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Engineering Good Times: Fiscal Manipulation in a Global Economy

Published online by Cambridge University Press:  25 November 2010

Angela O’Mahony
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Abstract

In a global economy, a country’s international economic ties affect both how desirable pre-electoral fiscal manipulation is to the government, and how costly it is to the government to engage in such manipulation. Governments are more likely to engage in pre-electoral fiscal manipulation when the country’s exchange rate is flexible and the domestic economy is highly open to international trade, and when the exchange rate is fixed and the domestic economy is relatively closed to international trade. This argument is tested empirically through a quantitative analysis of changes in government debt in twenty OECD countries from 1974 to 2008.

Type
Research Article
Information
British Journal of Political Science , Volume 41 , Issue 2 , April 2011 , pp. 315 - 340
Copyright
Copyright © Cambridge University Press 2010

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References

1 For a recent review of the literature on pre-electoral fiscal manipulation, see Franzese, Robert J. Jr, ‘Electoral and Partisan Cycles in Economic Policies and Outcomes’, Annual Review of Political Science, 5 (2002), 369–422CrossRefGoogle Scholar.

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5 This literature has focused on two strategies for economic expansion: monetary policy and fiscal policy. Of the two, fiscal manipulation appears to be more effective. See Drazen, Allen, ‘The Political Business Cycle After 25 Years’, NBER Macroeconomics Annual, 15 (2000), 75–117CrossRefGoogle Scholar. This review focuses on political budget cycles.

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11 Minority governments must get expenditures approved in parliament, and therefore, if opposition parties act to constrain government spending, minority governments might spend less. This depends in part on the bargaining position of the minority governing party and whether opposition parties would actually constrain spending. To the extent that opposition parties can be bought off, this may be another reason why manipulation is greater under single-party minority governments.

12 For coalition governments, multiple veto players only act as a constraint on manipulation if the coalition partners are in disagreement over an election-year expansion. Bawn, Kathleen and Rosenbluth, Frances (‘Short versus Long Coalitions: Electoral Accountability and the Size of the Public Sector’, American Journal of Political Science, 50 (2006), 251–65)CrossRefGoogle Scholar and Persson, Torben, Roland, Gerard and Tabellini, Guido (‘Electoral Rules and Government Spending in Parliamentary Democracies’, Quarterly Journal of Political Science, 2 (2007), 155–189)CrossRefGoogle Scholar present models in which coalition governments have higher expenditures than other types.

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18 For a summary of PBCs in the United States, see Drazen, ‘The Political Business Cycle After 25 Years’. For Britain, see Sattler, Thomas, Brandt, Patrick T. and Freeman, John R., ‘Democratic Accountability in Open Economies’, Quarterly Journal of Political Science, forthcomingGoogle Scholar.

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23 Rodrik, Dani, ‘Why Do More Open Economies Have Bigger Governments?’ Journal of Political Economy, 106 (1998), 997–1032CrossRefGoogle Scholar; Easterly, William, Islam, Roumeen and Stiglitz, Joseph E., ‘Shaken and Stirred: Explaining Growth Volatility’, in Boris Pleskovic and Nicholas Stern, eds, Annual World Bank Conference on Development Economics 2000 (Washington, D.C.: World Bank) 2001, 191–212Google Scholar.

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28 Greider, William, One World, Ready or Not: The Manic Logic of Global Capitalism (New York: Simon & Schuster, 1997)Google Scholar; Friedman, Thomas L., The Lexus and the Olive Tree: Understanding Globalization (New York: Anchor, 2000)Google Scholar; and Korpi, Walter and Palme, Joakim, ‘New Politics and Class Politics in the Context of Austerity and Globalization: Welfare State Regress in 18 Countries’, American Political Science Review, 97 (2003), 425–446CrossRefGoogle Scholar.

29 Burgoon, ‘Globalization and Welfare Compensation’; Hays et al., ‘Government Spending’.

30 Garrett, ‘Capital Mobility’.

31 Hicks and Zorn, ‘Economic Globalization’.

32 Edwards, Sebastian and Levy-Yeyati, Eduardo, ‘Flexible Exchange Rates as Shock Absorbers’, European Economic Review, 49 (2005), 2079–2105CrossRefGoogle Scholar.

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35 Broda, Christian, ‘Coping with Terms-of-Trade Shocks: Pegs versus Floats’, American Economic Review, 91 (2001), 376–380CrossRefGoogle Scholar; Edwards and Levy-Yeyati, ‘Flexible Exchange Rates’.

36 di Giovanni, Julian and Shambaugh, Jay C., ‘The Impact of Foreign Interest Rates on the Economy: The Role of the Exchange Rate Regime’, Journal of International Economics, 74 (2008), 341–361CrossRefGoogle Scholar.

37 Evidence for real exchange rate depreciation under a flexible exchange rate regime in response to a fiscal shock is found in Kim, Soyoung and Roubini, Nouriel, ‘Twin Deficit or Twin Divergence? Fiscal Policy, Current Account, and Real Exchange Rate in the U.S.’, Journal of International Economics, 74 (2008), 362–383CrossRefGoogle Scholar; Monacelli, Tommaso and Perotti, Roberto, ‘Fiscal Policy, the Trade Balance and the Real Exchange Rate: Implications for International Risk Sharing’ (working paper, Universitá Bocconi, 2006)Google Scholar; and Ravn, Morten, Schmitt-Grohe, Stephanie and Uribe, Martín, ‘Explaining the Effects of Government Spending Shocks on Consumption and Real Exchange Rate’ (National Bureau of Economic Research, Working Paper No. 13328, 2007)Google Scholar; Bénétrix, Augustín and Lane, Philip R., ‘Fiscal Shocks and the Real Exchange Rate’ (Institute for International Integration Studies Discussion Paper No. 286 (Dublin, 2009)Google Scholar.

38 Bénétrix and Lane, ‘Fiscal Shocks’, find that this real exchange rate depreciation may be relatively short-lived. The real exchange rate depreciates in the first two years after an increase in government spending and appreciates thereafter, but remains below its initial level.

39 Clark and Hallerberg, ‘Mobile Capital’.

40 For evidence of the positive relationship between government and private consumption, see Galí, Jordi, David López-Salido, J. and Vallés, Javier, ‘Understanding the Effects of Government Spending on Consumption’, Journal of the European Economic Association, 5 (2007), 227–270CrossRefGoogle Scholar; and Mountford, Andrew and Uhlig, Harald, ‘What are the Effects of Fiscal Policy Shocks?’ (National Bureau of Economic Research, Working Paper No. 14551, 2008)Google Scholar. For evidence of the weak relationship between government consumption and interest rates, see Perotti, Roberto, ‘Estimating the Effects of Fiscal Policy in OECD Countries’ (Centre for Economic Policy Rules, Discussion Paper No. 4842, 2005)Google Scholar.

41 As Lahiri, Amartya, Singh, Rajesh and Vegh, Carlos A., ‘Optimal Exchange Rate Regimes: Turning Mundell–Fleming’s Dictum on its Head’, in Carmen Reinhart, Andres Velasco and Carlos A. Vegh, eds, Money, Crises, and Transitions: Essays in Honor of Guillermo Calvo (Cambridge, Mass.: MIT Press, 2008)Google Scholar, demonstrate, the automaticity of monetary adjustment under the Mundell–Fleming model reflects the assumption of asset market flexibility. More broadly, Beetsma, Roel, ‘A Survey of the Effects of Discretionary Fiscal Policy’, Rapport till Finanspolitiska rådet 2008/2 (Stockholm: Swedish Fiscal Policy Council, 2008)Google Scholar, discusses how international asset market segmentation generates results in conflict with the Mundell–Fleming model.

42 For a review of new open economy macroeconomics, see Lane, Philip R., ‘The New Open Economy Macroeconomics: A Survey’, Journal of International Economics, 54 (2001), 235–266CrossRefGoogle Scholar.

43 Beetsma, ‘A Survey’.

44 Ravn et al., ‘Explaining the Effects of Government Spending Shocks’.

45 Monacelli and Perotti, ‘Fiscal Policy’.

46 Galí et al., ‘Understanding the Effects of Government Spending on Consumption’.

47 Beetsma, Roel, Giuliodori, Massimo and Klaassen, Franc, ‘The Effects of Public Spending Shocks on Trade Balances and Budget Deficits in the European Union’, Journal of the European Economic Association, 6 (2007), 414–423CrossRefGoogle Scholar; Bénétrix and Lane, ‘Fiscal Shocks’.

48 Similarly, lowering interest rates or expanding the money supply to increase economic output generates higher inflation. However, it is generally assumed that post-election inflation does not constrain pre-electoral monetary expansion. See Alesina, Alberto and Roubin, Nouriel with Cohen, Gerald D., Political Cycles and the Macroeconomy (Cambridge, Mass.: MIT Press, 1997)Google Scholar.

49 While Beetsma, Giuliodori and Klaassen, ‘The Effects of Public Spending Shocks’, find a later onset for exchange rate appreciation, this may reflect the inclusion of flexible exchange rate regimes in their sample.

50 Brock Blomberg, S., Frieden, Jeffry A. and Stein, Ernesto, ‘Sustaining Fixed Rates: The Political Economy of Currency Pegs in Latin America’, Journal of Applied Economics, 8 (2005), 203–225Google Scholar; Schamis, Hector E. and Way, Christopher R., ‘The Politics of Exchange Rate-Based Stabilization’, World Politics, 56 (2003), 43–78CrossRefGoogle Scholar. This empirical regularity has led Stein, Ernesto H. and Streb, Jorge M. (‘Elections and the Timing of Devaluations’, Journal of International Economics, 63 (2004), 119–145CrossRefGoogle Scholar) and Stein, Ernesto H., Streb, Jorge M. and Ghezzi, Piero (‘Real Exchange Rate Cycles Around Elections’, Economics & Politics, 17 (2005), 297–330CrossRefGoogle Scholar) to develop formal models in which the government signals its competence by slowing the rate of currency devaluation below its sustainable level prior to the election. Bonomo, Marco and Terra, Cristina (‘Elections and Exchange Rate Policy Cycles’, Economics & Politics, 17 (2005), 151–176CrossRefGoogle Scholar) develop a model where the government engages in a pre-electoral fiscal expansion in order to generate a real exchange rate appreciation that helps consumers and hurts the tradable sector, thus signalling to voters that the government has not been captured by the tradable sector.

51 In fact, for consumers, a real exchange rate appreciation makes foreign goods cheaper, increasing their ability to purchase imports. For voters in the tradable sector, I assume their concentrated interests as producers outweigh their diffuse interests as consumers. If these voters care more about their increased purchasing power, then they are unlikely to punish the government for a pre-electoral real exchange rate appreciation.

52 Bonomo and Terra (‘Elections and Exchange Rate Policy Cycles’) highlight the costliness of a real exchange rate appreciation for the tradable sector. Based on their model, as the political importance of the tradable sector increases, governments will manufacture smaller real exchange rate appreciations.

53 Technically, the association between trade and pre-electoral fiscal manipulation is less positive under a fixed exchange rate than under a flexible exchange rate. This implies that the rate of increase in pre-electoral fiscal manipulation as trade increases is smaller under a fixed than under a flexible exchange rate. Whether increasing trade under a fixed exchange rate absolutely decreases pre-electoral fiscal manipulation depends on how important competitiveness is to the government with respect to offsetting volatility. When the government is relatively more concerned about competitiveness (as is assumed in Hypothesis 3), increasing trade reduces the likelihood that the government will engage in pre-electoral fiscal manipulation.

54 Clark and Hallerberg, ‘Mobile Capital’. I replicate Clark and Hallerberg’s results in the Appendix published by Cambridge University Press at http://www.journals.cambridge.org/jps. I thank William R. Clark, Mark Hallerberg, Jakob de Haan and Jan-Egbert Sturm for their data.

55 Linear regression with panel corrected standard errors represents a valuable combination that gains explanatory leverage from cross-national and cross-temporal data, while correcting for possible spatial and temporal correlation of errors. However, because the results may be a function of this specific estimation technique, either through the inclusion of panel-corrected standard errors, or through the exclusion of country and year controls, five alternative model specifications are tested. The first is a random effects model. The second and third add year and country dummies, respectively. The fourth includes both year and country dummies. The fifth is an Arellano–Bond linear dynamic panel data model with robust standard errors. All five alternative models provide support for the argument. To ensure that the results are not sensitive to country outliers, I exclude each country individually. All robustness tests are presented in the Appendix at http://www.journals.cambridge.org/jps.

56 Economic variables are from Organisation for Economic Cooperation and Development, Economic Outlook (Paris: Organisation for Economic Cooperation and Development, various years), unless otherwise specified.

57 Results are similar if level of unemployment or GDP growth is used.

58 The data are differenced to control for temporal trending. To assess whether these data are sufficiently de-trended, I run Prais–Winsten and Cochrane–Orcutt generalized least squares regressions to test for the presence of a unit-root. These models provide support for the argument, and based on the Durbin–Watson statistics (close to 2 in value), there is no evidence of a unit root either in the original or the transformed series.

59 Defined by Clark and Hallerberg as ‘the change in the real interest rate minus the change in the growth rate times the gross deficit in the previous year’, where the growth rate used was nominal. I recreate this measure using real GDP growth, as this seems more consistent with the change in real interest rates. The analysis is robust to the inclusion of either transformation.

60 Election data were collected from Binghamton University’s Center on Democratic Performance Election Results Archive http://www.binghamton.edu/cdp/era/; the International Foundation for Election Systems Election Guide http://www.electionguide.org/; the International Institute for Democracy and Electoral Assistance http://www.idea.int/index.cfm; and various national election sources. For a discussion on identifying regular elections, see Strøm, Kaare, Müller, Wolfgang C. and Bergman, Torbjörn, Delegation and Accountability in Parliamentary Democracies (Oxford: Oxford University Press, 2003)CrossRefGoogle Scholar.

61 Kayser, Mark Andreas, ‘Who Surfs, Who Manipulates? The Determinants of Opportunistic Election Timing and Electorally Motivated Economic Intervention’, American Political Science Review, 99 (2005), 17–27CrossRefGoogle Scholar; Smith, Alastair, Election Timing (Cambridge: Cambridge University Press, 2004)Google Scholar.

62 Five alternative election measures are presented in the Appendix at http://www.journals.cambridge.org/jps.

63 International Monetary Fund, Exchange Arrangements and Exchange Restrictions, (Washington, DC: International Monetary Fund, various years).

64 These data are from Organisation for Economic Cooperation and Development, National Accounts (Paris: Organisation for Economic Cooperation and Development, various years). Four alternative measures for Trade are presented in the Appendix at http://www.journals.cambridge.org/jps. First, Imports and Exports as a percentage of GDP are both used, with similar results to Trade. Secondly, two globalization indices from Dreher, Axel, Gaston, Noel and Martens, Pim, Measuring Globalization: Gauging its Consequences (New York: Springer, 2008)CrossRefGoogle Scholar, are used. These results are similar to those found when using Trade, but are less statistically significant. The results provide support for the article’s focus on trade, rather than economic globalization more broadly.

65 Countries under a fixed exchange rate tend to have higher levels of trade than countries with a flexible exchange rate. To account for this, the absolute range of Trade assessed in Figure 3 differs under fixed and flexible exchange rates – Trade ranges from the 5th to the 95th percentile under the respective exchange rate samples.

66 Hellwig, Timothy, ‘Globalization, Policy Constraints, and Vote Choice’, Journal of Politics, 70 (2008), 1128–1141CrossRefGoogle Scholar; Hellwig, Timothy and Samuels, David, ‘Voting in Open Economies: The Electoral Consequences of Globalization’, Comparative Political Studies, 40 (2007), 283–306CrossRefGoogle Scholar; Duch, Raymond M. and Stevenson, Randy, ‘The Global Economy, Competency, and the Economic Veto’, Journal of Politics, 72 (2010), 105–123CrossRefGoogle Scholar.

67 The effect of the Maastricht Treaty as a constraint on pre-electoral fiscal manipulation is also considered in the Appendix at http://www.journals.cambridge.org/jps. Its inclusion does not affect the results.

68 The regressions are presented in the Appendix at http://www.journals.cambridge.org/jps.

69 The Reinhart and Rogoff categorization reports five types, of which the fifth type, freely falling, does not appear in this sample. I collapse ‘category 3: managed float’ and ‘category 4: free float’ into one floating exchange rate category. This creates three categories, each of which contains roughly one-third of the observations (fixed exchange rate: 26 per cent; intermediate exchange rate: 38 per cent; flexible exchange rate: 36 per cent).

70 This measure was created from country-specific exchange rate studies, as discussed in the Appendix at http://www.journals.cambridge.org/jps.

71 Chinn, Menzie and Ito, Hiro, ‘A New Measure of Financial Openness’, Journal of Comparative Policy Analysis, 10 (2008), 309–322CrossRefGoogle Scholar. High and low trade categories were created by bifurcating the sample by the median value of Trade under fixed and flexible exchange rates. With the exception of the Flexible Exchange Rate, all variables displayed in Figure 5 are continuous and are treated as such in the following analyses. Mean values are reported in Figure 5 for descriptive purposes.

72 The constraining effect of international capital mobility in recent years can be seen in the regression results presented in the Appendix at http://www.journals.cambridge.org/jps.

73 Beck, Thorsten, Clarke, George, Groff, Alberto, Keefer, Phillip and Walsh, Patrick, ‘New Tools in Comparative Political Economy: The Database of Political Institutions’, World Bank Economic Review, 15 (2001), 165–176CrossRefGoogle Scholar.

74 Bernhard and Leblang, ‘Democratic Institutions and Exchange-Rate Commitments’.

75 Both variables range from 0 to 1 and represent the proportion of a year the government had minority support in the legislature or was a coalition of multiple parties. Data are from Müller, Wolfgang C. and Strøm, Kaare, eds, Coalition Government in Western Europe (Oxford: Oxford University Press, 1999)Google Scholar, as updated in the Comparative Parliamentary Data Archive (http://www.pol.umu.se/ccpd/) as well as with country-specific data collected by the author.

76 Clark and Hallerberg, ‘Mobile Capital’.

77 For an overview of the Mundell–Fleming framework’s contribution to political economic analyses, see Bernhard, William T., Lawrence Broz, J. and Clark, William R., ‘The Political Economy of Monetary Institutions: An Introduction’; International Organization, 56 (2002), 693–723CrossRefGoogle Scholar.

78 See Obstfeld, Maurice, ‘International Macroeconomics: Beyond the Mundell–Fleming Model’, IMF Staff Papers, 47 (2001), 1–39Google Scholar, for a discussion of how open-economy macroeconomics has refined the assumptions embedded in the Mundell–Fleming model.

79 Drazen, , ‘The Political Business Cycle After 25 Years’, p. 76Google Scholar.

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