Capitalism, Not Globalism: Capital Mobility, Central Bank Independence, and the Political Control of the Economy

Chapter 4 Elections and Fiscal and Monetary Policy

CHAPTER 4 Elections and Fiscal and Monetary Policy President Johnson has found in modern economic policy an instrument that serves him well in giving form and substance to the stuff of which his dreams for America are made, in molding and holding a democratic consensus, and in giving that consensus a capital “D” in national elections. —Walter Heller, chairman of the Council of Economic Advisers, 1961–64 In the previous chapter, evidence was presented that called into question the partisan perspective on macroeconomic policy. The extant empirical literature is full of contradictory findings.An attempt to control for the modifying effects of institutional context deduced from the theoretical models in chapter 2 failed to clarify this web of tangled results. One conclusion that can be drawn from the exercise in chapter 3 is that systematic partisan differences in monetary and fiscal policy simply did not exist before, during, or after the recent increase in international capital mobility because partisan convergence occurred a long time ago. Does this mean that monetary and fiscal policies have been, and remain , apolitical? Perhaps, but another alternative is that it was electoral pressures that induced partisan convergence and also induced the politically motivated policy choices predicted by the political business cycle literature. This chapter asks whether monetary and fiscal policies are tied to the electoral calendar . As was the case with the partisan model, the existing literature on electoral cycles in monetary and fiscal policies is fraught with contradictory findings . Can sense be made of the empirical results if we pay adequate attention to the institutional context in which policy choices take place? 85 This chapter examines how the interaction of the international environment with domestic political institutions constrains a government’s ability to use monetary and fiscal policy to engineer preelectoral macroeconomic expansions . It has long been argued that incumbent politicians who want to win the next election may manipulate economic tools at their disposal in an attempt to satisfy the electorate enough so that they are reelected (Nordhaus 1975; MacRae 1977; Tufte 1978; Keech 1995, chap. 3). Clark and Nair Reichert (1998) find that such cycles are almost entirely absent in states with independent central banks. They also find that opportunistic cycles are not likely to occur when capital is mobile and the exchange rate is fixed. Clark and Nair Reichert’s evidence is consistent with the decision-theoretic model in chapter 2, but it is not consistent with the game-theoretic model in that same chapter. Specifically, one aspect of their findings is curious. While there are good reasons to expect the identified constraints to make it difficult to use monetary policy for electoral purposes, there is no a priori reason to expect fiscal policy to be constrained under such circumstances. Even when a central bank has complete control over monetary policy, the government can still attempt to affect macroeconomic outcomes through cuts in taxes or increases in expenditures. Similarly, while monetary policy may be constrained when exchange rates are fixed and capital is mobile, incumbents are free to use fiscal policy to create preelectoral expansions. The temptation to use these instruments before upcoming elections to win over undecided voters may be especially high; in particular, discussions of taxes and attempts to reduce them often seem to dominate election campaigns. Clark and Nair Reichert’s results regarding the conditions under which electoral cycles in output and unemployment occur will be examined more fully in chapter 6. This chapter will focus on the electorally motivated manipulation of monetary and fiscal instruments thought to produce such cycles. While open-economy models have often privileged monetary policy over fiscal policy, the literature on the domestic determinants of fiscal policy tends to ignore the international environment in which policy is made. This may be one reason that these studies have produced inconclusive results: while Burdekin and Laney (1988) and Franzese (1996) find that independent central banks do reduce the size of deficits, several others have not confirmed the relationship (Grilli, Masciandaro, and Tabellini 1991; Pollard 1993; de Haan and Sturm 1994a [the latter two works as quoted in Eijffinger and de Haan 1996].) The Mundell-Fleming model indicates that governments can, at best, pursue only two of the following three goals: capital mobility, fixed exchange rates, and independent monetary policy.1 The absence or presence of each of these con86 Capitalism, Not Globalism ditions affects the nature of...