Political Marcoeconomics

Politics, Time Inconsistency,
Credibility and Reputation

 The incorporation of rational expectations such as those explained by my members
into macroeconomic models has led to the dominance of game theory in economic
policy literature. Policymakers are viewed as playing dynamic games with private-
sector economic agents (voters), a concept popularized by Kydland and Prescott in
1977. They highlighted the issue of "time inconsistency," where governments, using
discretionary policies, face an incentive to cheat by creating inflation surprises to
boost employment, which voters anticipate, resulting in an inflationary bias.
Credible policy announcements, therefore can be defined as those which are time
consistent. Solutions to the inconsistency include contractual arrangements,
delegation of decisions, and legal or institutional constraints.
 Rational voters will only believe politicians who make ex ante policy announcements
which are also optimal to implement ex post. However, since rational agents have
imperfect information about the real motives of politicians as opposed to their pre-
election promises. Policymakers, on the other hand, must maintain credibility and
manage reputation, balancing election strategies and long-term commitments.
 Alesina’s work challenges the idea of policy convergence in two-party systems, such
as those in some western countries, arguing that pre-election promises are time-
inconsistent and that partisan interests take over after elections.
In the period before an election both parties find it in their interest to announce
convergent policies on the assumption that this will appeal to the median voter.
Ideological issues take back stage in order to maximize re election prospects.
However, if there is no mechanism for holding an elected government to its
promises, these announced convergent policies must be time-inconsistent. After the
election the influence of partisan considerations will predominate as the elected
politicians re-optimize and follow a programme which best fits their ideological
stance.
Voters, therefore, should expect politicians to follow ideological policies post-
election, despite pre-election promises. This theory was evident in the UK's 1997
election when the Labour Party under Tony Blair pledged to be tough on inflation.
Political and Economic Instability:
Are They Related?
 The relationship between political and economic stability is a key area of research in
the politico-economic sphere. Studies suggest that political instability, such as riots,
violence, and revolutions, negatively affects economic performance. Keynes has
always emphasized that uncertainty depresses investment and entrepreneurship.
Alesina's partisan theory predicts that political instability increases when partisan
differences lead to divergent policies, creating uncertainty. Governments with little
chance of re-election may adopt short-term, irresponsible policies.
 Fragile coalition governments often struggle to implement necessary economic

reforms for long-term stability. Alesina found a correlation between political
instability and Okun's misery index (inflation + unemployment) and showed that
delays in economic reforms occur when competing political parties engage in a "war
of attrition," i.e they attempt to shift the fiscal burden onto the other party’s
supporters. This leads to debt accumulation and economic crises.
 Cross-country studies, such as those by Cukierman, demonstrate that politically

unstable countries rely more on seigniorage (inflation tax) to finance their budgets,
leading to higher inflation. This finding is substantiated with research by Edwards
and others, who noted that the incentive to use inflationary finance increases with
political volatility. In extreme cases, this can lead to hyperinflation.
The Political Economy of
Economic Growth
Political instability has significant adverse effects on economic growth, as
highlighted by recent research into the deeper determinants of growth, including
politics and institutions. Drazen (2000a) suggests that political economy literature
on growth is a natural extension of the research on income redistribution.
OLD v/s NEW
A key distinction exists between the "old" and "new" views of inequality's impact on
growth. The old view, dominant in the 1960s and 1970s, emphasized capital
accumulation as essential to economic growth, based on models like the Harrod-
Domar growth model. In this perspective, inequality was seen as beneficial because
the wealthy were assumed to save more, fostering growth. The idea was supported
by the "Kuznets hypothesis," which posits an inverted U-shaped relationship
between inequality and GDP per capita: inequality initially rises during development
and then decreases. However, by the latter half of the 20th century, the new view
began to emphasize the negative effects of inequality on growth. Studies by Aghion
et al. (1999) and others challenged the notion that inequality is necessary for
growth, showing that it can instead hinder development.
Theories
 Several mechanisms explain how inequality harms growth. One is the "credit market
channel," which limits poor individuals' access to financing for education, thereby
reducing human capital formation and growth. Another is the "fiscal channel," where
redistributive policies raise taxes on potential investors, discouraging investment. A
third channel links inequality to rent-seeking, corruption, and crime, which
destabilizes property rights and discourages investment. As Glaeser et al. (2003)
argue, inequality allows the rich to subvert legal and political systems to maintain
their power, undermining economic institutions.
 Hirschman (1973) introduced the "tunnel effect," where initially, low-income groups
tolerate inequality during early development stages, but this tolerance erodes if
they do not benefit from growth. Persistent inequality can lead to political instability
and "development disasters."
 Moreover, Murphy et al.'s (1989b) "Big Push" theory argues that industrialization
requires a large domestic market, which inequality suppresses, making it difficult to
achieve economic growth.
Overall, modern research supports the view that inequality can negatively affect
growth through various mechanisms, including reduced investment in human
capital, increased social tensions, and a suppression of domestic demand.
Redistributive policies, though necessary to reduce inequality, must balance the
costs of taxation against the benefits of greater social stability.
Political barriers to economic
growth
Economists generally understand the essentials for economic growth and the pitfalls
to avoid. However, many governments persist in adopting policies that hinder
productivity, growth, and entrepreneurship, often marked by high corruption (Aidt,
2003). This raises the question: why don’t governments learn from these failures
and shift to more effective policies? Acemoglu and Robinson (2000, 2003) offer
insights into the political dynamics that maintain economic stagnation:
1. New technologies that promote growth also alter political power dynamics.
2. Groups fearing a loss of power due to technological advances may resist change,
even if beneficial to society.
3. While new technology can increase overall wealth, it can also empower rival
factions, threatening the existing elite.
4. This creates a dilemma for elites: they must balance potential economic gains
from progress against the risk to their political dominance.
5. Commitment issues prevent elites from supporting changes that would benefit
the economy and their interests.
6. External threats can force elites to accept modernization, as seen in Japan during
the Meiji Restoration.
Acemoglu and Robinson analyze political shifts and industrialization in countries like
the USA, Britain, Germany, and Russia, arguing that competition among political
elites drives acceptance of change. In contrast, insecure elites, like absolute
monarchs in Russia and Austria-Hungary, resisted industrialization to protect their
power. In contrast, entrenched elites in the USA and Britain adapted incrementally
to promote growth.
Kleptocratic regimes, where leaders exploit power for personal gain, exemplify
severe developmental failures. Historical examples include Trujillo (Dominican
Republic) and Mobutu (Zaire). The longevity of such regimes often stems from weak
institutions that facilitate a divide-and-rule strategy, where kleptocrats undermine
collective action against them by bribing influential groups (Bates, 1981, 2001).
Access to natural resources and foreign aid further entrenches these regimes,
particularly in low-income nations. Ethnic diversity can be exploited for this
strategy, as kleptocrats may use targeted bribery to diminish opposition. Studies by
Mauro (1995) and Easterly and Levine (1997) link political instability and poor
economic performance in regions like sub-Saharan Africa to ethnic fractionalization.

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Politics, Time Inconsistency,

Credibility and Reputation

 Fragile coalition governments often struggle to implement necessary economic

 Cross-country studies, such as those by Cukierman, demonstrate that politically

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