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10.14 The Political Economy of Debt and Deficits

During the mid-1970s several OECD countries accumulated large public

debts. This rise in the debt/GNP ratios during peacetime among a group of

relatively homogeneous economies is unprecedented and difficult to reconcile

with the neoclassical approach to optimal fiscal policy represented by the

‘tax smoothing’ theory. While countries such as Greece, Italy and Ireland had

accumulated public debt ratios in excess of 95 per cent in 1990, other countries

such as Germany, France and the UK had debt ratios in 1990 of less than

50 per cent (Alesina and Perotti, 1995b).

In order to explain the variance of country experience and the timing of the

emergence of these rising debt ratios, Alesina and Perotti (1995b) argue that

an understanding of politico-institutional factors is ‘crucial’. In explaining

such wide differences Alesina and Perotti conclude that the two most significant

factors are:

1. the various rules and regulations which surround the budget process; and

2. the structure of government; that is, does the electoral system tend to

generate coalitions or single party governments?

In the face of large economic shocks weak coalition governments are

prone to delaying necessary fiscal adjustments. While a ‘social planner’ would

react quickly to an economic shock, in the real world of partisan and opportunistic

politics a ‘war of attrition’ may develop which delays the necessary

fiscal adjustment (see Alesina and Drazen, 1991). Persson and Tabellini (2004)

have investigated the relationship between electoral rules, the form of government

and fiscal outcomes. Their main findings are that: (i) majoritarian

elections lead to smaller government and smaller welfare programmes than

elections based on proportional representation; and (ii) presidential democracies

lead to smaller governments than parliamentary democracies.

Research by Alesina and Perotti (1996b, 1997a) also indicates that the

‘composition’ of a fiscal adjustment matters for its success in terms of its

sustainability and macroeconomic outcome. Two types of adjustment are

identified: Type 1 fiscal adjustments rely on expenditure cuts, reductions in

transfers and public sector wages and employment; Type 2 adjustments depend

mainly on broad-based tax increases and cuts in public investment.

Alesina and Perotti (1997a) find that Type 1 adjustments ‘induce more lasting

consolidation of the budget and are more expansionary while Type 2 adjustments

are soon reversed by further deterioration of the budget and have

contractionary consequences for the economy’. Hence any fiscal adjustment

that ‘avoids dealing with the problems of social security, welfare programs

and inflated government bureaucracies is doomed to failure’ (see Alesina,

2000). Type 1 adjustments are also likely to have a more beneficial effect on

‘competitiveness’ (unit labour costs) than policies which rely on distortionary

increases in taxation (see Alesina and Perotti, 1997b).