Policy makers' preferences, party ideology, and the political business cycle.

• Author: Krause, Stefan

1. Introduction

   It is generally accepted that partisan interests and the beliefs of policy makers subject to a democratic electoral process are important determinants of actual macroeconomic policies. More disagreement exists, however, about the nature of the/rue behavior of policy makers. In this respect, most of the attention within the political business-cycles literature over the last 30 years has been captured by the notions of opportunistic and partisan cycles (see Drazen (2000) for a literature review).

   Initially formalized by Nordhaus (1975), opportunistic cycles are the result of preelection manipulative policies. Given an electoral cycle, opportunistic policy makers choose macroeconomic policies likely to generate lower unemployment rates and higher income levels right before election time, with the intention of gaining the voter's favor. The cycle is then completed when both inflationary pressures and contractionary tendencies appear after the elections.

   As pointed out by Hibbs (1977) and later by Alesina (1987), political business cycles can also arise from ideological differences across political parties that alternate power. (1) One party, traditionally the left-wing party, appeals more to a labor base and promotes expansionary policies that minimize the output gap at the cost of eventual inflationary pressures. The other party, in contrast, appeals more to capital owners and is more concerned with keeping inflation in check at the cost of some unemployment. The cycle is generated as the two parties alternate power and the opposing preferences translate into opposing policies.

   Whether opportunistic or partisan behavior actually takes place is an empirical question yet to be resolved. The most common test of both theories is to run an econometric autoregression of a macroeconomic variable (such as unemployment, output growth, or inflation) on itself, other economic variables, and a political dummy (for electoral years or the type of party in power) and then look for a link between the political events and the dependent macroeconomic variable.

   The results of these empirical tests change noticeably with the measure of economic activity that is chosen as the dependent variable. Studies that use GDP or unemployment measures as dependent variables generally support partisan cycles theories but do not find evidence of opportunism (Beck 1987; Paldman 1991: and Alesina, Cohen, and Roubini 1992). In contrast, studies that use inflation or monetary instruments as dependent variables tend to reject partisan cycles and favor claims of opportunistic behavior (Sheffrin 1989; Alesina, Roubini, and Cohen 1997: and Faust and Irons 1999). (2)]

   It is not surprising that the results of these tests change as the choice of macroeconomic variable studied changes. Figure 1 illustrates this point graphically by plotting time-series data on inflation, output growth, and electoral dates for a sample of countries. As can be seen for all these countries, inflation and output growth sometimes move in opposite directions. Thus, the analysis of a sustained period of economic growth and low inflation could naturally lead to different conclusions regarding the opportunistic behavior of the government.

   [FIGURE 1 OMITTED]

   This paper reexamines how policy makers and political parties behave by using a new approach. Instead of looking at macroeconomic variables and their relation to political variables, this paper focuses on measuring policy makers' revealed preferences toward stabilizing inflation and output growth directly. We argue that this method has several advantages over the traditional approaches: First, by generating a one-dimensional measure for preferences, we eliminate the complications associated with choosing among several macroeconomic variables as the dependent variables in our study.

   Second, it is possible that some parties are more efficient than others in achieving policy targets or that some parties have a different perception of the output-inflation trade off in the economy. In this respect, authors like Cecchetti, Flores-Lagunes, and Krause (2006) have argued that policy makers become more efficient over time. Given that most of these differences are unobservable, studies that compare the behavior of macroeconomic variables across political parties with different ideologies or across electoral cycles are potentially biased. Our study of preferences, in contrast, overcomes this problem because the estimated preference parameters are independent of policy efficiency considerations.

   Finally, our method directly deals with some of the endogeneity concerns of past studies. If the political dummy variables included in typical econometric regressions are determined by some omitted variables that also affect macroeconomic outcomes or if the timing of the elections is chosen strategically by the incumbent when macroeconomic conditions are good, then the results obtained in such regressions are likely to be biased (see Faust and Irons 1999 for a more detailed explanation).

   We isolate this bias by comparing our results for the total sample with the results obtained from a subsample consisting only of electoral cycles that are predetermined by either law or custom. (3) Furthermore, as shown in the next section, our measure of political preferences is independent of the level of macroeconomic variables and omitted variables that create temporary shocks to the economy, thus avoiding any possible reverse causality problems.

   Using a standard loss function and a series of macroeconomic variables, we estimate policy makers' preferences toward inflation and output growth stability for a sample of 24 countries during the period 1974-2000. We then combine these estimations with political records about electoral dates in order to answer three basic questions: (1) How do preferences toward stabilizing the main macroeconomic variables (inflation and output) change along the electoral cycle? (2) How do these preferences change as the ideology of the party in power changes? (3) Does the incumbent party try to resemble the behavior of a rival party as an election year approaches?

   The results of our estimations show that political parties with a leftist ideology have a stronger preference toward stabilizing output growth than right-wing political parties for the majority of countries studied; that is, there exists an ideological gap between parties of the kind proposed by Alesina (1987) and Hibbs (1977). At the same time, our results also show that, in some countries, the incumbent's party acts opportunistically either by stimulating the economy before the elections or by making their economic policies similar to those of opposing parties. The presence of party resemblance strategies has been neglected in the past, but it emerges as an important form of opportunism in our results.

   The remainder of the article is organized as follows: Section 2 explains the method we employ to estimate the relative weight that authorities place on inflation and output stability. Section 3 discusses our main findings regarding the behavior of incumbent political parties, and Section 4 presents our conclusions and possible directions for future research.

2. Measuring Policy Maker's Preferences

   Deriving the Preference Parameters

   In order to obtain our measures of policy makers' preferences and study its behavior over the political business cycle, we begin by assuming that the primary concern of the incumbent government is to achieve stabilization of the economy through the reduction in the variability of inflation and output growth. In doing this, we abstract from other policy goals, such as stabilizing exchange rates and interest rates, as well as achieving more equity in income distribution, for we consider that these serve rather as intermediate goals toward achieving domestic macroeconomic performance, measured by price and output stability.

   Also, at this point, we declare ourselves agnostic as to which policy instrument the authorities will use (e.g., monetary policy, fiscal policy, exchange rate policy, or any other demand-side policy), and we simply represent the control variable by r, to which, from here on, we will refer simply as the interest rate for expositional convenience. We do not include in our analysis policies that may have effects on the supply side of the economy because most of them are associated with longer term goals that go beyond the scope of our study.

   It is also important to note that many of the countries included in our sample have independent central banks, the primary objective of which is short-run economic stabilization. Therefore, if the monetary authorities in these countries, as we should expect, have relatively stable preferences, any observed variation in policy maker's behavior would capture the influence of other policies that are under the control of the incumbent party.

   Consistent with most contemporary analyses of government policy and the theory of political business cycles, we summarize the policy maker's objective through the following standard quadratic loss function: (4)

   (1) L = [E.sub.t][[lambda][([[pi].sub.t] - [[pi].sup.T.sub.t]).sup.2] + (1- [lambda])[([y.sub.t] - [y.sup.T.sub.t]).sup.2];

   where E, is the expectation operator at time t, [pi] is inflation, y is (log) aggregate output; [[pi].sub.t] and [y.sup.T] are the target levels of inflation and output, (5) and [lambda] is the relative weight given to squared deviations of inflation relative to deviations of output from their respective desired levels.

   Minimization of the loss function in Equation 1 requires knowledge of the determinants of deviations of inflation and output from their respective targets. We assume that two random shocks push y and [pi] away from [y.sup.T] and [[pi].sub.T]. First. an aggregate demand shock (d) moves inflation and output in the same direction, while an aggregate supply shock (s) moves inflation and output in...