Macroeconomic policies and Veto Players

Two aims and Three topics Aims: to show that 1) Policy stability does not refer only to legislation, but also to outcomes (states of the world). 2) The veto players theory enables research not only on single dimensional phenomena, but also on multidimensional ones. Topics 1) Budget deficits. 2) Composition of budgets. 3) Growth, taxation, and inflation.

(1) Budget Deficit In the late 1970s and 1980s almost all OECD countries started trying to reduce the budget deficits generated by the oil shocks. Some of them stabilized their policies and reduced their deficits faster than other. Why ? 2 explanations 1) Collective action approaches. the more parties participating in government, the higher the budget deficits, because each one of them wanted to serve its own privileged constituency, and as a result, increased spending (and deficits) was the only possible compromise among different government partners. (it is a prisoner’s dilemma) 2) Inertia theory: more government partners find it more difficult to change (reduce) the size of the deficit and stabilize.

Budget Deficit. Collective action approaches Budget Deficit is the common pool problem: in a decentralized policymaking government, where each spending minister only has authority over his own portfolio, the cost of over-spending is shared with other ministries. Each minister is motivated to over-spend to please his constituency at the expense of other ministries. Since each ministry internalizes only part of the cost of rising spending on their own goods, all of the groups have an incentive to spend more than the optimum so as to appropriate more resources for their benefits. Minister’s 2 Choice Minister’s 1 ChoiceNot to spendSpend Not to spend(0,0)(-4,4) Spend(4,-4)(-0.5,-0.5)

Budget Deficit. Collective action approaches Imagine a country where the resources that can be extracted by taxation are 8 (billions..). There are two ministers and two constituencies. Each minister would like to spend 8, taken for granted that his/her constituency will have to pay 4 (-8/2=-4) in taxes. The final equilibrium will be (Spend/Spend). As the final public Expenditure will be 16 and the resources are 8 the government will be obliged to run into a debit and to pay the annual interests. (in the example rate interest=1/8=12,5%) Minister’s 2 Choice Minister’s 1 ChoiceNot to spendSpend Not to spend(0,0)(-4,4) Spend(4,-4)(-0.5,-0.5)

Budget Deficit: collective action approaches As the collective action literature argues that the more dispersed the decisionmaking authority, the higher the budget deficit. The proposed solution, accordingly, is to completely centralize decisionmaking authority by delegating the decisionmaking power to an independent agent, such as a strong minister of treasury. In this way not spending can become a dominating strategy Minister’s 2 Choice Minister’s 1 ChoiceNot to spendSpend Not to spend(0,0)(0,-4) Spend(-4,0)(-4,-4)

Budget Deficit. Policy Inertia Approach (Veto Players) The policy inertia approach argues that delays in the adjustment or the elimination of existing deficits might result from struggles between coalition partners (or the social groups they represent) about who will bear the necessary costs/cuts in budget spending, even if these players agree that current debt requires adjustments. The distributional struggle among different groups leads to deadlock in the policymaking process, which, in turn, delays the implementation of policing aimed at eliminating the budget deficit. Moreover, it predicts that delayed stabilization and prolonged deficits are more likely to occur in fragmented and polarized social/political systems.

Budget Deficit. Policy Inertia Approach (Veto Players) All empirical analyses of delayed stabilization test cases where governments aimed at reducing budget deficits, so while the argument at the theoretical level is different from the collective action literature, the empirical finding of slow deficit reduction under government coalitions is consistent with both theories. However Franzese (2002) was able to produce an empirical result that contradicts the collective action literature. He came to the conclusion that multiple veto players delay changes to budget deficits regardless whether these deficits were high (in countries like Italy) or low (in countries like Germany and Switzerland). Franzese tests seven different political economy theories of public debt. He uses alternatively as independent variable for the Policy Inertia Approach (The government composition and delayed stabilization theories) exactly the number of veto players ( Fractionalization) and the distance of the veto players in a single dimension (Polarization).

Budget Deficit. Franzese tests 7 political economy theories of public debt 1) The government composition and delayed stabilization theories (weak governments) 1a) The parties in government exercise an influence proportional to their size 1b) The “veto-actor” theories 2) The wealth and age distributions and the inter- and intra- generational transfer of debt 3)The electoral and partisan political-budget cycles 4) The strategic manipulation of debt to alter future government policies. 5) The multiple constituencies and distributive politics. 6) The tax structure complexities and fiscally alluded voters. 7) The central bank autonomy and reduction of debt financing.

J-tests procedure These theories are non-nested, none can be expressed as a restriction of the other by setting some of the coefficients to zero ; Therefore Franzese uses J-tests (Davidson and MacKinnon (1981)) to compare their predictive power. The procedure for J- tests is the following: 1) Imagine two models Z=f(X,*) and Z=g(Y,*) one estimates first Z=f(X,*) and includes its predictions ̃ ^Z in the estimation of the second Z=g(Y, ^Z, *). If the coefficient of ^Z is nonsignificant, then the second hypothesis encompasses the first: there is no additional significant information covered by the first hypothesis. 2) The procedure is repeated by reversing the two theories. It is possible that both theories encompass each other, or none of them encompasses the other. 3) The only conclusive test is when one of them encompasses the other but not viceversa.

Results (1) The most frequent comparative result is that each of the models does not encompass the others: “the data insist that each of the theories adds explanatory power to any of the others However, there are some exceptions: the data do not reject that the veto-actor conception of the weak-government model encompasses the influence conception yet they easily reject the converse that the influence conception encompasses the veto-actor. Veto-players conception of fractionalization and polarization clearly dominates the influence conception.”

Results Theory 2 encompasses theory 1 But it is not encompassed by theory 1

Results (2) Testing for the size of a deficit as a function of the size of debt (Accumulated deficits) Franzese finds that “standard deviation rises in fractionalization centered on the mean (i.e. = +1.2 parties, from 1.5 to 2.7) raise deficits 0.2 percent of GDP at average debt, but the same NoP [number of parties] increase induces a 0.2 percent of GDP deficit reduction at low debt and a 0.55 percent of GDP increase at high: Multiple parties in government preserve the status quo more effectively whether this means that deficits will continue to be high (in countries like Italy) or low (in countries like Switzerland). This finding is evidence against the collective action theories and in favor of the inertia approaches.

25% Debt as Percent of GDP seems to Be the threshold value Over 25% 1 more government party means more inaction, more deficit; Under 25% means more inaction less deficit

(2) Composition of the budgets The composition of budgets is by definition a multidimensional phenomenon, and as a result, is likely to require multidimensional indicators for its study. Tsebelis & Chang article (2004) use for the first time multidimensional definition of ideological distance. For Tsebelis and Chang the composition of budgets is altered in two different ways: 1) Deliberate, the current government wants to increase or decrease the size of spending (the budget) and spend a higher or lower percentage of it in some area. 2) Automatic, the existing legislation (whether introduced by the current or previous governments) has economic consequences: increasing unemployment affects the composition of the budget because of specific provisions in the social security legislation.

Dependent Variable Dependent variable: the changes in the structure of budgets in advanced industrialized countries. The budget of each country allocates resources in a series of areas, so it was conceptualized as a vector in an n-dimensional Euclidean issue space. It consists of a sequence of percentages (in order to control for its size) allocated to different jurisdictions: (a1, a2, …..,an). Each year there is a different budget allocation, so each sequence is indexed by the time it was selected. As a consequence, the difference between two budgets can be represented by the distance between the composition of the budgets of two successive years.(Budget Distance)

Percentage allocated on area a1 Percentage allocated on area a2

Indipendent and Control Variables Indipendent Variables : 1) the ideological distances of the existing veto players (ID), (negative effect) 2) the ideological distance between successive governments, called alternation (A) Control Variables (automatic source of Budget alteration of Budget composition) 1) Inflation 2) unemployment, 3) percentage of dependent population (individuals over 65 years old), 4) rate of growth Fluctuations in these 4 variables may affect the Social Security component of the budget. 5) country dummy variables, because legislation in one country may provide different solutions and have different effects on the country budget. Control variable (dummies) for Strom’s counter argument type of government (mimimum winning coalition, minority, or oversized government).

Operazionalization of Independent variables The two dimensions (Laver & Hunt expert survey) are: 1) Left and Right 2) “Pro friendly relations to USSR vs.Anti.” ID (ideological distances) is the average of the range of the coalitions in each dimension. A (alternation)= Where A 1 and A 2 are alternation in the first and in the second dimension

Results (1) 

Results (2)     

Results (3)

Results (4)

(3) Other Macroeconomic Outcomes Federalism and inflation. (Treisman 2000): 3 alternative group of theories 1) “commitment” theories expect lower inflation in decentralized countries, because the multiple actors involved in decisionmaking reduce the ability of a central government to inflate for political purposes. 2) The “collective action” theories expect higher inflation in federal countries,because the multiple actors involved will engage in local fiscal free riding. 3) “continuity” theories are the veto players theory: significant changes in inflation will be associated only with few and ideologically congruent veto players. Federalism increases number of incongruent veto players. Result: “strong support for the continuity hypothesis. In general, average inflation rates tended to rise during the 1970s and 1980s in both unitary and federal states. Although there was a general upward drift, the rise was less in federations with low inflation in the previous period compared to similar unitary states, and the rise was greater in federations that started from high inflation compared to similar unitary states.

(3) Other Macroeconomic Outcomes Taxation and Veto Players: According to the theory significant change in taxation will be possible only with few veto players. Hallerberg and Basinger (1998) found empirical evidence about the veto players role Growth and veto players. The theory does not make any predictions about a relationship between veto players and growth: 1) the underlying assumption of many economic arguments is that many veto players create the possibility for a political system to commit not to alter the rules of the economic game (like sudden confiscation of wealth through taxation). 2) the underlying assumption of most political analyses is that political systems should be able to respond to exogenous shocks. In fact “high level of commitment” = “inability for political response.” It is not clear whether many veto players will lead to higher or lower growth, because they will “lock” a country to whatever policies they inherited, and it depends whether such policies induce or inhibit growth.