

are uncertain about election outcomes, and (ii) uncontingent labour contracts

are signed for discrete periods and are not subject to renegotiation after the

election result is declared (see Alesina, 1987, 1988, 1989). In Alesina’s

model economic agents cannot enter into state-contingent nominal wage

contracts that provide insurance against electoral risk. Central to the rational

partisan theory is the idea that the political systems of many industrial democracies

are polarized. Alesina rejects the traditional view of politicians’

behaviour associated with Downs (1957) that vote-maximizing politicians in

a two-party system will generate a convergence of policies, as both parties

choose the policies favoured by the median voter (see also Minford and Peel,

1982). In the partisan theory politicians are ideological and adopt different

policies when in power. ‘There is no presumption that in a multi-party system

with self-interested politicians one should observe policy convergence’

(Alesina, 1989). In the case of the USA, empirical work has shown that

although the degree of polarization has varied throughout American history,

the Republican and Democratic parties have never fully converged (Alesina

and Rosenthal, 1995). This in part reflects the fact that a presidential candidate

has to appeal to the median voter in his/her own party in order to win the

nomination. ‘Since the platform adopted in the primary is a constraint on the

choice of platform for the presidential elections, even self-interested politicians

may have to choose polarized policies’ (Alesina, 1989). Alesina follows

Wittman (1977) and Hibbs (1977) and emphasizes the ideological preferences

of politicians who aim to please their supporters by implementing

policies which are likely to lead to a redistribution of income in their favour.

Hence the rational partisan theory shows how parties follow different macroeconomic

strategies because of their impact on the redistribution of income.

It is assumed that voters are well aware of these ideological differences

between the parties. In this framework macroeconomic policies create shortrun

aggregate disturbances because rational voters are uncertain about election

results. When Republicans or Conservatives are elected, economic agents are

confronted in the period immediately following the election with a deflationary

shock, that is, inflation is lower than expected. When Democratic and

Socialist governments are elected, the opposite occurs. There is a larger than

expected ‘inflation surprise’. It is the combination of election outcome uncertainty

combined with ideological differences between the two parties that

leads to aggregate instability in Alesina’s model. If a common macroeconomic

policy could be agreed between the two political parties aggregate

fluctuations would be reduced.

The ‘eclectic’ macroeconomic framework adopted by Alesina is based on

Fischer’s (1977) well-known rational expectations model which includes a

labour market where nominal wage contracts are signed and extend for considerable

time periods (see Chapter 7). The ‘neutrality’ result or ‘policy

ineffectiveness proposition’ associated with Lucas (1972a) and Sargent and

Wallace (1975) depends on perfect (instantaneous) wage and price flexibility

as well as agents having rational expectations (see Chapter 5). Fischer (1977)

demonstrated that the crucial assumption for new classical results is instantaneous

market clearing. With nominal wage contracts, an element of price

stickiness is introduced into the model and in a non-market-clearing setting

policy effectiveness is restored with monetary policy having real effects on

aggregate output and employment. When ideological politicians use monetary

policy in such a setting a rational partisan business cycle is generated.

How does this come about? Consider equations (10.10)–(10.13) below.

yt Pt Wt yNt = β[ ˙ − ˙ ]+ , and β > 0 (10.10)

Ignoring capital accumulation, equation (10.10) shows that the rate of output

growth (yt) depends on the natural rate of growth of output (yNt) and positively

on the difference between the rate of inflation (P˙t ), and nominal wage

growth (W˙t ), that is, the path of real wages. (By Okun’s Law unemployment

and output are assumed to be inversely related and the natural rate of output

growth is that which is compatible with the natural rate of unemployment.)

Alesina uses output growth rather than the level of output since this is the

variable that empirical research uses to capture partisan effects on the economy.

If we assume that non-indexed nominal wage contracts lasting one period

(for example, two years) are drawn up with the objective of maintaining a

real wage consistent with natural output growth, we derive equation (10.11),

which shows that nominal wage growth is set equal to the current expected

rate of inflation (P˙t ) :

e

W˙ P˙ t t

= e (10.11)

Unlike the situation in the Nordhaus and Hibbs models, agents form their

expectations rationally. The rational expectations hypothesis is given in equation

(10.12):

P˙ E[P˙ | I ] t

e

= t t−1 (10.12)

Here E is the mathematical expectations operator and It–1 indicates the information

which has been accumulated by economic agents up to the end of

time period t–1. By combining (10.10) and (10.11) we arrive at equation

 (10.13), which tells us that output growth will deviate from its natural rate if

there is an inflation surprise, that is, an unexpected change in monetary

policy:

yt Pt Pt y

e

Nt = β[ ˙ − ˙ ]+ (10.13)

In rational partisan models it is assumed that the incumbent politicians

have the ability to control the rate of inflation by monetary policy. Since party

preferences with respect to the extent of aversion to inflation differ, with the

right being assumed to be more averse than the left, an election which brings

about a change of government will lead to an inflation surprise, causing

output to deviate from its natural growth path. Agents have rational expectations

but are uncertain about forthcoming election results. Because agents

sign nominal wage contracts before the election result is known, the rate of

inflation forthcoming after the election can differ from the rational expectation

of inflation formed by wage negotiators in the pre-election period. Consider

the following possible sequence of events. Suppose the current administration

is a party of the left (Democrats in the USA, Labour in the UK).

Following Hibbs (1977), we can assume that left-wing governments have a

reputation for wanting to lower unemployment. Wage negotiators, if they

assume that the incumbents will win the election, will sign nominal wage

contracts which have built into them a high expected rate of inflation. Even if

the right-wing party looks like winning the election, risk-averse negotiators

will probably sign contracts involving inflation expectations higher than would

have been the case if agents knew for certain that the right would win. If a

Conservative (inflation-averse) government replaces the left-wing incumbents,

they will begin to tighten monetary policy in order to reduce inflation, thus

creating a surprise which has not been built into the wage contracts. As a

result, following an election victory by a Republican or Conservative party,

the Alesina rational partisan theory predicts a recession in output growth and

a rise in unemployment as inflation declines. The opposite sequence of events

would follow a change in government from right to left (Maloney et al.,

2003). In the period following an election, left-wing governments expand the

economy and reduce unemployment. Eventually, when inflationary expectations

adjust to the new situation, output growth returns to the natural rate but

the economy is locked into an equilibrium with high inflation. The election of

parties of the left will, according to Alesina’s model, be followed by a

cyclical pattern which is the opposite of that predicted by the Nordhaus

model. In both cases expectations are assumed to adjust to the actual rate of

inflation in the second half of a term of office, and from equation (10. 13) we

can see that output growth will settle back to its natural rate for both rightand

left-wing governments during this period of the electoral cycle. Since

there are no election surprises in the second half of an administration’s term

of office, real variables settle down to their natural rates. However, because

left-wing governments will be locked into a high-inflation equilibrium in

Alesina’s model, they may feel obliged to fight inflation before the next

election. President Carter found himself in such a situation in 1979–80.

We can now summarize the predictions of the rational partisan theory of

the business cycle:

A1 A change to a Conservative or Republican government will be followed

by a recession and rising unemployment. Once inflationary expectations

have been reduced, output growth returns to its natural rate. Inflation

is low as the next election approaches.

A2 A change to a Labour or Democratic government will be followed by

an acceleration of inflation as the economy expands more rapidly. Unemployment

will initially fall. Once inflationary expectations adjust,

output growth returns to its natural rate but inflation remains high.

Should a government of the left attempt to fight inflation in the run-up

to the next election, it will create a recession.

A3 The stronger the ideological convictions of the two parties, the greater

will be the disturbance to output and employment following a change of

policy regime after an election.

A4 Unlike the Hibbs model, the rational partisan theory predicts that differences

in unemployment and growth resulting from changes in government

will only be a temporary phenomenon.

10.10.1 Empirical evidence for rational partisan cycles

A considerable amount of empirical work has been done in recent years to

test the rational partisan theory (see Alesina and Sachs, 1988; Alesina, 1989;

Alesina and Roubini, 1992; Alesina and Rosenthal, 1995). These studies have

found supporting evidence for temporary partisan effects on output and employment

and long-run partisan effects on the rate of inflation as predicted.

For the USA systematic differences have been found to occur in the first half,

but not the second half, of a large number of administrations. This evidence is

reported in Table 10.3. Although the rational partisan theory of Alesina and

the political business cycle model of Nordhaus (1975) give similar predictions

for Republican and Conservative administrations, the data in Table 10.3

do not show, on average, evidence of opportunistic behaviour. In line with the

predictions of the Alesina model, ‘Every Republican administration in the

post-World War II period except Reagan’s second one has started with a

recession. No recessions have occurred at the beginning of Democratic administrations’

(Alesina, 1995). The deep recessions in the US and UK

economies following the elections of President Reagan and Prime Minister

Table 10.3 Rates of growth of GDP in real terms

Year

First Second Third Fourth

Democratic administrations

Truman 0.0 8.5 10.3 3.9

Kennedy/Johnson 2.6 5.3 4.1 5.3

Johnson 5.8 5.8 2.9 4.1

Carter 4.7 5.3 2.5 –0.2a

Average 3.3 6.2 5.0 3.3

Average first/second halves 4.8 4.1

Republican administrations

Eisenhower I 4.0 –1.3 5.6 2.1

Eisenhower II 1.7 –0.8 5.8 2.2

Nixon 2.4 –0.3 2.8 5.0

Nixon/Ford 5.2 –0.5 –1.3a 4.9

Reagan I 1.9 –2.5 3.6 6.8

Reagan II 3.4 2.7 3.4 4.5

Bush 2.5 0.9 –0.7 –

Average 3.0 –0.3 2.7 4.3

Average first/second halves 1.4 3.5

Note: a Oil shocks.

Source: Economic Report of the President, 1992 (cited in Alesina, 1995).

Thatcher conform very well to predictions A1 and A3 above. Prediction A2

fits very well the experience in France in the period 1981–3. During the early

part of the French Socialist administration of Mitterand, expansionary policies

were pursued initially, even though many other major economies were in

recession. Both President Mitterand and President Carter in the USA ended

their administrations trying to fight inflation, although it should be recognized

that the second OPEC oil-price shock complicates matters in the case

of the Carter administration.

Alesina concludes that the more recent rational versions of politico-economic

models of cycles have been much more successful empirically than the

earlier models of Nordhaus and Hibbs. In particular, ‘partisan effects’ appear

to be ‘quite strong’ while ‘opportunistic effects’ appear to be ‘small in magni544

tude’ and seem to affect only certain policy instruments, particularly fiscal

variables (see Alesina, 1995). It is also well documented that during the

Reagan and Thatcher administrations the income distribution consequences

of the micro and macro policies were ‘particularly partisan’. Inequality increased

under both administrations (see Alesina, 1989).

10.10.2 Criticisms of the rational partisan theory

There are a number of important weaknesses in the rational partisan theory.

First of all, if the cyclical effects are due to the signing of wage contracts

before an election, then one obvious solution is to delay the signing of

contracts until the election result is known. This solution is, of course, not as

applicable where the timing of elections is fixed endogenously. However, in

the USA wage contracts are staggered and overlapping, which means that at

least a significant proportion of wage contracts will inevitably go over the

election date. A second important criticism is that, in line with other models

which assume nominal wage rigidity, the Alesina model implies a countercyclical

real wage which is at odds with the stylized facts of the business

cycle. For theoretical purists a third criticism relates to the lack of firm

microeconomic foundations in such models to explain the mechanism of

nominal wage contracting. Alesina (1995) describes this as the ‘Achilles heel’

of the rational partisan theory. A fourth line of criticism originates from the

most recent generation of equilibrium business cycle theories. According to

real business cycle theorists, monetary policy cannot be used to produce real

effects on output and employment, although they agree that monetary growth

determines the rate of inflation. In real business cycle models aggregate

fluctuations are determined mainly by shocks to the production function, and

such shocks are endemic. The pre-electoral behaviour of politicians and postelectoral

monetary surprises are largely irrelevant. A benign monetary policy

would not bring to an end aggregate fluctuations (see Chapter 6). A fifth

criticism relates to hysteresis effects. If the natural rate properties of rational

partisan models do not hold due to persistence effects following an aggregate

demand disturbance, the political business cycle may be turned ‘upside down’

(see Gartner, 1996). A sixth criticism relates to the empirical evidence. In an

extensive survey Carmignani (2003) concludes that monetary policy is not

the source of political cycles in real variables (see also Drazen, 2000a, 2000b).

Finally, some theorists argue that partisan and opportunistic models are not

incompatible and a more complete model should incorporate both influences

(see Frey and Schneider, 1978a, 1978b; Schultz, 1995). It is to this latter

criticism that we now turn.