Political Business Cycles and Macroeconomic Credibility: A Survey

Political Business Cycles and Macroeconomic Credibility: A SurveyAuthor(s): Simon PriceSource: Public Choice, Vol. 92, No. 3/4 (1997), pp. 407-427Published by: SpringerStable URL: http://www.jstor.org/stable/30024270 .

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Public Choice 92: 407-427, 1997. @ 1997 Kluwer Academic Publishers. Printed in the Netherlands.

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Political business cycles and macroeconomic credibility: A survey*

SIMON PRICE Department of Economics, City University, London, EC1V OHB, U.K.

Accepted 18 November 1996

Abstract. There is clear evidence that government popularity and election performance is affected, in part, by economic performance, suggesting that governments may manipulate the economy to political advantage. Simple models incorporating adaptive expectations which allowed the government to exploit this relationship were developed in the 1970s, but fell out of fashion with the advent of new-classical economics. However, modern theories of the political business cycle, which are closely related to the macroeconomic policy game literature, assume rational expectations, and lead to forms of political business cycle, driven by the existence of uncertainty of one type or another. The international evidence suggests that some aspects of the theories apply, although definitive conclusions are - as we might expect - hard to come by.

1. Introduction

The "political business cycle" has no unique definition. The primary interpretation of the term is a relationship between elections and cyclical fluctuations in output, but there are other aspects the term can encompass. These include pre- and post-electoral fluctuations in inflation and policy instruments, as well as partisan effects that may not necessarily be associated with elections at all, although they may be. There are at least five versions of the political business cycle that we discuss below, and it may be helpful to list them now. They are: irrational partisan cycles; irrational opportunistic cycles; rational partisan cycles; rational opportunistic cycles; and strategic debt cycles. A common theme not always spelt out in the early literature is that these cycles typically result from the outcome of some form of game. Although the political aspect of the models has tended to be emphasized in the past, it is now clear that the implications of modern analysis extend to all areas of policy; the electoral dimension is just one aspect of this. The ideas of credibility and time inconsistency which pervade current thinking on policy and the evolution of economic institutions, both have origins that can be found in the political business cycle literature.

* This survey was invited by the editors of Public Choice. I am grateful to Apostolis Philippopoulos for helpful discussions on the issues.



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The notion of the political business cycle may be traced back to Kalecki (1943), but the first formal flowering of the literature began in the 1970s, sem- inally with Nordhaus (1975). Ironically, this early literature, which assumed adaptive expectations either implicitly or explicitly, was an immediate vic- tim of the evangelism of the early, fundamentalist, new-classical movement.1 It is easy to see how the dominant Keynesian, activist, view of the 1960s led ineluctably to the conclusion that governments would use their powers to manipulate the economy for electoral ends; it is equally easy to see why economists keen to disprove the possibility of governments having any systematic effect on output2 were opposed to the idea. But as rational expectations became part of the everyday economics tool-box, the existence of political business cycles once again became a possibility. The key was the existence of some form of uncertainty, about government competence or preferences over economic outcomes, or about election results. The result is a rich menu of empirical possibilities which enable us to discriminate between models of the political cycle.

This paper is designed to survey this literature. To some extent, this task has

already been undertaken elsewhere. A large number of issues were already clear in Alesina (1988). Gartner (1994a) provides a particularly helpful exposition within a simple, unifying framework, of many of the central models. Alesina and Tabellini (1988) focus on the important relationship between

"credibility and politics", which is now seen as the crucial insight of the past ten years. Persson and Tabellini (1990) provide a general survey and exposition of a wide range of related topics, while their collection (Persson and Tabellini, 1994) is not only a central source of key references, but also con- tains two useful introductory essays. Nannestad and Paldam (1994) offer an exhaustive survey of the popularity literature. However, this remains a good moment to survey the scene. The political business cycle refers to output or inflation cycles, caused by one of the several mechanisms put forward over the past two decades. We now have a pretty clear picture of what these are. The literature has merged seamlessly with the more general work on strate-

gic policy formation. The literature appears to be well-consolidated now, but recent attention has turned to focus on fiscal cycles and strategic debt formation. This marks the latest and least formed area of research; but it may also be the last uncharted area to investigate. Other, related, areas include the literature on credibility and institutions, for example, the role of central bank

independence in policy and electoral cycles. The paper is structured as follows. We begin by summarizing the evi-

dence regarding voting behaviour, popularity and economic variables. Next, we review the original vintage of (irrational) models. In the following section we outline the implications of strategic policy games, uncertainty and



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credibility-gaining devices, which places the political business cycle in a wider macroeconomic context. In the subsequent sections we examine partisan and opportunistic models of the cycle. After a discussion of fiscal policy and strategic debt formation, the final section concludes.

2. Government popularity

2.1. The "votes" or "popularity "function

There is clear evidence from innumerable couhtries3 that good economic news helps incumbent governments win elections. For example, in the U.K. context Price and Sanders (1994) examine the determinants of government popularity over a long (40 year) period up to the early 1990s. Extraordinary political factors matter a great deal,4 and most of the variance in models is unaccounted for. But economic factors are important and have a remarkably stable impact.

This evidence has a natural interpretation; the public, in their role as "voters", have well-defined preferences over economic variables. A standard way of expressing this is to define the instantaneous5 quadratic loss function

L = ap2 + b(u - U*)2; a, b > 0 (1)

where p is inflation, u unemployment and u* the natural rate. The bliss point is at zero inflation and the natural rate. This may be interpreted as an expression of "Downsian rationality". Voters reward governments which deliver high welfare. Alternatively, voters value competent governments, where competence is defined as the ability to achieve high welfare (low cost). In this view, ideology plays little or no part. Parties are judged purely in terms of performance, rather than their ideological match, which might be taken to determine the parameters a and b.

2.2. Political rationality

It is hard to understate the impact that rational expectations has had on the literature we survey here. It is therefore worth asking whether there is evidence for rationality in voting behaviour, a question rarely asked in theoretical models, where rational expectations is one of the maintained, primitive, assumptions.

The results referred to above are based on the relationship between past performance and current popularity. Yet there is a sense in which history should not matter, except inasmuch as it sheds light on the future. Voters are concerned about the impact of their vote after the election. So they should



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look forward to the future performance of the party in question. Suppose that voters have an expectation about the future competence of a party. This will be based on current perceptions which are based on past information. Thus

tCt+l = f(-t) (2)

The current estimate of competence expected tCt+l (at time t) to hold next period (next electoral term, time t+1)6 depends upon the information available at the current time, Ct. Obviously, this information includes past economic variables as well as other information. We can define the expectational error as

tet+1 == Ct+l - Ct+1 (3)

As is well known, rational expectations implies any change in the estimate must be based on new information. What "new" implies is, partly, that it could not have been predicted the previous period. This in turn means that the new information, and therefore the expectational error tEt+l, must be a white noise random shock, uncorrelated with its own past, or any other past variable. The implication of all this is that the change in expected competence, and therefore popularity, will be a simple random walk, so

Ct+1 = Ct + ut+1 (4)

where ut+1 is a white noise process. This amounts to a very strong hypothesis, which can be tested very simply by adding other variables (dated t or earlier) to the regression.7 The results of performing this exercise are somewhat mixed (Price and Sanders, 1994; Chrystal and Peel, 1986). However, if the process generating expectations changes, the relationship will be unstable. This is an example of the Lucas critique (Lucas, 1976), and weakens the power of the tests considerably. More generally, the hypothesis being tested is a strong form of RE that takes no account of learning. On balance it may be that the strong assumption of rational expectations can be rejected, although the evidence is not overwhelming, but we cannot claim a weaker (bounded) form of rationality does not hold. It needs to be pointed out that the existence of rational political expectations does not invalidate the popularity function approach. Voters have to form theirfuture expectations with current and past data; so there must be a (reduced form) relationship between competence and past data, albeit one that may be evolving. But regardless of the evidence, for theoretical analysis we really have little choice but to assume RE, as while the alternative assumptions may deliver particular results, they cannot be considered robust within the dominant economic paradigm of rationality.



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3. Irrational cycles

As we observed above, political theories of the business cycle effectively date back to the 1970s, predating the rational expectations "revolution". Those theories can be categorised into either "opportunistic" or "partisan" models, and this is the order in which we take them here.

3.1. Opportunistic cycles

In opportunistic models, the aim of government is to maximize the chances of being re-elected. This is consistent with a Downsian view of the electoral process, in contrast to the ideological, partisan, view, where parties have distinctly different preferences. This probably accords best with the popular view of the cycle, which can be encapsulated in a typical quote from Victor Keegan, a respected U.K. economic commentator, who wrote that "we have become quite accustomed to an 'official' boom before an election" (The Guardian, 18 March 1996: 13). The best known of the early opportunistic models was due to Nordhaus (1975; see also Lindbeck, 1976; and MacRae, 1977). In Nordhaus' model, there are three elements. First, there is a Lucas surprise aggregate supply or Phillips relation; second, voters have voting preferences that rely on expected economic outcomes such as inflation and output, such as in equation (1); and crucially, third, expectations are formed "myopically" with some non-rational algorithm, such as an adaptive rule. This simple framework, with modifications, especially regarding the expectations hypothesis, forms the basis for much of the analysis underlying the models surveyed in this paper. We might also add that the aim of government is (at least partly) to be re-elected. It follows that if governments are able to manipulate the economy, they may well wish to fix the business cycle to maximize their re-election chances. Under these circumstances governments will wish to generate pre-election surprise inflation; moreover, without a rational electorate, they are able to do so.

This story is problematic from both a theoretical and empirical perspective. To take the theory first,8 then, as McCallum (1977) pointed out with devasta- ting effect, the electorate would have to be irrational for the process to work. They would have to ignore the evidence of the past. The other problem is with the evidence. As we observed in the Introduction, Nordhaus introduced his theory at just the time that the idea of rational expectations was getting a commanding hold over the economics profession. But had the evidence supported the theory, it may have proved more durable. In fact, it did not. Another two proponents of the idea were Frey and Schneider who wrote a series of papers (including Frey, 1978; Frey and Schneider, 1978, 1981) developing a "Politico-Economic model" which they applied to the U.K. and other countries. Their aim was to construct a structural model of the politi-



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cal and policy process. Their work was subject to criticism at the time, for example by Chrystal and Alt (1981) who demonstrated that the results were less robust than they seemed. However, with the resurgence of interest in rational political business cycles, the conceptual issues they addressed seem to have maintained their relevance today. In retrospect it seems clear that the opportunistic cycle was an incomplete move towards a theory of inflation incorporating strategic behaviour on the part of the government and the

public; see Section 4 below.

3.2. Partisanship

The other class of model emphasized partisan or ideological differences. Evi-

dently, political differences exist between governments.9 Before considering these models, we note that the explanation for these differences is not obvious. To begin with, the proposition that parties maintain partisan differences is in contrast to, first, the opportunistic view of government behaviour, and second, more generally, to the Downsian (Downs, 1957) view of policy convergence in the face of vote-seeking parties. A modern expression of this latter position is given by Calvert (1985), who describes the notion of policy convergence as

theoretically "robust". In fact, it is possible to argue that the existence of time

inconsistency, a dominant theme below, makes this notion far from robust. Even small ideological biases will lead to a failure of policies to converge, as Alesina and Rosenthal (1995) observe. Essentially, this is because of the

time-inconsistency of advocating policies that differ from true party preferences. To anticipate, the argument is precisely the same as that set out in Section 4. Since Kydland and Prescott (1977), it has been well known that in the absence of binding pre-commitment governments cannot credibly pursue policies that, while optimal ex ante, are against the government's interest ex

post. The point is that the government always has an incentive to renege (in this case) after winning an election, even if it was clearly in its electoral interest to appease the voters by modifying its policy stance during the cam-

paign. As voters know this, "moderate" policies are not credible.10 Moreover, there is a great deal of anecdotal and formal evidence that party policies do not converge. This does beg the question of why parties are polarized in this

way. One story is that parties' policies are determined by activists, and that activism is a costly activity (in terms of time and effort). Plausibly, people with extreme views care more about which policies are implemented and are therefore more willing to be activists. So the activists are over-sampled from

among the extremists in the population. See Feddersen (1992) for a formal model: Alesina and Rosenthal (1995) discuss some other possibilities.

Whatever the explanation, partisan differences evidently exist. If so, we expect systematic differences between left and right-leaning governments



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in terms of policy outcomes. In the pre-rational expectations world, these differences were hypothesized to be that left governments run with higher inflation and less unemployment than right ones. The political scientist Hibbs (1977, 1987) has been particularly associated with this view. But just as with opportunistic cycles, rational expectations weakens this conclusion. Inflation cycles might be expected, although even this is unclear, but sustained real effect should not exist, although there may be transitory effects, as we shall see. If real effects do exist, it is unclear whether these are strictly "cycles". So far as the evidence for irrational partisan phenomena is concerned, Hibbs (1977) finds small difference in U.K. unemployment rates between adminis- trations and large U.S. differences; somewhat smaller effects emerge for the U.S. in Hibbs (1986); also see Balke (1991). However, Alesina and Roubini (1992) find no significant Hibbsian partisan effects on output or unemployment in a panel of OECD countries. In an earlier vintage of empirical work, Frey (1978) and Frey and Schneider (1978, 1981) estimate a model that may be characterized as opportunistically partisan, where governments pursue partisan objectives where electoral constraints allow. They operationalize this by assuming that opportunistic behaviour dominates when the lead over the opposition party falls below an arbitrary level. They present weak evidence for partisan effects, but (as discussed above) the critique in Chrystal and Alt (1981) casts doubt on their results. Schultz (1985) and Price (1996a, 1996b) estimate similar models on U.K. policy instruments and find some support for the model, suggesting the Frey and Schneider line has some validity. However, neither author is looking for partisan effects on output; Price finds evidence of partisan differences in interest rates and government spending on transfers.

4. Time inconsistency, credibility, policy games and the electoral inflation bias

The problem McCallum and others addressed is now seen to be a profoundly important issue. The political business cycle is one aspect of the process of strategic policy formation. McCallum was writing at roughly the same time as Kydland and Prescott (1977) published their influential paper on the time inconsistency of optimal plans, including macroeconomic policy. While the connection was not made explicitly at the time, the approach was a critique of the Nordhaus model. The literature was developed further by Barro and Gordon (1983a, b) and Backus and Driffil (1985). Many of the key references are collected in the two volumes by Persson and Tabellini (1994), who also survey the literature. The issue that emerges from this literature is the credibility of policy. The simple insight is that the timing of the relevant



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choice variables leads to a change in the structure of the constraints facing the government as time passes. The private sector forms expectations of, e.g., inflation conditional on policy, before the policy is implemented. Thus the public's choice is ex post, no longer a free variable for the government. In non-cooperative policy games of this type low inflation becomes hard to achieve. Time inconsistency introduces an inflation bias. If it were possible to credibly commit to low inflation, the game would become cooperative and a Pareto improving outcome would arise; but it is hard to devise such means. A large part of the macroeconomic policy debate over the past decade has been an attempt to find these credible commitment devices. While these are normally discussed in the context of general macroeconomic policy, it should be clear that all the discussion carries over into electoral cycles. At the heart of all policy games is an incentive for the policy maker to deviate from the ex ante optimal policy. These incentives include seigniorage and any loss function not minimised at the NAIRU, but the most obvious incentive is that created by the electoral process, although this is not usually stressed in the macroeconomic policy literature." Thus the democratic, electoral system itself tends to induce an inflationary bias.

4.1. Institutional fixes

Given this background, the search is clearly on for credible commitment devices to emeliorate the electoral bias. In Giavazzi and Pagano's (1988) graphic phrase, there is an "advantage of tying one's hands". One possible mechanism is a fixed exchange rate. A fixed exchange rate does not by itself ensure low inflation. However, it does imply that inflation carries a higher loss, compared to a freely floating or discretionally managed rate. So inflation is more costly, and this helps to persuade people that the government will maintain its policy. The evident problem is that one incredible policy (low inflation) is replaced by another, the fixed exchange rate. In a European context, ERM membership met with only limited success. Some ERM members

possessed high credibility to begin with, like Germany. Others, like France and Italy, did indeed end up with lower inflation, but at no less cost than countries that did not join. Indeed, for these countries the process may have been unnecessarily protracted as "short, sharp shocks" were ruled out by the ERM rules. Other, smaller, countries like Ireland and Denmark, do seem to have gained, however.12

Another device is an independent monetary authority. This strategy cuts

through the problem of credibility in monetary policy (anti-inflation policy) by removing it from the government's remit. Although the government might like to renege on its low-inflation promises, it has not the means to do so, and this makes the low-inflation equilibrium attainable. Up to a point, this strategy



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seems to work. The obvious example is Germany. Historically, Germany has achieved the lowest post-War inflation rates in Europe (although pressures from reunification have tarnished this record somewhat). Germany also has a constitutionally independent Bank, whose explicit aim is price stability - zero inflation. However, there is an obvious problem of causality here; low- inflation loving countries like Germany may choose institutions that deliver this target; see Posen (1993).13 It is also easy to find counter-examples. The U.S.A. has a notionally independent Fed but a poor inflation record. Japan has a puppet Bank but very low inflation. Nevertheless, the best evidence based on econometric research in a range of countries is that more central bank independence generally leads to less inflation.14

An argument against independence is that central bank independence may lead to a higher variance of output (Rogoff, 1985) if some shocks are real and there is a fixed inflation target. A solution is to design a more flexi- ble rule. An optimal contract will give the central bank exactly the right incentives to achieve the right mix of policy (although the problem of dynamic inconsistency still exists). Seen in this light, the problem is a standard

principal-agent relationship; Alesina and Gatti (1995), Walsh (1995a) and Persson and Tabellini (1993); McCallum (1995) has a relatively optimistic view of the role of bank independence. An example of this process exists in New Zealand (Walsh, 1995b). It is possible this simply shifts the credibility problem (McCallum's, 1995, second "fallacy" regarding central bank independence). But reneging on the central bank's constitutionally determined, contract may carry a high political cost (Fischer, 1990; Persson and Tabellini, 1993). While explicit contracts are rare, implicit ones may exist may exist. This may explain why no additional costs in terms of output growth or variability in output or inflation have been found where independent Banks exist. This leads Grilli, Masciandro, and Tabellini (1991) to conclude that independent central banking is the nearest thing we have to a free lunch. Moving the argument back to a more focused political perspective, it also seems that independent central banking is more useful to some countries than others. Heylen and van Poeck (1995) find that the gains to independent banks are greater in countries where other factors make inflation control difficult - such as unstable government (or steeply sloped Phillips curves).

4.2. Reputation

These devices help alleviate the time inconsistency the electoral process generates. But there is an alternative to an institutional fix that has an immediate interpretation in the electoral cycle. The original solution to the time- inconsistency problem proposed by Barro and Gordon (1983a) was for policymakers to acquire "reputation", made credible by some "punishment"



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strategy. One form the public's punishment can take is the adoption of pes- simistic (high inflation) expectations for some period after the government slips in an inflation surprise. These rules will support low inflation equilibria in infinite horizon games, and can be shown to be maximizing and therefore rational strategies for the private sector to adopt. In the electoral case the force of this argument is reduced by a finite time horizon - the electoral period.15 Backus and Driffill (1985) extended the model to include some uncertainty about government preferences, which may rescue the electoral model. This approach, of reputation enforced by a punishment strategy, has particular force in the political context, where party preferences over inflation are uncertain and where there is a clear punishment mechanism; namely, being voted out of office. Indeed, the electoral punishment strategy clearly exists in all democratic societies, while the Barro-Gordon punishment strategy is far harder to observe, as well as requiring a degree of coordination on the part of the public.

There may be other routes towards a tough electoral reputation. One way to acquire a reputation for acting against your apparent best interests,16 which has not been explored in the formal economics literature, is to do crazy things. This is the "Madman" theory of nuclear deterrence. Only a madman would start a nuclear war. So to make deterrence credible, a nuclear state has occasionally to do insane things - for example, invade Cambodia in the course of an unwinnable war in Vietnam.17 This has been termed "rational irrationality" (Powell, 1990: 23). Mrs Thatcher's deflationary policies in the U.K. between 1979 and 1981 can be interpreted in this light.'8 The key insight for the political business cycle, then, is that governments can achieve reputations for, e.g., being tough on inflation; the punishment is that they will not be re-elected if they renege on their electoral bargain. The other political point to make here, is that reputation may be transferrable across domains. For example, Mrs Thatcher's success in the Falklands conflict which led to a large increase in her political popularity, may well have enhanced her reputation in the other battle, against inflation.

4.3. Measurement

This raises the question of how we might measure credibility, an aspect of the debate that has not been considered explicitly in the political business cycle context. There is scope for research in this area. Credibility must be inferred, not observed.19 A credible policy is one that engineers a fall in expectations. So when a credible policy is introduced, we may expect to observe shifts in any relationships that are conditioned on expectations, like the term structure or the Phillips curve. However, by itself this merely moves the onus to another unobservable variable, inflation expectations. One way of



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doing this is to compare the yield curves of indexed and nominal bonds. King (1995) uses this approach in the context of U.K. ERM entry and exit, and to policy announcements in November 1993 and September 1994. In principle it could be applied after elections, rather than after policy pronouncements. The most common method, however, is to use some form of prediction error in a forward looking relationship, such as a Fisher interest rate equation or a wage setting relationship. In the wage equation

Wt = E(Pt) +_... + f(Z) + et (5)

W is proportional to the expected price level, E(P).20 E(P) is not observed, but a reduced form will exist, constructed from the implicit forecasting equation for P, conditioned on lagged information. But if E(P) shifts due to a credible policy announcement, then such a reduced form will break down.21 So one test of a credible policy is to look for evidence of a structural break at the appropriate point in time.22 Examples include Blanchard (1984), Christensen (1987a), Kremers (1990) and Choi and Price (1994). The problem here is that the test is a rather crude one, that cannot distinguish between the standard reason for breakdown - misspecification - and the credibility hypothesis, and may therefore have low power. Another method is to include an explicit proxy for credibility, such as the variability of the exchange rate (Christensen, 1987b). This may suffer from an inadequate choice of proxy, however. An alternative strategy involves treating credibility as an unobserved variable evolving according to some specified stochastic process. This unobservable component may then be estimated by state space methods, for example using the Kalman filter. This is the method used by Ag6nor and Taylor (1992) and in a series of papers by Weber (1991, 1992). In the political business cycle, these methods could be used to measure the public's assessment of the government's credibility.

5. Rational opportunistic models

The discussion on credibility should now put the opportunistic cycle into macroeconomic perspective. If agents are rational and well informed then there will be no cycle. But there is room for uncertainty about critical parameters, which makes room for types of cycle. In Rogoff and Sibert (1988), the uncertainty is about the competence of the incumbent. In their formal model, unobservable competence follows a stochastic (MA(1)) process. Competence must be inferred by the electorate, by observing policy outcomes. Thus this leaves room for parties to signal competence (for example) cutting taxes; ceteris paribus, competent governments can cut taxes most. Persson and



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Tabellini (1990) extend the model from spending on public goods to macroeconomic management. The benefit of signalling is that the incumbent is re-elected; thus the model has opportunistic characteristics. However, there is also a cost, which is that policy is driven from the minimum loss point. Signalling is costly, and therefore inefficient (although only in a first-best sense). In the sense that parties have well-defined objectives, the model could also be interpreted as partisan. Depending on the relative costs and bene- fits, the model predicts either separating or pooling equilibria, both of which generate pre-election cycles, but with different characteristics. This makes the model difficult - possibly, impossible - to test. However, Persson and Tabellini (1990) argue the separating equilibrium is more likely. So we might expect to observe pre-electoral cycles in inflation; Alesina has found such evidence for some countries, which is consistent with this story. Generally, the evidence for pre-electoral instrument cycles is fairly robust (although recall this need by no means imply cycles in output); see Haynes and Stone (1989), Harrington (1993), Grier (1987), Hakes (1988), Alesina, Cohen, and Roubini (1992, 1993), Alesina and Roubini (1992) and Blais and Nadeau (1992). Moreover, as the model predicts that the incentive to manipulate the economy depends on the probability of re-election, the extent of the cycle may depend upon the popularity of the government. One interpretation of this is that policy responds continuously to poll ratings, as in Keil (1988). An alternative specification, more in keeping with the spirit of the model, is that the relationship only exists when it is needed, prior to an election. Rogoff and Sibert (1988) treat re-election probabilities as exogenous. Frey and Schneider (1978, 1981), Schultz (1995) and Price (1996a, b) have empirical models of U.K. elections in which the assumption of exogeneity is either relaxed or used to determine the degree to which electoral manipulation takes place; there is some evidence for the expected effects (see also Davidson, Fratianni, and Von Hagen, 1991).

6. Rational partisan models

The other main strand in the recent political business cycle debate is the partisan issue. Once again, the theoretical conundrum is the mechanism whereby preferences translate into outcomes. Rational agents should foresee the higher inflationary pressure that left governments will bring, and will build this into their expectations. So left governments might bring higher inflation, but not lower unemployment or higher output. But just as uncertainty exists about competence, so it also exists about the outcome of elections. The insight of Alesina (1987) was simply to recognize this. Consequently, agents' expectations have to be a weighted average of the outcome under both right and left



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victories. The actual inflation rate must therefore differ from that anticipated; there must be a post-election inflation surprise (although it could be a small one). So the theory predicts permanent partisan inflation effects, and tempo- rary (post-election) output effects. The evidence seems to support this. This sub-section is a relatively short one, but the idea of rational partisan cycles has probably attracted more attention than any other area within the scope of this paper. Some of this follows from the fact that the model was the chrono-

logical leader in the race to introduce rational expectations into the political cycle, and that the implications of the theory (post rather than pre electoral effects, conditional on the leanings of the new government), were novel. This may have tended to exaggerate the primacy of the theory. Alesina himself has generated a small industry in this area. See, for example, Alesina (1987, 1988, 1989), Alesina and Rosenthal (1995) and Alesina and Sachs (1988). So far as empirical studies are concerned, most of the evidence has been interpreted to lend support to the model. This conclusion is based on the cross-country studies reported in the references cited above; Alogskoufis, Lockwood, and

Philippopoulos (1992) have a richly structured economic model of the U.K. within which they test the theory.

However, there is a problem of endogeneity in many countries. In some countries - notably the U.S. - the election data is fixed. But this is not the case everywhere, and clearly governments will try to call elections at the most advantageous time. Thus election timing is endogenous, and this is hard to model adequately (see Cargill and Hutchinson, 1991, for an attempt at the Japanese case, where election timing is discretionary; see also Ginsburgh and Michel, 1983). Moreover, Sheffrin (1989) uses estimates of post-election forecasts derived from financial data to test the theory for the U.S., and time-series models for a group of OECD countries; he finds no evidence for the theory (but see Alesina, 1990). Ohlsson and Vredin (1996) find partisan effects, but no electoral cycles for Sweden. Girtner (1994b) examines the issues in OECD countries, and concludes there are permanent partisan effects in outcomes. The truth may be Frey and Schneider's original work has been unjustly neglected, and that models that test for either partisan effects or opportunistic effects are misspecified, as Gartner suggests. It may also be that elections are too idiosyncratic and infrequent, and countries' political institutions and mores too diverse, to allow definitive conclusions, even with large panels of country data. Finally, the theory also predicts that the

magnitude of the effect should depend upon the uncertainty surrounding the election outcome. As this can easily be measured with poll data, surprisingly few studies have exploited this link. An exception is Chappell and Keech (1988).



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7. Strategic debt policy

The conventional political business cycle relates to macroeconomic management of fiscal or monetary policy. As we have seen, there is some support for both the partisan and opportunistic models. But there is an alternative

explanation of debt behaviour. This is the notion of strategic debt accumula- tion. Persson and Svensson (1989) asked the interesting question, whether a "stubborn conservative" might run a deficit. In Alesina and Tabellini (1990) two parties with different preferences alternate in power. Each party prefers a different mix of spending.23 Towards the end of the electoral term, the incumbent party has an incentive to run up debt to reduce the successor government's freedom to spend. In an early version of their paper, the authors

quote the New York Times (25 January 1987; also quoted in Milesi-Ferretti and Spolaore, 1994) to illustrate the point:

the deficit is not a despised orphan. It is President Reagan's child, and

secretly he loves it, as David Stockman has explained: the deficit rigor- ously discourages any idea of spending another dime on social welfare.

Lockwood, Philippopoulos, and Snell (1996) extend the model to allow partisan differences about the level of spending and some limited opportunistic behaviour. They test this model for the U.K., and do not reject the model.24

Aghion and Bolton (1990) have a model where a "moderate right-wing" incumbent can increase the chances of re-election by accumulating debt. A

left-wing administration will rationally default, and the median voter will choose the incumbent. These arguments might be characterized as "poisoned chalice" cases. They also have the characteristic that commitment devices (in this case debt) can lead to inefficiencies - unlike the standard case, where an institutional fix leads to Pareto improving states. Milesi-Ferretti and Spolaore (1994) have an example which makes this very clear, where the incumbent

deliberately manipulates the efficiency with which taxes are collected.

8. Conclusions

To conclude, there is evidence that various forms of economic cycles exist that are related to the electoral, political cycle. This seems to hold for a range of countries. However, their existence seems to be somewhat weaker than

many lay observers believe. The view of the economics profession is neatly summarized by the following quote (Alesina and Perotti, 1995: 235).

The theory suggests that electoral budget cycles (i.e., loose policies in election years) should be observed only occasionally and should not be very large.



421

Where there are cycles, they are at least partly interpretable in terms of differing political preferences between parties (the partisan model), rather than outright manipulation of the economy for electoral purposes (the opportunistic model), although this does seem to occur. There is evidence of pre-election cycles in policy instruments and inflation, although effects tend to be erratic and on a relatively small scale, with little or no consequences for output. There are good reasons for expecting these results. The main arguments flow from the natural suspicion the public carries regarding the government's actions. The existence of this belief carries a cost in terms of higher than necessary inflation, so the payoff of schemes for allaying the public's fears about the consequences of electoral democracy is potentially very high. This helps us to understand the rise of autonomous agencies and supra-national policy bodies in recent years. The current popularity of central bank independence is the main manifestation of this view. However, none of this should imply that the literature has led us up a blind alley. Far from it; our understanding of the political business cycle has been transformed since the ground-clearing work of Nordhaus and Frey and Schneider in the 1970s. There is now a rich variety of models available to us; if the models tend to suggest effects are small and variable, then at least we know why this is to be expected, which is a considerable advance in understanding. Moreover, the literature has become fully integrated with the wider study of strategic policy making. The insights from the political business cycle now have general applications throughout the area of macroeconomic policymaking.

Notes

1. Which is not to claim there were no other problems with the literature; see Chrystal and Alt (1981), for example.

2. Sargent and Wallace (1975) provided a model of policy ineffectiveness (possibly pedagogic in intention, although it did not seem so at the time); Barro (1977, 1978) was one of many who began to search for supporting evidence of the proposal. McCallum (1977) used the Barro framework to test for the political business cycle at an early stage in the rational expectations revolution.

3. Time-series analyses have a long history; see Goodhart and Bhansali (1970), or Miller and Mackie (1973) for early papers. Two excellent surveys of the international evidence are Nannestad and Paldam (1994) and Norpoth, Lewis-Beck, and Lafay (1991). Most studies use time series evidence alone; one exception is Sanders and Price (1995), which uses a large (84,950 case) pooled cross-section/time-series data set.

4. For instance, in the U.K. the Falklands war boosted Mrs Thatcher's by no less than 30%, although it is sometimes suggested this result is controversial. Sanders, Marsh, and Ward (1987) claimed there was no independent effect of the war on popularity; other authors, with differing models, differed; see Norpoth (1987) and Clarke, Mishler, and Whiteley (1991).

5. Obviously this can be generalised to the intertemporal case. 6. A better view of C here is that it is the future discounted flow of utility associated with the

party - not just next period, but over the whole future. See Chrystal and Peel (1986).



422

7. However, the presence of measurement error implies that the equation residuals should follow a first-order moving average process, which needs to be modelled explicitly.

8. McCallum (1977) offers evidence as well as theory; but see also Keil (1988) and Minford and Peel (1982).

9. See Hibbs (1992) for a review of the status of partisan theory. 10. As in the macroeconomic environment, punishment strategies will help, but reputational

effects can not ensure full convergence (Alesina and Rosenthal, 1995: 30-34). 11. The games normally considered are between the public inflation-expectation setters and

the government inflation-setter. Detken and G5irtner (1991a, b) allow a wider choice of actions for "unions" playing with the government in a "supply-side" game.

12. See Weber (1991, 1992) and De Grauwe (1990). This asymmetry - large countries gain no benefit, small do - may flow from the attention the financial markets pay to the larger countries exchange rates. The move to EMU may be seen as a development of this process, invulnerable to speculative pressure and probably less revocable.

13. The standard response to endogeneity is to look for testable restrictions that identify a structural model. We are unlikely to find these in this case.

14. Alesina (1988), Alesina and Summers (1993), Cukierman (1992), Cukierman, Webb, and Neypati (1992), Grilli, Masciandro, and Tabellini (1991), Eijffinger, van Rooij, and Schaling (1994) and Eijffinger and van Keulen (1994).

15. One shot games cannot support a reputational equilibrium, for the obvious reason that there is no punishment period. Finite games under certainty always unravel back to a one-shot outcome, by backward induction.

16. This amounts to a definition of reputation, given the time-inconsistency context. 17. In case the reader thinks this example is too far-fetched, here is a quote reported by

Rasmusen (1994), admittedly turning the argument in the text on its head, where Richard Nixon is speaking to his aide, H.R. Haldeman: "I call it the Madman Theory, Bob. I want the North Vietnamese to believe that I've reached the point where I might do anything to

stop the war. We'll slip the word to them that 'for God's sake, you know Nixon is obsessed about Communism. We can't restrain him when he's angry - and he has his hand on the nuclear button' - and Ho Chi Minh himself will be in Paris in two days begging for peace" (Haldeman and DiMona, 1978: 83).

18. There is a sense in which this behaviour was a response to the failure of another credibility gaining device - the Medium term Financial Strategy (MTFS). This was introduced partly to lend credibility to the medium-term anti-inflation policy, by announcing money supply and PSBR targets several years in advance. Yet there is no evidence of a credibility effect on the introduction of the policy; see Drifill (1992) and Choi and Price (1994).

19. See Ag6nor and Taylor (1992) for some discussion of methods. 20. It is also affected by a set of variables Z and by the excluded dynamics implicit in .... 21. This is, of course, a classic example of the Lucas Critique. 22. Given we are normally testing for a credible reduction in inflation the appropriate test is

one-sided, so standard F-tests are inappropriate. 23. This idea can be traced back to Strotz (1956), where a consumer's tastes change over time.

In the political case, governments alternate. 24. Paldam and Skott (1995) have a "balancing" model of voter choice where voters choose

their optimal policies by alternating governments of different persuasions to allow outcome to evolve over time, which is reminiscent of this idea.



423

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