Macroeconomic Policy and Public Choice

 

Springer

1999

 

Study Edition

ISBN 3-540-64872-0

 

Macroeconomic policy and public choice are linked. Macroeconomic stabilization is generally practiced as an explicit public policy. This book focuses on positive questions relating to stabilization. We are most interested in how governments affect the economy. Democratic countries give their governments the responsibility of reducing the severity of the business cycle; and elections are decided at least in part by voter perceptions about the ability of the candidates to manage the economy. An insight of the public choice approach is the realization that presidents and voters can have different objectives. For example, we take a particular interest in the political business cycle hypothesis, the use of stabilization policy to manipulate the economy for electoral advantage.

            The democratically managed economy arose after the Second World War. We begin with a macroeconomic history of the past century that stresses the Keynesian revolution and government’s changing role. Chapters 2 through 4 develop a theoretical background from microfoundations. Chapter 2 outlines the microeconomics of general equilibrium with particular reference to categories of behavior relevant to macroeconomic analysis. Chapter 3 provides a theoretical foundation for public choice beginning with a positive note, May’s theorem, followed by a negative one, Arrow’s theorem. The general impossibility of guaranteeing an acceptable social decision rule suggests more restricted models of democracy; the median voter model is such a theory. In its usual deterministic form, the median voter model is remarkably unstable, requiring rather implausible conditions for a political equilibrium. But in its probabilistic form it provides a more realistic theoretical foundation. The probabilistic model has a unique and stable political equilibrium under more general conditions, providing a basis for a positive theory of political economy.

            Macroeconomic theory is the subject of the fourth chapter. In recent decades the once well-established Keynesian consensus has been surprised by unexpected events, and shaken by the rise of alternative doctrines. There is even a popular book titled The Seven Schools of Macroeconomics. We do not attempt to extend these debates with new twists of theory, nor do we settle arguments about theoretical coherence. We do present the main conceptual differences of the competing models within a microeconomic framework. Our discussion emphasizes the Keynesian approach because it is the one most closely identified with activist stabilization. Its insights are essential to applications involving the democratic appointment of discretionary policymakers.

            Chapters 5 and 6 provide a statistical background on the relevant variables organized around the Phillips curve and the stabilization tools (the deficit and the money stock). We devote considerable space to the statistical measurement of macroeconomic concepts to insure the robustness of our econometric inferences. Although the Phillips curve began as the inverse relation between wage inflation and the unemployment rate, economists often substitute the level of output for the unemployment rate without changing the curve’s meaning. This substitution is legitimate when the output concept is the deviation from the macroequilibrium. Several decades ago the Phillips model was augmented to account for the effects of inflationary expectations. This development leads to the controversial concept of rational expectations, a hypothesis that has attracted considerable interest for its relevance to political macroeconomics.

            Theorists have spun complex theories about the business cycle, but their empirical support remains uncertain. For example, the Phillips curve is a fairly weak tendency in the postwar data, and, as we show, estimates of its slope are rather inaccurate. The empirical definitions of the main stabilization tools also are uncertain, and their hypothesized impact on output or inflation is not well verified by Granger causality tests. In the face of this meager statistical support, the relevance of our macroeconomic models may be questioned. Of course, we might equally question many other books on macroeconomics. We persevere in the hope that the process will lead to better explanations.

            Chapters 7 through 12 are the core of the book. Chapter 7 compares the hypothesis that the swings of the business cycle are inherent in the market economy against the alternative hypothesis that booms and busts are merely the manifestations of external shocks. Here we address the underlying nature of business cycles, a topic that logically precedes any discussion of intervention. We develop a nonlinear Keynesian cycle model that is theoretically general enough to include convergence or perpetual cycling as special cases. Our results, both theoretical and empirical, verify the Keynesian conclusion that without intervention recessions can be long-lasting.

            Chapter 8 uses the Gallup Poll to study the nature of voter preferences for economic policy. Our tests support the assumption that inflation and output are high priorities for US voters and that the quadratic form we assume for their objective function is plausible. Such preferences are used in Chapter 9 to investigate the possibil­ity that voters prefer conservative presidents due to their roles as eco­nomic man­agers. In a model where the president practices short run stabilization policy to dampen the im­pact of exogenous shocks we find that voters can often gain by electing a conservative president.

            It seems obvious that the four-year cycle of elections influences economic policy. Chapters 10 and 11 explore this issue. We begin with an examination of a plot of US inflation versus output in search of cycles synchronized with national elections. Unfortunately, existing theories do a poor job of explaining the postwar history of employment and inflation. Recent research reports new evidence that election effects exist, and offers a new explanation based on the rational expectations hypothesis. Our contribution is a negative evaluation of the rational explanation due to its inconsistency with postwar US history. Because there have been only a few US observations (11 elections), we turn to a larger sample of 173 elections in 18 democracies for verification. For both data sets, our analysis suggests a return to an older theory in which expectations are less sophisticated.

            We conclude with the most talked about economic issue of the day, the long-lasting public deficit. We survey the relevant views on this issue. On one side are the Ricardians who feel that the public debt is of no concern since farsighted consumers have already adjusted their savings and bequests to help their children pay off the debt they did not get to vote on. On the other is the view that persistent deficits have crowded out investment and will eventually reduce productivity by a significant amount. We use an overlapping approach to explain these views and compare their predictions. Model predictions vary drastically when assumptions are changed.

            The organizing idea of this book is the existence of a political economic equilibrium in an activist democracy. Given the election cycle and the fact that agents make forecasts of stabilization policy, this equilibrium may be a cycle rather than a point. We pay special attention to the relevant data and to possibilities for hypothesis testing, finding relatively weak evidence in favor of Keynesian assumptions.