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10.12 Politics, Time Inconsistency, Credibility and Reputation

Following the incorporation of the rational expectations hypothesis into macroeconomic

models, the theoretical literature on economic policy has been

dominated by the game-theoretic approach. Policy makers are seen to be

engaged in a complicated dynamic game with private sector economic agents

(who are also voters). This literature was stimulated by the seminal paper of

Kydland and Prescott (1977), who raised the general problem of time inconsistency

of policy (see Chapter 5). According to Kydland and Prescott,

governments that are free from rules (pre-commitment) so that they can use

discretionary policies will be unable to persuade rational agents that they will

stick to low-inflation policies. Agents know that if they lower their inflation

expectations the government will have an incentive to cheat and, by creating

an inflation surprise, increase employment temporarily. However, because

rational agents are aware of the policy makers’ incentives, the time-consistent

policy involves an inflationary bias. If a government has discretion, lowinflation

declarations are time-inconsistent and are not credible. Therefore a

credible policy announcement can be defined as one which is time-consistent.

Solutions to the time-inconsistency problem include contractual arrangements,

delegation of decisions and institutional and legal constraints (see

Drazen, 2000a).

As we have already seen, in industrial democracies subject to regular

democratic elections, politicians have an incentive to deviate from optimal

547

Table 10.4 Alternative politico-economic models

Politico-economic model Main assumptions Predictions

All governments, both left and right, behave the same.

Output will increase and unemployment will fall before an

election. Inflation will accelerate as the election approaches

but will peak and be observed by voters after the election.

Governments of different ideological persuasions will have

different macroeconomic objectives with respect to

inflation and unemployment. Governments of the right will

tend to have persistently higher unemployment and less

inflation than governments of the left.

All governments behave the same.

Monetary growth and fiscal expansions before elections.

Left-of-centre governments produce an inflation bias

compared to right-of-centre governments. Output is above

(below) the natural rate at the beginning of a left- (right-)

of-centre government. The partisan effect of monetary

policy on real variables is temporary.

If incumbent’s popularity is in deficit (below some critical

level) prior to an election, the incumbent switches from

partisan to opportunistic behaviour.

Incumbents with a popularity surplus behave ideologically.

Non-rational

opportunistic business

cycle theory (Nordhaus,

1975)

Strong partisan theory

(Hibbs, 1977)

Rational opportunistic

theory (Rogoff and

Sibert, 1988)

Rational partisan theory

(Alesina, 1987)

Weak partisan theory.

Opportunistic–partisan

synthesis. (Frey and

Schneider, 1978a)

Expectations-augmented Phillips curve. Politicians only

care about re-election. Agents are myopic and have nonrational

expectations.

Exploitable Phillips curve trade-off. Policy makers and

voters are ideological and non-rational. Left-of-centre

parties have a strong aversion to unemployment relative to

inflation. Right-of-centre parties have a strong aversion to

inflation relative to unemployment.

Short-run Phillips curve trade-off. Agents have rational

expectations, but imperfect information.

Voters elect the party that they expect to perform best.

Politicians care only about re-election.

Short-run Phillips curve trade-off. Agents have rational

expectations, but election outcome uncertain.

Left-of-centre parties have a strong aversion to

unemployment relative to inflation. Right-of-centre parties

have a strong aversion to inflation relative to

unemployment.

Politicians alternate between partisan and opportunistic

behaviour. Actual behaviour of politicians depends on their

‘popularity surplus’ in the polls.

Source: Adapted from Edwards (1994).

policies and create an inflation surprise. In the Nordhaus model there is an

incentive to expand the economy before an election in order to gain votes.

This is possible in the Nordhaus model because the policy makers never lose

credibility due to the assumption of non-rational economic agents and myopic

voters. In models with rational expectations and forward-looking voters,

policy makers are under pressure to establish their credibility and reputation

(see Blackburn and Christensen, 1989). By reputation in this context economists

are referring to ‘the actions that policymakers are expected to take’

(Drazen, 2000a). In a game-theoretic context the reputation of a player will

depend on the way they have played and reacted to events in the past.

Rational agents will only believe politicians who make ex ante policy announcements

which are also optimal to implement ex post. However, rational

agents have imperfect information about the real motives of politicians as

opposed to their pre-election promises. Therefore private sector agents will

need to analyse carefully the various signals that politicians give out. In this

scenario it may be difficult for voters to distinguish ‘hard-nosed’ (inflationaverse)

from ‘wet’ (inflation-prone) politicians since the latter will always

have an incentive to masquerade as ‘hard-nosed’ (see Backus and Driffill,

1985).

Alesina (1987) has shown that the prediction of the median voter theorem,

that in a two-party system there will be policy convergence, is time-inconsistent.

In the period before an election both parties find it in their interest to

announce convergent policies on the assumption that this will appeal to the

median voter. Ideological issues take back stage in order to maximize reelection

prospects. However, because there is no mechanism for holding an

elected government to its promises, these announced convergent policies

must be time-inconsistent. After the election the influence of partisan considerations

will predominate as the elected politicians re-optimize and follow a

programme which best fits their ideological stance. Thus the time-consistent

equilibrium involves no policy convergence and the two parties ‘follow their

most preferred policy’ (Alesina and Tabellini, 1988). This inevitably creates

too much volatility in policy making which, in turn, causes politically induced

business cycles.

It follows from the above analysis that only those pre-election announcements

and promises which are consistent with a party’s ideology should be

taken seriously by voters. Once elected, politicians will tend to follow a more

partisan strategy. This may prove to be a particular problem for parties of the

left that declare themselves to be ‘tough on inflation’. Given the underlying

assumptions of the Hibbs (1977) and Alesina (1987) models that politicians

on the left give a high priority to reducing unemployment, voters may well

look with suspicion at pronouncements claiming an aversion to inflation.

Inflation-prone parties have an incentive to masquerade as ‘hard-nosed’ on

this objective. Rational voters are likely to interpret such signalling as the

‘dissembling actions of an impostor’ (Blackburn, 1992). An implication of

this is that ‘a low inflation policy announced by a government concerned with

unemployment would not be credible; indeed if expected inflation was low,

this government would create an inflation surprise in order to reduce unemployment’

(Alesina, 1989).

These issues were very pertinent in the UK in the run-up to the 1997

election. The ‘New’ Labour Party, led by Tony Blair, declared that it intended

to be ‘tough on inflation’ and that it also aimed to achieve much lower

unemployment. In terms of Alesina’s model, the statement on inflation is

clearly time-inconsistent. However, to give credibility to its anti-inflation

rhetoric, on winning the 1997 election, new Labour immediately granted

operational independence to the Bank of England (see Snowdon, 1997).