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10.15 Political and Economic Instability: Are They Related?

A further related area of research in the politico-economic sphere concerns

the relationship between political and economic stability (see Carmignani,

2003). There are good reasons to believe that economic performance will

suffer if a country is politically unstable. Frequent riots, politically motivated

violence and revolution inevitably have a negative impact on a country’s

economic performance. As Keynes always highlighted, uncertainty has a

depressing effect on investment and productive entrepreneurship.

Alesina’s partisan theory predicts that instability will increase the greater

the partisan effects because widely divergent policies create uncertainty and

destabilize expectations. It is also unlikely that reputational considerations

will be important to a government which feels that it has little chance of

being re-elected. In this situation an incumbent has an ‘incentive to follow

particularly shortsighted policies, since it is not concerned with a future in

which it is likely to be out of office’ (Alesina, 1989).

A further destabilizing influence on policy arising from political instability

derives from the inability of fragile coalition governments to carry through

the tough but necessary economic policies crucial for long-run stability.

Alesina (1989) finds a positive correlation between an index of political

instability and Okun’s misery index (inflation + unemployment) for the period

1973–86. An exception in his 20-country sample is the UK, which

managed to combine relatively poor economic performance during this pe556

riod despite having a high degree of political stability. In Alesina and Drazen’s

(1991) analysis of why necessary stabilization policies are frequently delayed,

they consider a situation where two parties with different ideologies

engage in a war of attrition as they each attempt to pass on the burden of

fiscal reform to the other party’s supporters. The resultant delay and government

inaction in the reform process leads to debt accumulation and crisis

before one of the parties is forced to accept a larger share of the fiscal burden.

As Drazen (2000a) notes, ‘the failure to adopt socially beneficial economic

reforms or their adoption only after long delays is a leading example of the

divergence between the simple textbook models of economic policymaking

and real world experience’.

Considerable cross-country evidence now exists which indicates that seigniorage

(the inflation tax) is positively related to the degree of political

instability. In a study of 79 developed and developing countries for the period

1971–82, Cukierman et al. (1992) found evidence in support of their hypothesis

that ‘more unstable countries rely relatively more on seigniorage to

finance the government budget than do stable and homogenous societies’.

These conclusions are also supported by Edwards (1994), who found that the

incentive to use inflationary finance is closely related to the volatility of the

political system. In the extreme, hyperinflation may erupt (see Capie, 1991;

Siklos, 1995; Fischer et al., 2002).