Parliamentary Democracy and the Political Business Cycle

The temporary monopoly provided to governments in an election not only promotes a policy in favour of interest groups, it may also have a dynamic impact on promoting political business cycles.

This basic hypothesis was first proposed by William D. Nordhaus (1975). In the elections, voters evaluate the government’s past ability to steer the economy between unemployment and inflation under the assumption of a Phillips curve. They weigh unemployment more negatively than inflation. The government can gain votes if it steers the economy in a way that unemployment is low at election time (even if inflation is somewhat higher). If, after the election, inflation has to be reduced again and unemploy­ment increases, the government’s popularity decreases. However, before the next elec­tions, voters will have forgotten these hardships and will vote again for the government if unemployment is low, even if inflation is high.

These considerations are diametrically opposed to the traditional economic policy paradigm: whereas in traditional public finance it is assumed that a government controls its expenditures and revenues in a way that the economic fluctuations are dampened, Nordhaus concludes from his model that the government can use incentives to generate these fluctuations. In other words, if the private sector of the economy does not generate fluctuations on its own, then the government of a representative democracy, which has to be re-elected periodically, would cause them. Therefore, the attention of public choice economists should focus more on endogenous cycles than on exogenous cycles.

The Nordhaus hypothesis has triggered an intensive discussion. Three alternative models have been proposed: the partisan theory by Douglas A. Hibbs (1977), the theory of rational expectations by Alberto Alesina (1987) and an intermediary theory by Bruno S.

1. Hibbs argues that parties have their partisans and they will support the interests of their partisans if they come to power. Hibbs, therefore, does not follow the Nordhaus (and Downs) hypothesis according to which parties make their programmes accord­ing to vote maximization. In Hibbs’s model, parties follow a political science atti­tude in that they try to win an election with the ideology of their partisans. Left-wing parties pursue an expansive and inflationary labour market policy favouring infla­tion rather than unemployment for their lower middle-class clientele. Right-wing parties pursue an opposite policy for their upper middle-class clientele. As a conse­quence, Hibbs predicts a political business cycle when the governing party changes.

2. Alesina and other proponents of the political economics school are critical of the theory of the political business cycle of Nordhaus whom they include in the public choice school. Their approach is “anti-public choice” (Blankart and Koester 2006). They argue that the Nordhaus public choice theories contradict the theory of rational expectations. A government acting according to the Nordhaus model systematically and permanently deceives the voters. If, for example, the government pursues an

inflationary policy to lower unemployment, it is allegedly assumed that workers do not understand that this policy is accompanied by a decrease in the real wage. Only under this illusion will they be willing to work more, and only in this case is a drift along the Phillips curve possible for the government. If, however, rational expecta­tions are assumed, individuals do not evaluate the government on the performance in the expired legislative period, but rather on the impact that governmental actions will have in the future. The individuals see through the intentions of the government, they do their appropriate disposals and attempt to block their impacts: for example, unions will anticipate the inflation effects of an expansive tax and spending policy; they will not accept the decrease in real wages and therefore will demand higher wages, and similar, with the consequence that a positive employment effect will not be initiated and there will be no political business cycle.

Indeed it makes no sense why a government should try to create political business cycles. A political influence on the economic cycle - if any - has to be justified in another way. Alesina takes Hibbs’s partisan theory as a starting point and intro­duces the assumption of an uncertain election outcome. Before the election, voters do not exactly know if a left-wing party with a preference for an expansive national budget or a right-wing party favouring a contractionary budget will come to power. Therefore the citizens will behave cautiously in their function as workers and union agents. They will assume an average budgetary policy for their wage claim if the labour agreement will hold beyond the election date. If one party comes to power, there will be surprises and real (expansive or contractionary) effects. From this perspective, politics will keep its influence on the economy. However, it remains an open question why workers with rational expectations do not adjust their labour agreements to the election dates. Then there would be no political business cycles. Thus the question remains: why do really rational unions and employers not adjust their negotiations to the election dates? In this way they could avoid surprises. In as much as Alesina leaves this question open, his unions do not seem to have fully rational expectations.

Mueller (2003: ch.19) puts the different models to the test and analyses which one better explains the US business cycles between 1949 and 2000. Hibbs’s parti­san theory performs best. If the president is a democrat, unemployment decreases whereas it increases if the president is a republican. The theories of political business cycles of Nordhaus perform slightly less satisfactorily and the theoretically ambi­tious models of Alesina (in Alesina and Rosenthal 1995) perform definitely worse.

While Hibbs’s partisan theory seemed to work well for the United States it was less successful for other countries. For Germany, Gerrit B.

3. An intermediate approach between Nordhaus and Alesina has been developed by Frey and Schneider (1978). In their theory, incentives of the government to become budgetary politically active depend on the electoral-political need. This is given if elections are about to be held and the economic situation is bad. With a bad economic situation, for example, high unemployment or high inflation, the regularly measured

Table 3 Government budgetary policy dependent on election dates and economic situation

Source: Frey and Schneider (1978).

popularity of the government is low. With upcoming elections, the government sees itself forced to take immediate budgetary counteractions. In the case of high unem­ployment, it will raise the expenditures (especially transfers) and lower taxes. In case of high inflation, it will lower the expenditures for goods and services and, possibly, raise taxes. In doing so, it hopes to win back lost popularity and to avoid an election loss. This case is illustrated in the upper left field in Table 3. In all other cases where either the economic situation is good and the popularity is high or no elections are coming up, the government does not need to become politically active. The govern­ment can plan its incomes and expenditures in the long run dependent on its ideology and does not have to directly consider the interests of the voters. The approach of Frey and Schneider has been successfully tested for different countries.