Institutions, politics, and macroeconomic performance : on incomplete information in political agency games

Abstract

This thesis analyses the interactions between politics, institutions, and policy outcomes using a political agency framework with incomplete information. After an introductory chapter, we develop a political agency model that is consistent with the empirical evidence on politically-induced fiscal cycles, and especially budget deficit cycles. We find that electoral concerns create, on average, a rising budget deficit prior to elections. The net welfare effect of elections is ambiguous: although they give rise to a deficit bias, they increase the quality of office-holders. The next chapter uses this microfounded model to study the incentive and welfare effects that the imposition of fiscal constraints has on policy makers' decision to create excessive deficits. Three types of constraints are investigated: deficit ceilings, a Golden Rule of public investment, and a balanced-budget rule. We find that constraints are effective in reducing excessive budget deficits - although at the expense of unconstrained instruments. Only one can yield higher welfare than the fully discretionary case. No appropriately designed fiscal constraint can achieve the first-best. In Chapter 4, we show that two key results in the political agency literature are not robust. The first is that a cutoff rule followed by voters in re-electing an incumbent always motivates the latter. The second is that this cutoff rule is an optimal incentive mechanism. Under symmetric incomplete information, the first result can be reversed since elections can reduce the experimentation effect of office-holders (i. e. the incentive to raise effort so that performance becomes a more accurate signal of ability). This reduction may more than offset the positive effect of elections on effort. When incentives to stand for office are modelled, result two can be overturned since a revealing equilibrium at the candidate entry stage can always be designed. This screens out low-ability citizens from policy making and therefore eliminates the adverse selection problem. If this latter is more important than moral hazard issues, the cutoff rule at the policy stage is no longer an optimal mechanism. In Chapter 5, we investigate in more details whether relevant (private) information about citizens' competence in political office (ability, honesty, etc. ) can be revealed by their entry and campaign expenditure decisions. We find that this depends on whether voters and candidates have common or conflicting interests; only in the former case can entry be revealing in equilibrium. We apply these results to Rogoff's (1990) Political Budget Cycles model, allowing for candidate entry: as interests are common, low-ability candidates are screened out at the entry stage, and so there is no signalling via fiscal policy. In a variant of the Rogoff model where citizens differ in honesty, rather than ability, interests are conflicting, and so the political budget cycle can persist in equilibrium. The final chapter concludes the thesis