Comparative Political Economy

Western Industrialized Democracies

I. The Classical View of MacroeconomicsA. Long-run growth determined by population (labor

supply), technology, and wealth (supply of capital)

B. Market self-corrects for deviations from long-run growth rate (no politics, hence no political economy)

C. Key Assumptions: Flexible Wages, Flexible Prices

D. Implications: 1. No one loses a job when demand is low (wages fall, or

they get another job with lower wages)2. No unsold inventories (suppliers simply lower prices

as needed)

E. Problem: Ever-larger economic shocks

Prices

Unemployment

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1900 1910 1920 1930 1940

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II. Keynesian Macroeconomics: A Simplified Explanation

Keynes: “In the long run we are all dead.” Focus on managing short-run fluctuations

A. Key Variables1. Dependent variables:

a. Output: Real Gross Domestic Product (GDP)

b. Inflation: Rate of increase in prices

c. Unemployment: People looking for work but unable to find it

2. Independent Variables

a. Consumption Function (70% of US GDP)

i. Primarily determined by disposable income: Income – Net Taxes

ii. Net Taxes = Taxes - Transfers

Consumption and Disposable Income

Disposable Income,YD

Co

nsu

mp

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n,

c

ConsumptionfunctionC = c0 + C1YD

Slope = c1

b. Investment (10% of US GDP)

c. Government spending (20% of US GDP after transfers)

B. Economic growth in the short run: Supply and Demand

1. Aggregate Demanda. Definition: How much stuff everyone in

society buys at a given price level

b. Demand = Consumption + Investment + Government Spending + Exports – Imports

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

Aggregate demand

Higher prices

Lower prices Less output

demandedMore output demanded

Aggregate demand curve

2. Aggregate Supply

a. Definition: How much stuff firms choose to produce and sell at each price level

b. Supply curve determined by income (ability to produce at a given price level)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

REAL OUTPUT (quantity per year)

Aggregate supply

More output supplied

Higher prices

Aggregate Supply Curve

3. Equilibrium: Where supply meets demand

a. Best single predictor of economic output.

fig

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Pric

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vel

National output

Y2

AS

Y3 Y4 YP

b. Equilibrium effects of increases in aggregate demand on outputb. Equilibrium effects of increases in aggregate demand on output

AD3AD2AD1

AD4

c. What shifts aggregate demand?

• Remember the equation: Demand = Consumption + Investment + Government Spending + Exports – Imports

• So changes in any one of these independent variables can shift aggregate demand at a given price level (policy levers political economy)

4. Disequilibrium

a. Definition: Actual price level is higher or lower than equilibrium point

b. Equilibrium may be unstable: Example of Great Depression

PR

ICE

LE

VE

L (a

vera

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REAL OUTPUT (quantity per year)

E

QE S1

P1

PE

Aggregate demand

Aggregate supply

Macro Disequilibrium: Oversupply and Low Demand

E

QE

PE

Aggregate demand

Full employmentEquilibrium

output

Aggregate supply

PR

ICE

LE

VE

L (a

vera

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REAL OUTPUT (quantity per year)

QF

P*F

c. Equilibrium may be Undesired: Excessive Unemployment

C. Keynesian Policy Recommendations1. Focus on “demand side” by manipulating

independent variables such as government spending and taxes

2. If people demand a product, producers will supply it get money into people’s hands and production will rise

3. Spending increases more effective than tax cuts: All of spending is consumption but some of tax cuts will be saved by taxpayers instead of being used for consumption

D. The Success of Keynesian Policies: Countercyclical Management

III. Alternatives to Keynesian Macroeconomics

A. Problem: Emergence of stagflation in 1970s

1. Cause: External force shifted supply curve (firms less willing to supply at a given price)

2. Leading suspect: Oil price shocks increased costs of production so much that even large increases in price didn’t stimulate more production (simultaneous inflation and unemployment recession)

3. Effect – Negated the “Philips Curve”

Unemployment and inflation: The Philips Curve (US, 1960s)

BUT: High inflation can create expectations of future inflation

3. Why not increase government spending?

a. Increased spending increased inflation even further (usually not a problem, since inflation is low during recessions)

b. Very large deficits limited governments’ ability to spend (in US: Vietnam expenses and increased social spending)

B. Demand-side alternative: Monetarism1. Interest rates and money supply affect people’s

willingness to buy at a given price2. Shift demand curve by manipulating interest

rates or money supply (Interest rates actually easier to manipulate! “We don’t know what money is anymore.”)

3. Increase interest rates (reduce money supply) to cut inflation at expense of increasing unemployment (induce a recession to prevent stagflation). Key is to alter expectations of future inflation.

4. Cut interest rates to lower unemployment at expense of increasing inflation (economic stimulus)

5. Example: The US Monetary System

a. The Federal Reserve Board: Created in 1913 to act as a central bank (mixes public appointees with private banks)

b. Functions of the Federal Reserve

i. Conduct Monetary Policy

i. Formal mandate: Low inflation and Low Unemployment

ii. Actual policy emphasizes low inflation over full employment or economic growth

ii. Serve as a lender of last resort to commercial banks within the District

iii. Issue Currency – “In God we Trust”

iv. Provide Banking Services to the U.S. Government

v. Supervise and regulate financial institutions

c. The FRB Toolkit

i. Buying/selling government securities• Stimulation: Fed purchases U.S. Government Securities

in the bond market (U.S. Treasury Notes) – Raises bond prices; reduces interest rates

• Cash flows from the Fed to sellers of bonds; sellers deposit cash in their banks, thereby increasing the nation’s deposits and the excess reserves of the banking industry

• Restraint: Fed sells U.S. Government Securities in the bond market (U.S. Treasury Notes) – Lowers bond prices; increases interest rates

• Cash flows from the banks to buyers of bonds and ultimately to the Fed, thereby reducing the deposit accounts and restricting the ability of commercial banks to loan money

ii. Alter the Fed Funds or Discount Rates

• Fed Funds Rate: the interest rate commercial banks must charge one another to lend or borrow on an overnight basis for reserve management purposes

• Discount Rate: the interest rate commercial banks must pay the Fed to borrow directly from the Fed for reserve management purposes

iii. The reserve rate: The Fed’s ultimate weapon

• Amount of cash banks have to keep on hand to cover withdrawals

• Use of this tool would be perceived as a reaction to extraordinary events– Fed will be very cautious and publicize its

intentions well in advance– Last time required reserves changed – 1980

– resulted in a credit crunch that plunged the economy into the worst recession since the Great Depression

6. The role of Banks in Monetary Policy

a. Banks Create Money: Banks can be viewed as counterfeit operations authorized by the government, and are an essential tool in affecting monetary policy• Banks lend money that they don’t have -- so

they are essentially minting their own currency!

• Reserve requirements set by the government determine the extent to which banks can counterfeit

b. Banks depend on confidence

• Customers could bankrupt a bank simply by asking for all of their reserves back, which they can do at any time.

• Customers don’t ask for their money back when “counterfeiting” is profitable and they earn a part of the returns (interest)

• Customers will tolerate the behavior only as long as they believe that the bank is reputable in this activity

c. Money creation through fractional reserves

The money creation process: Making one loan creates the opportunity to make another loan, a process which continues in perpetuity.

Step 1: Bank issues a promissory note for which there is no “direct” reserve. (ie. the bank makes a loan and gives the borrower a receipt against that banks reserves)

Step 2: This receipt (loan) is traded for a good or service (promissory note is passed on to a new holder)

Step 3: The promissory note is deposited back into a bank by the new holder, creating a new deposit (bank liability).

Step 4: The promissory note is available once again to be loaned.

Money Creation Example

•A bank receives $100 Million in deposits, keeps $20 million in reserve.•But the $80M in loans returns to the banking system somewhere else -- the second generation bank

Assets: Liabilities:

Reserve: $16 M Dep. of loan from 1st bank: $80 M

Loans from new deposit: $64 M

Assets: Liabilities:

Reserve: $12.8 M Dep. Of loan from 2nd bank: $64 M

Loans from new deposit: $51.2 M

The third generation bank receives $64 million of new loan deposits, allowing another $51.2 million in loans

NewDeposits

New loans/Investments

Cash reservebalances

Original Bank $100 M $80 M $20 M

2nd generation bank 80 64 16

3rd generation bank 64 51.2 12.8

4th generation bank 51.2 41.0 10.2

5th generation bank 40.9 32.8 8.2

6th generation bank 32.8 26.2 6.5

7th generation bank 26.2 21.0 5.2

8th generation bank 21.0 16.8 4.2

9th generation bank 16.8 13.4 3.4

10th generation bank 13.4 10.7 2.7

Sum of first 10 banks $446 M $357 M $89 M

Sum of remaining banks $54 M $43 M $11 M

Total for banking system $500 M $400 M $ 100 M

7. Is Monetary Policy Effective?

• Easy to curb inflation (excess money) -- at cost of lower growth / recession and increased unemployment

• Harder to stimulate growth– Example: Fed can lower interest rates, increase the banks’

deposits BUT– It cannot force a broke person (business) to borrow– Good risks in prosperous times become poor risks in recessionary

times– Central banks’ ability to stimulate often compared to problem of

trying to push a string – no matter how much effort you give it, it just doesn’t move much

C. Supply-side economics

1. Adverse shift in supply curve means BOTH higher prices (inflation) AND lower output (recession and unemployment)

2. Demand-side shifts cannot simultaneously boost production and lower inflation

3. Solution: Shift supply curve by altering ability and willingness of firms to produce at a given price point

4. Policy levers: Corporate tax cuts, deregulation, increased labor supply (immigration), lower tariffs on raw materials, education and training (increases in per-worker productivity) etc.

D. Comparison: Keynes, Monetarists, and Supply-Siders

1. Responding to Recession

Theory Recommendations

Keynesian Increase spending and cut taxes to stimulate demand

Monetarism Wait it out, since stimulus would increase inflation

Supply-Side De-regulate, cut taxes on business, increase incentives to produce

2. Responding to InflationTheory Recommendations

Keynesian Cut spending and increase taxes to reduce demand

Monetarism Tighten money supply and convince public it will remain tight

Supply-Side De-regulate, cut taxes on business, increase incentives to produce and save (inflation = too much money, not enough goods)

E. Conclusions

1. Economics has become political: Few classical economists around anymore, and they don’t get to stay in office!

2. Political choices (fiscal policy, monetary policy, trade policy, immigration policy, etc) affect economic outcomes

3. Political Business Cycle: Desire to stimulate economy before election at expense of slowdown/recession after election

4. Summary: The Macro Political Economy

DETERMINANTS OUTCOMES

MACROECONOMY

Policy levers

Internal marketforces

External shocks

Output

Jobs

Prices

Growth

Internationalbalances

V. Characteristics of Monetary Policy

A. The Choices1. Central Bank dependence vs independence

The Time Inconsistency Problem

• Policymakers have incentives to promise low inflation (economic stability, prevent more inflation)

• Policymakers have incentives to renege on promises of low inflation to increase growth/employment (political business cycle)

• Problem: Private actors know these incentives and therefore anticipate high inflation by raising wages and prices, so short-term stimulus fails to do anything except further increase inflation

• Solution: Central bank independence makes low-inflation promises credible, prevents political manipulation

I. Characteristics of Monetary Policy

A. The Choices1. Central Bank dependence vs independence

2. Exchange rate regimes: fixed vs. floating

Exchange Rates: Fixed vs. Floating

• Floating: Government has more autonomy because has no duty to pay specific amount for own currency (not backed with gold or other reserves)

• Fixed: Government promises to exchange specific amount of gold/reserves for currency. Government cannot release too much money or speculators may try to cash in and “break the bank”

I. Characteristics of Monetary Policy

A. The Choices1. Central Bank dependence vs independence

2. Exchange rate regimes: fixed vs. floating

3. Wage-setting institutions: centralized vs decentralized

Wage Coordination Problem

• Even where workers wish to avoid wage-price spiral, incentives to free-ride on other workers’ restraint

• So each union assumes that other settlements will be inflationary and compensates by raising its own demands

• Coordinated bargaining reduces ability to free-ride by imposing same agreement on all workers: allows incomes policy

4. Comparison: Economic Institutions in Five Industrialized Democracies

UK France, US

Germany Japan

Central Bank Indep

Medium* High (US) High* (Fr)

High Medium*

Wage-Setting

Decent.: Strong,

fragmented unions

Decent.: Weak,

fragmented unions

Centralized by industry

Shunto (Pattern-setting

industries)

* Increased from Low in last 20 years

IV. Economic Learning by Leaders, 1973-2000

• Cross-national differences are not static: Countries seem to “learn” and change in response to crises

• Three types of change:– Alter the usual variables (incrementalism)– Try a different variable (innovation)– Rethink how all settings work together and

alter many at once (paradigm shift)

A. Japan1. Initial system: Large, interlocking alliances with

government sponsorship (keiretsu)a. Dangers of inflation: High growth rates combined with fear of

social instability from unemploymentb. National labor talks produce 30% wage increases

2. 1973 Oil Shock: Policy inconsistencya. Japan received 82% of oil from Middle Eastb. Initial price shock causes inflation fearsc. Workers demand raises to compensated. Increased wages lower profits lower investment and

recession (worst one in any industrialized nation in % terms)e. Attempts to tighten money to fight inflation deepen recessionf. Crisis ends when price shock stabilizes, prices allowed to

rise, full employment resumes

3. 1979 Oil Shock: Consistency

a. Response: Immediate tightening of money supply only mild reduction in profits/investment

b. Fine-tuning prevented wage-price spiral

4. The 1980s: Export-led growtha. Huge trade surplus bolsters demand throughout

1980sb. However, non-export sectors begin to encounter

problems (low productivity increases, unable to lay off workers)

c. Banks tied to failing enterprises prop them up with profits from successful ones (no problem as long as exports continue to surge)

d. Profits from exports lead to “easy money” for banks speculation in stocks and real estate

e. 1986-1990: The Bubble: Stocks and real estate bid up by bankers and investors choicest parcels bid up to $93,000 per square foot

5. Early 1990s: The Bubble Bursts

5. Early 1990s: The Bubble Bursts a. Late 1989: Central Bank raises interest

rates in effort to deflate bubble --> reduces investment in stock market, popping a bubble in stocks Crash

The Stock Market Crashes

5. Early 1990s: The Bubble Bursts a. Late 1989: Central Bank raises interest

rates in effort to deflate bubble --> reduces investment in stock market, popping a bubble in stocks Crash

b. Failing domestic enterprises lead banks to slow investment, call in some loans discover many loans are unrepayable

c. Result is credit crunch as businesses and banks (tied together) try to reduce own debt load instead of expanding production

A Credit Crunch Emerges

6. The “Lost Decade:” A Failure of Governance?a. 1988 law reduces workweek from 44 to 40 hours by 1992 (

lower per-worker productivity)b. Government maintains tight money supply, leading to deflation

(money sucked out of economy leads to expectations of lower prices, leading to saving instead of consumption, leading to price cuts, etc)

c. Government tries to loosen money supply by cutting interest rates, but even ZERO interest fails to spark investment (business cartels are trying to reduce debt load and banks are skittish about lending)

d. By 2004, prime "A" property in Tokyo's financial districts had slumped to less than 1 percent of its peak

GDP Growth Rates (Compare to US 2.5% for 1990s)

B. United Kingdom

1. Initial system: Internal and external goalsa. Internal: Commitment to full employment, to be

achieved by wage restraint (politically unstable combination) general tool of “incomes policy.” Inflation “fought” by measures to increase production (= lower unit prices, in theory, but failed).

b. External: Maintain value of the pound to sustain Commonwealth stability/trade (removed certain monetary options like devaluing currency or inflation)

2. The 1973 Crisis: Political Instability and “Paradigm Shift:a. Conservatives lose powerb. The “Social Contract:” Informal agreement

between Labour and labori. Labour converts to monetarism! Exchanges

promise of no price rises for “voluntary” wage restraint. Allows pound to fall.

ii. Bargain fails: subsidies and sales tax cuts to hold down prices lead to huge deficits inflation through government spending; monetary instruments fail to control money supply until mid-1980s; government consistently overestimates future productivity growth

iii. Wage-price spiral follows, along with recession

3. The 1979 Crisis: Thatcherism

a. “Winter of Discontent” – Labor turns on Labourb. 1979: Thatcher elected on promises to cut spending,

cut taxes, curb inflation, deregulate (supply-side stimulation and monetarist deflation). Unable to effectively control money supply (lack of adequate measures – remember the Fed’s solution…)

c. Government soon abandons attempts to cut spending/taxes both rise

d. 1980: North Sea oil begins to increase revenues BUT leads to overpricing of British goods (Dutch disease – exchange rate distortions) and decline in domestic manufacturing

4. The 1980s: Monetarism abandoned

• Problem: Monetary control without proper exchange rate controls killed inflation but also much of the UK manufacturing base

• Government gradually seeks integration with European monetary policy to control both inflation and exchange rates

• Integration fails: Europe unable to stabilize pound (we’ll see why when we get to Germany…)

5. The 1990s: Return to stability

• Anti-inflation policies finally pay off: Government began targeting real interest rates instead of nominal rates or money supply

• Pound allowed to sink

• 1997: Central bank independence increased

C. France

1. Before the crises: Dirigismea. Government owns energy, infrastructure,

defense, communications industries

b. Unions are weak (no exclusivity or closed shops), so workers look to government to set wages and working conditions

2. 1973: Government tries to cushion shock

• Efforts to increase social spending and stimulate economy lead to high rates of inflation

• 1976: New P-M focuses on deflation. Allows unemployment to rise in order to hold down inflation. Balanced budgets become norm.

• No effort to deal with unions by Conservative governments

3. 1979: Socialism Fails

a. Voters elect Socialistsb. Socialists nationalize more industries to

prevent them from failing and achieve strategic control of economic development

c. Socialists raise wages (also increase benefits, lower hours per week) and make it harder to fire union leaders and other workers (thus increasing unemployment), also stimulate economy through spending, hoping to increase productivity enough to offset inflation (complete failure)

Unemployment in France

4. The 1980s: Malaise

a. Recession avoided in France BUT cost was continued high unemployment and inflation

b. Socialists retreat from economic stimulus, lowering inflation and tying the Franc to the DM -- BUT are blamed for previous failures and lose power in 1986

5. The 1990s: Still More Malaise

• The plan: “Competitive disinflation” argued that keeping inflation lower than neighbors (UK and Germany) would make France more competitive and increase unemployment– Central Bank independence dramatically increased to

fight inflation

• Problem: Huge gains in competitiveness unacceptable to French trading partners

D. (West) Germany1. Prior to crisis: Strong, independent central

bank (with price stabilization mandate) combined with national-level labor-industry wage bargaining. High job security, with government tasked with full employment and unions free to pursue max % of economy as wages.

2. The 1973 Shock: Government implements counter-cyclical Keynesian policies, but has little effect on unemployment (manages to increase deficit/debt, however). Hiring freeze on foreign workers has some effect, causing some migration.

3. The 1979 Shock

a. Shock is widely perceived as loss of competitiveness (real effect was largely on exchange rates)

b. Business anticipates downturn and cuts investment, people then follow by cutting consumption

c. Policy recommendations from Council of Economic Experts: Don’t stimulate demand-side at all, since this would cause inflation. Instead reduce regulations on investment. (Shared by Bundesbank and FRG)

d. Policy recommendations from Trade Unions: Stimulate demand to provide full employment (shared by SPD)

e. Government coalition (SPD plus FDP) is divided – FDP joins CDU to form conservative government in 1982

4. The 1980s: A Conservative Approach?

a. Little deregulation; subsidies not cut; mild reductions in spending growth and taxes

b. Firms do invest more – but they invest in labor-substitution instead of new jobs!

c. Inflation controlled by Bundesbank, unemployment continues through most of decade

5. The 1990s: Reunification

a. Immediate problem: East German industry cannot compete high unemployment

b. West Germany promises to exchange DM for Ostmarks 1:1 (essentially means printing lots of money)

c. Massive wage increases for East German workers (benefit of West German labor contracts)

d. Bundesbank restricts money supply to prevent massive inflation ( recession in 1993 and unemployment throughout decade)

E. Conclusions: National Political Differences Drive Economic Differences

1. Democratic leaders learn: When economic programs fail, leaders try new ideas policy inconsistency

2. Greater crises = greater changes in economic management

The Economic Crisis, 1972-1983

E. Conclusions: National Political Differences Drive Economic Differences

1. Democratic leaders learn: When economic programs fail, leaders try new ideas policy inconsistency

2. Greater crises = greater changes in economic management

3. “Economic voting” can be sophisticated: French Socialists don’t get credit for tight money and German Conservatives aren’t blamed for high unemployment

E. Conclusions: National Political Differences Drive Economic Differences1. Democratic leaders learn: When economic programs

fail, leaders try new ideas policy inconsistency2. Greater crises = greater changes in economic

management3. “Economic voting” can be sophisticated: French

Socialists don’t get credit for tight money and German Conservatives aren’t blamed for high unemployment

4. Path dependence: Previous choices can constrain current policy options

5. Critical variables include central bank independence, exchange rates, wage-setting institutions, and job protection

6. International trade critical to most non-US economies