Monetary policy is the alternative to fiscal policy for stabilization purposes. By default, it is currently the main instrument of American economic stabilization policy, because the flexibility of fiscal policy is severely limited by large deficits. The possible actions available to monetary authorities have to do with the levels of interest rates and the rate of growth of the money supply, which in turn may affect the level of economic activity and rates of inflation.

Good and successful monetary policy can bring an appropriate balance between economic growth and stable prices, but of course the meaning of “appropriate” is contestable. Poor or unsuccessful monetary policy runs two main risks. If the money supply grows much faster than real economic activity, the result will be inflation or even hyperinflation. The opposite risk is that there will not be enough financial liquidity to support the real economic activity that would take place if credit were more readily available. The United States has never experienced hyperinflation, but monetary policy has been at least partly responsible for the sustained increases in price levels since World War II. The second risk was experienced in the banking panics and recessions of the nineteenth and early twentieth centuries, and the Great Depression itself has been attributed to poor monetary policy.

Just as there are two main risks inherent in poor monetary policy, there are two basic alternative strategies for good policy.

An advantage of using the lens of macroeconomic issues through which to view democratic practice is that there is a large body of macroeconomic theory. This theory derives from the effort to understand the way the economic world works, to explain and predict, and to know what is possible and what is not. For better or worse, the unmistakable message of this chapter is that there is no single, uncontested theory of the way the macroeconomic world works. That means that political disagreement about economic issues is likely to involve differences of opinion and belief about what is realistic and feasible, as well as about what is desired. This chapter shows how macroeconomic theory is, in a sense, political theory.

POLITICAL ECONOMICS AND ECONOMIC THEORY: THREE QUESTIONS

Economic theory is the source of our most authoritative understanding of the way the macroeconomic world works, and there is an impressive body of such theory. As such, it seeks to identify what is possible; it seeks to identify the consequences of alternative courses of action; and it “defines the norms that determine when certain conditions are to be regarded as policy problems” (Majone, 1989, pp. 23–4). But macroeconomic theory does not speak with one voice. There are competing theories, deriving from competing systems of belief about the way the world works. We shall review a sequence of these theories with an eye to their answers to the following three questions:

Does the economy regulate itself?

The answer to this question is fundamentally important, because it has obvious implications for the roles of public officials and for the issue whether government should take an active or a passive stance toward economic stabilization.

According to one conventional view of macroeconomic politics in contemporary democracy, governments are responsible for performance regarding inflation, unemployment, and income growth. Periodic elections give voters an opportunity to judge that performance and to approve or disapprove, choosing new leaders if performance has been unsatisfactory. From that perspective, democratic institutions provide ways to ensure both the accountability of public officials and the adequacy of government performance. A persistent or unusual problem may lead to a reform that is designed to resolve the problem, such as the creation of the quasi-independent monetary authority in 1913, or the establishment of a new set of budgetary procedures in 1974.

According to another conventional view, the democratic process is not so benign. In that view, politicians are opportunistic, and voters are naive. Incumbents manipulate their performance to appear misleadingly good at election time, and both challengers and incumbents make unrealistic and insincere promises. Voters are myopically oriented to the present, which makes them unprepared to hold incumbents accountable for their performance over entire electoral periods, or to relate electoral choices to future well-being in a meaningful way. Economic performance deteriorates. Politicians exploiting popular discontent propose superficial reforms that fail to solve the problems, such as the Gramm-Rudman-Hollings deficit-reduction acts of 1985 and 1987.

The truth is likely to be found somewhere in between those extreme alternatives, which I shall designate as the benign and the malignant views, and the truth is likely to vary over time and place.

This book uses macroeconomic issues to address questions about how democracy works. It continues the kind of investigation I pursued in my first book, The Impact of Negro Voting: The Role of the Vote in the Quest for Equality (1968, 1981), which used racial issues to study the consequences of extending the franchise. It is a statement of applied democratic theory that uses economic issues to bring into focus questions about democratic institutions and practices. It brings together a body of research that has been written largely in the past fifteen years on the political dimensions of macroeconomic policy and performance. The book draws on work done by economists and by political scientists in roughly equal measure, and it is designed to present a variety of arguments fairly and neutrally.

I have taken aim at several audiences. First, the book is written to be accessible to a nontechnical audience of advanced undergraduates and thoughtful nonacademic citizens who might be interested in the relationship between politics and the macroeconomy, and in the implications for democratic theory. No special training in economics or political science is presumed. But while the book is meant to be readable by the nontechnical general public, it draws heavily on technical academic literature. As such, it makes the case that this literature is relevant to issues of broad public concern. Another audience is graduate students and faculty in political science and economics.

This is the first of two chapters that review the two most prominent models or theories of politics in macroeconomic policymaking: the electoral-cycle theory and the partisanship theory. These theories each capture special features of democratic politics and help us to understand democratic dynamics. In doing so, they abstract from the institutional details through which economic policy is made. Each leaves a great deal about macroeconomic politics unexamined and unexplained. The electoral-cycle model focuses on periodic elections as the democratic institution of interest, and the partisanship model focuses on dual alternatives in these elections. Both types of models connect these features of focal interest to macroeconomic outcomes: unemployment, income growth, and sometimes inflation.

In the real world, the impacts of elections and party differences are mediated through complex institutional structures of fiscal and monetary policies. For example, most of the contemporary models to be considered in these two chapters presume that governments influence macroeconomic performance through monetary policy, that is, through government control of the money supply and interest rates. Monetary policy is controlled by central banks, such as the U.S. Federal Reserve System (“the Fed”). Electoral-cycle and partisanship models often assume that the Fed obediently follows the preferences of politically motivated public officials. In fact, the Fed is considered to be one of the most politically independent of the central banks in the industrialized nations.

Fiscal policy consists of public decisions about government expenditures and revenues. Spending policy and taxation policy have always been of interest in their own right, but at least since the 1930s, spending and taxing and the balance between them have been seen by at least some economists as having controllable consequences for the performance of the macroeconomy. For example, Keynesians have advocated active discretionary manipulation of the size of the budget deficit (or surplus) to stabilize the economy, to reduce unemployment, and to shift the path of economic growth. The Kennedy-Johnson tax cut of 1964 is seen by Keynesians as a successful example of how fiscal policy can increase prosperity by increasing aggregate demand. Supply side economists have acknowledged the success of that tax cut, but explain its success in terms of increasing aggregate supply, rather than demand. They would defend the Economic Recovery Tax Act of 1981 on the same, supply oriented grounds.

Causality goes in the other direction as well. That is, the performance of the economy has an effect on the size of the government's deficit (or surplus). Specifically, when the economy expands, revenues may rise faster than expenditures, thus reducing a deficit. And when the economy goes into a recession, expenditures may rise (e.g., because of increased unemployment compensation claims) while revenues fall, because of declining incomes and reduced economic activity.

Voters are the ultimate authority in a democracy. Their preferences and behaviors are the fundamental sources of legitimacy for policymakers, who get their power through elections. Their preferences and behaviors also place constraints on what elected politicians can do. The electorate is the source for the authority of constitutional rules of procedure and for the authority of official statements of public goals. When there is ambiguity about what goals are appropriate for public policy, voter choices can resolve them at least provisionally. When there is ambiguity about which potential officeholders have correct or appropriate beliefs about the way the economic world works, voter choices can determine which ones will get to test their views against experience.

All this would be true in a world of ideal democratic citizens, but it is true in the real world as well. Yet the effort to maximize one's share of the votes of even ideal citizens can lead to opportunism, according to some of the models of political economy we have reviewed. And whereas ideal citizens may be public-spirited and fully informed, real-world voters may not have either of those qualities. This chapter will assess what we know about how voting behavior is affected by macroeconomic issues, as well as the implications for policy making.

Most real-world voters are not well informed about political issues; they sometimes are characterized as being vulnerable to cynical manipulation by opportunistic politicians.

INTRODUCTION

The model of the American political economy described in chapter 8 has several empirical implications. These are tested in this chapter using United States data for the period 1915 to 1988. We examine the behavior of the annual growth rate of the gross national product and of vote shares in presidential elections and in elections for the House of Representatives.

Throughout this volume we have stressed the interdependence of politics and economics. A basic theme is that partisan politics introduces uncertainty in both the polity and the economy; both the voters and the economic agents need to hedge. Specifically, uncertainty in presidential elections leads economic agents to hedge by expecting an inflation rate equal to an average of the inflation policies that would be followed by the two parties. Similarly, voters adjust their on-year congressional votes so that there is not a decisive tilt towards either party. At midterm, the identity of the party of the president for the next two years is known; thus the voters can complete their balancing of the president.

In other words, expectations about future policies tie the political and economic systems together. Therefore we undertake a simultaneous estimation of four equations: one for GNP growth; one for the vote share in presidential elections; one for House vote shares in on-years; and another for House vote shares in midterms.

Our most general formulation of the GNP growth equation incorporates the two basic determinants of growth highlighted in the previous two chapters: the partisan macroeconomic policies of the two parties and the competence of different administrations.

INTRODUCTION

A primary purpose of this book is to understand how politics affects public policy. In the previous chapter, we considered two possible scenarios. One had politics leading to middle-of-the-road policies as the result of electoral competition between electoralist parties. This approach was refuted both theoretically, because of the inability of candidates to make credible campaign promises, and empirically, because of widespread observations of party polarization. The other scenario had partisan politics with alternation between the relatively extreme policies pursued by two polarized parties.

This second scenario is also likely to be inaccurate because it ignores the institutional structure that leads to policy formation. In the United States, the Constitution provides for “checks and balances”. Legislation, including measures that affect economic policy, requires congressional majorities and a presidential signature. Regulatory agencies, important in policymaking (like the Federal Reserve), are subject to congressional oversight. The need for some degree of concurrence between the executive and legislative branches of government contributes to policy moderation.

In this chapter, we consider the effect of institutional “checks and balances” on policy moderation in a highly stylized manner that is, nonetheless, empirically descriptive. We build on the case of fully divergent and “immobile” parties of section 2.4: if the executive has full control of policy, the two parties implement their ideal policies. We posit, however, that the influence of the executive in policymaking is mediated by the legislature: policy depends on which party holds the presidency and on the composition of the legislature. We view policy as a compromise between the executive and the legislature.

INTRODUCTION

The primary focus of this book is on partisan politics where voters are concerned with policies that can be positioned on a liberal–conservative dimension. An alternative view of American politics is that voters are concerned with how a larger share of the federal pie can be garnered for their state, their congressional district, and, ultimately, themselves. These distributive concerns, coupled with the seniority system in Congress, provide voters with strong incentives to re-elect incumbents. In addition, incumbents, in part through use of the perquisites of office, have strong informational advantages over challengers. As a consequence, “incumbency advantage” is a major determinant of congressional elections. The “incumbency advantage” is particularly evident in the House in the postwar period where, until the wave of retirements in 1992, over 90 percent of incumbents stood for re-election and, of those standing, over 90 percent were reappointed. These high rates of re-election have led recent elections to produce, especially relative to earlier periods of American history, small changes in seat shares.

Thus far this book has ignored incumbency advantage. Instead, we have emphasized the balancing behavior of voters, which generates split-ticket voting and the midterm cycle. In this chapter we discuss how incumbency advantage and balancing behavior coexist.

The model of chapter 4 predicts substantial changes in vote shares as a result of the midterm cycle. While the theoretical prediction of a shift in votes receives overwhelming empirical support (figure 4.1), the shift in thevote has not had much impact on seats. Finding a midterm cycle that is far stronger in votes than in seats raises an important question.

INTRODUCTION

According to a widely held view about American politics, the two parties are indistinguishable and both located in the middle of the political spectrum. We emphatically disagree.

The notion of convergence of party platforms emerges from the initial rational choice models of two-party electoral competition in the contributions of Hotelling (1929), Black (1958), and Downs (1957). These seminal works assumed that although voters care about public policy, candidates care only about winning.' In this situation, the candidates propose identical platforms: one should observe complete convergence of policies toward the middle. Which policy is actually chosen by a candidate depends on the specification of the electoral process: the number of issues involved, the dissemination of information within the electorate, the nature of voters' preferences, and the ability of voters to make decisions consistent with their preferences.

The most famous convergence result is the “median voter theorem” (Black (1958)). It implies that, under a certain specification, the candidates converge to the policy most preferred by the median voter. For other specifications, Hinich (1977), Coughlin and Nitzan (1981), Ledyard (1984), and Tovey (1991) analyze cases of convergence not at the median. For our purposes, the important point is not so much “where” the candidates converge (at which particular point of the political “middle”) but the fact that they fully converge.

A different view of party competition holds that political parties, as well as the voters, care about policy outcomes, in addition to winning per se (Wittman (1977, 1983), Calvert (1985), and Roemer (1992)). According to this view, political parties represent the interests and values of different constituencies.

GENERAL OVERVIEW

Economics and politics deeply interconnect. On the one hand, incumbents are likely to benefit from an expanding economy and challengers to thrive on misery. On the other, the outcomes of elections influence economic policy and the state of the economy. This book studies the joint determination of political and macroeconomic outcomes. It focuses on the United States, but we also briefly discuss how our work sheds light on the political economy of other industrial democracies.

A few basic ideas underlie our work. The first one is that the American political system is “polarized”. Contrary to the widely held view, particularly in the “rational choice” framework, that a two-party system generates convergence of party platforms (Downs (1957)), we posit that, when in office, the two American parties follow different policies. The degree of polarization has varied greatly in American history (Poole and Rosenthal (1991a, 1993b)), but the two parties have never fully converged. What is important for us is not that polarization is constant, but simply that it does not vanish.

The second idea is that policy polarization leads to macroeconomic cycles. The two major parties follow sharply different macroeconomic policies. Whereas the Republicans are relatively more concerned with inflation, the Democrats emphasize reducing unemployment. These distinctive objectives, coupled with uncertainty about the outcome of elections, make macroeconomic policy not perfectly predictable. The actual outcomes of elections then generate economic recessions and expansions even though predictable macroeconomic policies should not influence growth in an economy with rational agents.