82nd International Atlantic Economic Conference

October 13 - 16, 2016 | Washington, USA

Political cycles - beyond rational expectations

Friday, October 14, 2016: 2:35 PM
Frank Bohn, Ph.D. , Department of Economics, Radboud University Nijmegen, Nijmegen, Netherlands
This paper introduces unsophisticated voters into the political cycle literature because they can explain empirical phenomena that cannot be explained by existing rational expectations models.  First, there is empirical evidence that political budget manipulations raise re-election chances. But rational expectations models of political cycles cannot produce this result by construction; if manipulations are rationally anticipated, any manipulation will be fruitless in equilibrium. Second, there is no (rational expectations) explanation why political budget cycles should be "context-conditional". However, empirical evidence shows that political budget manipulations only occur in "specific contexts", for instance in countries with fiscal or government intransparencies, in developing countries, or in new democracies. The institutional settings that are conducive to political budget cycles have one element in common though; they give rise to perceived uncertainties about the functioning of institutions. Unsophisticated voters are unable to take the optimal behaviour of others (fully) into account, but become more anxious when the world around them turns more intransparent or uncertain. As a result, they are likely to become more suspicious about being deceived by the government. The government, in turn, will increase its political budget manipulation in order to appear more competent and, ultimately, be able to increase its re-election chances.

In addition to providing the theoretical rationale for the aforementioned empirical phenomena, this paper also finds a new theoretical result which has already been verified empirically for Portugese municipalities (companion paper). The model presented here predicts that political opportunism produces, unintentionally, a countercyclical policy effect. It is clear that a government will adjust its fiscal manipulation, if its (honest) expectation of economic growth changes. But this paper suggests that the fiscal manipulation does not change 1-for-1 with the expected change in economic growth.
Take a recession. If the government cut spending too much, it could lose the support of unsophisticated voters (who may be unaware of a looming recession and/or unable to fully disentangle a recession from government policies). The government is, therefore, willing to accept a higher deficit, although it is costly. This is a countercyclical effect compared to the fiscal manipulation when there is no recession.

This paper also explains forecast manipulations observed in US states; uninformed voters are impressed by budget manipulations which were made possible (despite constitutional balanced budget constraints) by forecast manipulations. Finally, the paper contributes to the policy discussion of European (supra-) national fiscal rules.