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Rational Expectations and Business Cycle Models

Do you attribute the decline of interest in politico-economic explanations of

the business cycle between the late 1970s and mid-1980s to theoretical developments

associated with Robert Lucas and the rational expectations revolution

or was empirical failure a more important factor?

I think that the ‘rational expectations revolution’ was a much more important

contributing factor to the decline of interest in such models. Furthermore,

empirical ‘failures’ have not stopped economists investigating this matter

further in the 1990s.

An important criticism of democratic markets is that voters are, in most

cases, uninformed. For each voter the benefits of gaining more information

will be outweighed by the costs. In this world of imperfect information is it

not inevitable that politicians will engage in opportunistic fiscal behaviour

prior to elections?

To some extent this is the case, but I would not overemphasize this point for

several reasons. First, if this were the main explanation for budget deficits, it

should apply (more or less) to every democracy. Thus one should not observe

such large differences in fiscal policies in OECD democracies. Second, large

deviations from efficient policies, such as huge deficits in election years, are

easily observable, if not by the individual voter, then certainly by the press.

Third, I do not know of any conclusive evidence which shows that larger

deficits favour the re-election of an incumbent. I think that in practice what

happens all the time is that in election years fiscal favours may not be very

large, and may therefore be hard to detect. Nevertheless, the political benefits

may be quite significant. Let me add on this point that I am not a great fan of

models of politics where imperfect information is the critical factor. I personally

think that conflict of interest is much more important than asymmetric


In 1988 George Bush told the American electorate: ‘Read my lips, no new

taxes’. Each year in the UK the Chancellor of the Exchequer in his budget

speech emphasizes the competence of the administration in managing fiscal

affairs. Do you regard these examples as typical of the kind of political

behaviour predicted by the Rogoff–Sibert [1988] class of rational opportunistic


With the caveats discussed in the previous answer, I think that Rogoff and

Sibert have a good point. Their model is also much more consistent with the

empirical evidence than the original Nordhaus model. My empirical research

on the subject is quite supportive of their model. This research is included in

Alesina and Roubini, with Cohen (1997): Political Cycles and the Macroeconomy,

MIT Press.

What role does ‘fiscal illusion’ play in politico-economic models?

I think that this concept is oversold. Explanations of excessive fiscal deficits

based on fiscal illusion are not totally convincing because they imply a

systematic bias in the errors made by the electorate concerning their estimation

of the costs and benefits of taxes and spending. Fiscal illusion is also

unable to explain the timing of the deficit problem in OECD economies or

the cross-country differences in budget deficits. I prefer models based on

rational behaviour and expectations.

Rational Partisan Theories

How strong is the evidence against the median voter theorem?

It depends. For large elections I would not use it: in fact, its key implication is

that when in office all the parties do the same thing. This is clearly inconsistent

with the evidence even of predominantly two-party systems that exist in

countries such as the UK and the USA. In multi-party systems the median

voter theorem proves to be even less applicable. Therefore, for macroeconomic

and macropolitical research I would not use it. On the other hand, if I

want to study voting behaviour on one issue in a committee of five people,

then the median voter theorem is a good start!

In the UK Tony Blair’s ‘New Labour Party’ has been moving closer to the

position adopted by the Conservative Party on many economic issues. For

example, on 20 January 1997 the Shadow Chancellor of the Exchequer,

Gordon Brown, promised the electorate that ‘New Labour’ would not increase

tax rates if elected. On 21 January 1997 Tony Blair promised not to

reverse the Conservative Party’s industrial relations legislation of the 1980s.

Does this imply that polarization is less important than it used to be?

In the case of the UK we shall have to wait and see! However, on the more

general issue of increasing party convergence, in Political Cycles and the

Macroeconomy [1997] we conclude that ‘the idea that political parties are

becoming more alike when it comes to macroeconomic management is somewhat

exaggerated’. Our view is that while the macroeconomic problems of the

1970s and early 1980s ‘have probably made politicians on both sides of the

political spectrum more cautious in terms of macroeconomic management,

they have not completely eliminated ideological differences’. Furthermore, we

also point out that ‘both left-wing and right-wing governments in the next

decade will have to face issues of fiscal retrenchment’ and that ‘partisan conflicts

are very likely to explode on how to achieve this goal’.

In your rational partisan models [1987, 1989] you appear to adopt an

eclectic approach to your theoretical framework based on a variant of the

‘monetary surprise’ rational expectations model associated with Fischer

[1977]. Lucas and other new classical theorists now appear to attach more

importance to real shocks as an explanation of post-war macroeconomic

fluctuations. Does this not undermine the basis of models based on monetary


I do not like the view that macroeconomic fluctuations are due to either

supply or demand shocks. First, an economy can be subjected to both types

of shock. Second, real business cycle models have certainly not been an

empirical success. The rational partisan theory does not imply that real shocks

do not exist. In fact in empirical testing one may want to control for supply


What are the essential predictions of the rational partisan theory and have

they been supported by empirical work?

The basic idea of the model is that, given the sluggishness in wage adjustments,

changes in the inflation rate associated with changes in government

create temporary deviations of real economic activity from its natural level.

At the beginning of a right-wing government output growth is below its

natural level and unemployment is above its natural level. The opposite is

predicted for left-wing governments. After expectations, prices and wages

adjust, output and employment return to their natural level and the level of

economic activity should be independent of the party in office. However, the

rate of inflation should remain higher throughout the term of a left-wing

government. These implications of rational partisan theory are consistent

with the empirical evidence particularly for a subset of countries with bipartisan

systems or with clearly identifiable movements from left to right and vice

versa. The rational partisan theory is less applicable, and in fact tends to fail

in countries with large coalition governments with frequent government collapses.

In the UK the Conservative Party gained power in the four elections between

1979 and 1992. President Clinton has also been re-elected. What does the

rational partisan theory predict will be the effect of the repeated re-election

of a particular party?

Strictly speaking, it depends on how unexpected is the re-election. If the

Conservative Party had been sure to win in the previous four elections, not

much should have happened to the economy. Inflation should have continued

to remain low and growth (ceteris paribus) should have been stable. President

Clinton was probably less sure of being re-elected. In this case the

model predicts that growth should slightly increase in the USA.

What is likely to happen according to your model if a left-of-centre party

gains office at the peak of an economic expansion?

According to the model, the left-of-centre party will do as much as possible

to avoid a recession, including increasing inflation. If we speak of the UK in

1997, one has to consider other issues which may influence the outcome,

such as European Monetary Union. This kind of issue is clearly not considered

in the model.

What are the main policy implications of your model for the conduct of

macroeconomic policy and the design of political institutions?

The model in its stripped-down version is ‘positive’ rather than ‘normative’,

thus it does not have any direct policy implications. However, the

model can be used in a normative direction. Let me give a couple of

examples to illustrate the point. First, the model suggests that independent

central banks, by insulating monetary policy from partisan influences, can

reduce the extent of both monetary and real variability. This point is formally

derived in my paper with Roberta Gatti [1995]. Second, as for political

institutions, the model points towards a trade-off. Proportional electoral

systems which result in coalition governments lead to ‘compromise’ and

policy moderation. This reduces partisan fluctuations and polarization, but

may induce deadlocks in policy making, particularly with respect to fiscal

issues. Majoritarian systems leading to two-party systems have the opposite

feature, namely more policy polarization but no policy deadlocks. Extreme

versions of the two systems are unlikely to be optimal although I regard the

risk of excessive ‘governing by coalition’ to be a particularly significant

problem in the European context.

Which is likely to create the most instability: exogenous or endogenous

timing of elections?

Endogenous elections undoubtedly generate more frequent elections. Whether

that creates more or less instability is less obvious. Italy is a perfect example.

One may argue that in the post-war period Italy has been very unstable

because it has had numerous government changes and many early elections.

On the other hand, one may argue that at least until the early 1990s nothing

much ever changed, because the same parties and individuals were always in


What are the main weaknesses of the rational partisan theory?

I guess I am not the right person to ask that particular question, but elsewhere

[1995] I have pointed out that the Achilles’ heel of the rational partisan

theory is that the mechanism of wage formation is postulated exogenously

rather than derived from optimal individual behaviour.

Would you agree that rational voters will make their voting decision based on

information relating to both the past performance of a political party as well

as expected future performance?

Past information has to be used to form expectations about the future. Even

voters who are forward-looking have to look backward to form expectations.

The question ‘are voters backward or forward-looking?’ is very misleading.

Furthermore, I find the research on this point often both confused and confusing.

A different, more useful, question is whether the voters use ‘efficiently’

the past information that they have to form expectations about the future. In

other words, the question is whether voters use ‘rationally’ their past information.

This is a difficult but well-posed question, which is similar to questions

raised in finance.

To what extent do opportunistic behaviour and partisan behaviour depend on

the confidence of an incumbent administration that it will be re-elected? Is it

the case that the more confident an administration is of re-election, the more

likely it is to behave ideologically?

Possibly, perhaps likely. I have not seen a ‘rational’ model making this point.

Bruno Frey and Freidrich Schneider back in 1978 made this point in their

‘non-rational’ models.