10: Policy Reforms, Responsive Governments and (Strategic) Delay 1. A Seemingly Trivial Question: Why Reforms? 2. What Type of Reforms? Some Ideas about Optimal Policies 3. Reforms in Comparative Perspective 4. Reforms, Number of Parties and the Distribution of Voter Preferences 5. Obstacles to Reforms: A First Look at Veto-Player Theory 6. Obstacles to Reforms and Strategic Delays

Why do Governments from time to time implement policy reforms and sometimes even begin the ‘transformation’ of the polity? Discuss!

Why do Governments from time to time implement policy reforms and sometimes even begin the ‘transformation’ of the polity? -- of course: reforms could always result from a change in government -- the ‘old policy’ has proven to be suboptimal

(but are governments really social welfare optimizers?) -- sticking to the ‘old policy’ threatens to wipe the incumbent out of the office

that is: the incumbent responds to changes in the aggregate preferences of the selectorate

-- if a simple policy is largely reducing political support of the incumbent, why didn’t the

government conduct reforms much earlier? -- hence: ‘what causes reform delay’ is an important question

More open questions:

Why do governments in different countries respond differently to common shocks? Why do some governments do not respond at all? Why do some governments seem to overreact at times? How do governments respond to changes in voter preferences? How do governments respond to new ‘debates’? (Some call it ‘new ideas’, but in fact it is either an additional policy dimension or a change in the issue salience of one dimension.)

Normative Background: The Washington Consensus - Fiscal Discipline - Public Expenditure aiming at building Human Capital and Infrastructure - Broaden Tax Base and Cut Marginal Rates - Financial Liberalization - Reduce Tariffs and Eliminate NTB’s - Remove Capital Controls - Privatization of Public Corporations - Ensure Property Rights - Remove Superfluous Regulations

the normative recommendations fall in two camps: - reforms that eliminate market distortions - reforms that eliminate unsustainable policies

Public Debt

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Reforms and the Number of Parties a) change in the mean voter’s position b) change in issue salience case a): all political systems respond app. equally case b): two-party systems do not respond at all

the more relevant parties in multiparty systems, the stronger the reponse to a shift in issue salience

only a model artifact?

Obstacles to Reform 1 A first look at Veto Player Theory (we come back to VPT in 2-3 weeks) What are veto players? Does the number of reforms decline in the number of veto players? Necessarily?

Fernandez-Rodrik: Reform Inactivity Assumptions Reforms have a strong redistributive effect winners and losers individuals know whether they win or lose majority of voters are winners (by assumption), but that is unknown to the voters payoffs: do nothing: 0 successful reform

(reform and majority of voters is winners: 1 unsuccessful reform (reform and majority of voters is winners: -1)

Alesina and Drazen: War of Attrition Assumptions: - reforms are beneficial to all voters (by assumption) - there are two groups of voters: a and b - one group has to bear the burden of reform - the gains per individual exceed the costs Why does this constellation lead to delay and possibly reform inactivity?

11: Dictatorship and Democracy 1. A Typology of Autocracies 2. The Logic of Political Decisions in Autocratic Regimes 3. The Trilemma of the Autocrat 4. Democratization and Autocratization 5. Selectorate Theory: A Unified View on Government in Autocracies and Democracies 6. Two Views on Autocracy, Democracy and Economic Growth

Not all Autocracies are the same… and neither are autocrats

A Classification of Autocratic Regimes (Wintrobe) Totalitarians -- Complete Control “the permanent domination of each single individual in each and every sphere of life” (Hannah Arendt) Examples: Stalin Tinpots -- no/little interference with daily life -- main interest in political power to self-enrichment Examples: Marco, Shah of Persia, Noriega Tyranny

-- regime that maintains power through violence -- regime that ignores material needs of people Examples: Kim Il-Sung, Idi Amin Timocracy -- dictators, who ‘love’ their people (well, don’t they all?) Examples: Lee Kwan Yew

Political Survival in Autocratic Regimes: The Trilemma Assumption 1: Autocratic governments want to maximize survival in power AND seek (economic) benefits from being in power. Assumption 2: There are two possibilities autocrats can lose power: - to an autocratic successor (a coup-d’etat) - to the people (revolution) Assumption 3: The easiest way to model this is to allow for an elite divided into two groups (the dominant and the dominated) and the people Assumption 4: Autocrats can freely determine their ‘budget’ 1G ( )Yτ= − , and they can distribute the budget they raised across the factions of the elite 1G d ( )sα α= + − . Assumption 5:

A coup is more likely the larger tau and the larger alpha. Assumption 6: A revolution is more likely, the larger tau and the larger alpha. Results: Autocrats either buy support from the dominated group of the elite (by letting alpha be relatively small) OR from the people (by allowing a low tau). Predictions: If the economy weakens, autocrats need to strongly reduce their own consumption (they need to stabilize support from the dominated faction) or to gain the support of the people (by lowering tau, that is by implementing market reforms).

Thus: Autocrats cannot simultaneously maximize their individual welfare sufficiently reduce the likelihood of a coup sufficiently reduce the likelihood of a revolution

Why are Democracies on Average Richer than Autocracies: On Democratization and Autocratization Przeworski et al. Argument: Probability of regime change is always larger than zero. Probability of democratization is independent of per capita gdp. Probability if autocratization declines in per capita income. Accordingly: poor countries fluctuate between being autocracies and democracies; rich countries, once democratic, are relatively unlikely to become autocracies. democracies are richer.

Selectorate Theory (BDM, Smith, Siverson, Morrow) Definitions: The Selectorate: set of individuals that participate in chosing the leader

-- small in autocracies, large in democracies Winning Coalition: set of individuals that are needed to determine the leader -- often selectorate/2,

-- might be larger in autocracies -- size depends on political/electoral system in democracies

Autocracy, Democracy and Economic Growth The Random Choice of Leader Characteristics Theory Assumption 1: Autocratic regimes are economically superior, as they can direct resources to the most efficient sector. Assumption 2: Autocratic leaders are uncontrolled, democratic leader are controlled. Assumption 3: Autocratic leaders can use the resources ineffectively (i.e.: for themselves), democratic leaders cannot. Results:

Growth

0 Democracy Score

possibility space

Plümper/ Martin Assumption 1: Autocrats and Democrats can buy support by transferring resources to the ‘winning coalition’ or by providing public goods. Assumption 2: The efficiency of these Instruments (the amount of support one can buy) depends on the size of the selectorate: if small, transfers are more efficient, if large, public goods are more efficient. Assumption 3: Therefore, autocrats dominantly buy support by transferring resources to the selectorate, democrats buy support by producing public goods. Production Function

( )1 s sgS R P−= +

Result: For a wide range of parameter sizes, government spending decreases if we move from an autocratic to less autocratic regime, but increases if we move from a intermediate regime to a democratic regime. Predictions: 1. Government spending is u-shaped in the level of democracy. 2. Economic growth (is linear in government spending) is inverse u-shaped in the level of democracy. 3. The interaction effect between the level of democracy and government spending increases economic growth. (Thus: spending is more efficient in democratic regimes). Conclusion:

Autocrats overinvest in transfers ( and underinvest in public goods), democrats overinvest in public goods.

12: Political Systems, Veto Players, and the Politics of Reform Revisited 1. Another Seemingly Trivial Question related to Reforms: Why do some countries

reform so little? 2. A Recapitulation of Lesson 10: The Political Economy of Reform Delay 3. To Start With: What makes Political Systems Different 4. Institutional Obstacles to Reforms: A Closer Look at Veto-Player Theory 6. Empirical Analyses of Veto Player Theory 7. Criticism

Recapitulation of Lesson 10

Fernandez-Rodrik: Reform Inactivity Assumptions Reforms have a strong redistributive effect winners and losers individuals know whether they win or lose majority of voters are winners (by assumption), but that is unknown to the voters payoffs: do nothing: 0 successful reform (reform and majority of voters is winners: 1 unsuccessful reform (reform and majority of voters is winners: -1)

Alesina and Drazen: War of Attrition

Assumptions: - reforms are beneficial to all voters (by assumption) - there are two groups of voters: a and b - one group has to bear the burden of reform - the gains per individual exceed the costs Why does this constellation lead to delay and possibly reform inactivity?

What makes Political Systems Different?

What makes Political Systems Different? − Electoral System (Majoritarian vs. Proportional)

Consequence 1: The Number of Parties Consequence 2: Coalition Governments Consequence 3: MoP discipline?

− Additional Complications: 5% hurdles − Plurality Rule versus Double Ballot rule

− Parliamentarism versus Presidentialism

− Federalism/Bicameralism − Referenda (issue voting of electorate, Switzerland, California, Euro, European

Constitution,…)

− Constitutional Rules/ Constitutional Courts

In addition: − Independent Central Bank

− last time we discussed army, interest groups, …

Constitutions and Reforms − Electoral System

Reforms are easier to implement in majoritarian systems.

− Additional Complications: 5% hurdles

Impact on reforms unknown. (Suggestions?) − Plurality Rule versus Double Ballot rule

no impact on reform, perhaps more reforms in plurality systems since success of radical candidates is more likely

− Parliamentarism versus Presidentialism

Reforms in parliamentary systems less easy. (what are the underlying assumptions?)

− Federalism/Bicameralism

Bicameral systems largely reduce probability of reforms. − Referenda (issue voting of electorate, Switzerland, California, Euro, European

Constitution,…)

Referenda reduce probability of reforms. − Constitutional Rules/ Constitutional Courts

Constitutional Courts reduce probability of reform. (At times, courts demand reforms).

George Tsebelis In summarizing the advantages of his approach, Tsebelis explicates: ”This article does not replicate the pairwise structure (…) separating regime type (…), legislature type (…), and party system. In fact, I will show that it may be misleading to examine these factors in isolation.” (Tsebelis 1995: 292) Opinions?

Actors The veto player framework is a set of interrelated assumptions, generalizations, coding rules and definitions. In brief, a veto player is a political entity that has the right (or the power) to veto political reform proposals of the dominant faction in government: smaller parties in coalition governments (ibid: 310), presidents in presidential systems (ibid: 305), second chambers (ibid: 306), constitutional courts (ibid: 307), referenda (ibid: 307), sometimes the military, interest groups, and independent central banks (ibid: 307-08). Tsebelis is quite clear in stating that the number of veto players depends on the analyzed policy in a given country rather than on the country alone. (based on BJPolS article) Assumptions Veto players are assumed to have policy preferences which are assumed to be identical to the preferences of the political party controlling a veto player. Actors maximize their utility by simply accepting policy proposals which are closer to their most preferred policy than the status and the veto proposal that move away from the most preferred policy.

Classical Assumptions of Spatial Models

Propositions Proposition 1: As the number of veto players who a re required to agree for the movement of the status quo increases, the winset of the status quo doe not increase. (Tsebelis 1995: 297) Proposition 2: As the distance of players who are required to agree for a movement of the status quo increases along the same line, the winset of the status quo does not increase. (Tsebelis 1995: 298)

Introduction to Spatial Models

Assumptions: Both dimensions equally important and – more importantly – substitution elasticity identical for all actors.

Tsebelis “Proof” of Proposition 1

“I use the size of the winset of the status quo as a proxy for stability. There are several reasons for this. First, the more points (i.e.policy proposals) that can beat the status quo, the more susceptible to change is the status quo. Secondly, the bigger the winset of the status quo is, the more likely it is that some subset of it will satisfy some external constraints. Thirdly, if there are transaction costs in changing the winset of the status quo, then players will not undertake a change that leads to a policy which is only slightly different (…). Fourthly, even without transaction costs, if players undertake a change, a small winset of the status quo means that that the change will be incremental.” (Tsebelis 1995: 295)

Tsebelis “Proof” of Proposition 2

Empirical Tests of Tsebelis Typically do not consider and gather the preferences of actors ignore issue-specific differences in veto rights Test Proposition 1: “As the number of veto players increases, the likelihood of reforms declines.”

In the order of publication date: Mark Hallerberg and Scott Basinger, 1998, ‘Internationalization and Changes in Tax Policy in OECD Countries. The Importance of Domestic Veto Players’, Comparative Political Studies 31, 321-352; Kathleen Bawn, 1998, ‘Money and Majorities in the Federal Republic of Germany. Evidence for a Veto Players Model of Government Spending’, American Journal of Political Science 43, 707-736; George Tsebelis, 1999, ‘Veto Players and Law Production in Parliamentary Democracies. An Empirical Analysis’, American Political Science Review 93, 591-608; Mark Hallerberg, 2002, ‘Veto Players and the Choice of Monetary Institutions’, International Organization 56, 775-802; Philip Keefer and David Stasavage, 2003’ ,The Limits of Delegation. Veto Players, Central Bank Independence, and the Credibility of Monetary Policy, American Political Science Review 97, 407-423; Josephine Andrews and Gabriella Montinola, 2004, ‘Veto Players and the Rule of Law in Emerging Democracies’, Comparative Political Studies 37, 55-87; Daniel J. Minnich, 2005, ‘Veto Players, Electoral Incentives and International Commitments. The Impact of Domestic Institutions on Intergovernmental Organization Membership’, European Journal of Political Research 44, 295-325; Robert F. O’Reilly, 2005, ‘Veto Points, Veto Players, and International Trade Policy’, Comparative Political Studies 38, 652-675.

Proposition 1 is WRONG Unfortunately, the infamous proposition 1 of Tsebelis BJPolS article is wrong – or to be more precise, it is correct only under very restrictive additional assumptions. Consider the following distribution of parties 1-4 across a single policy dimension:

p1 p2 p3 p4

SQ

Figure 1: A Distribution of Partisan Preferences Scenario 1: Assume that p1 and p2 form a coalition. Since their preferences are located on the two sides of the status quo, they are not able to agree on a reform. Scenario 2: Assume that p2, p3, p4 form a coalition. In this case, the bold section of the x-axes is the pareto set.

Veto Player Approaches dumps unlike concepts into one Variable… Such a contract between coalition parties does not eliminate political conflicts. However, issue linkage may significantly increase the room for manoeuvre. Figure 2 provides an obvious and straightforward example.

p1 p2

SQ

p1 p2

SQ

policy a

policy b

Figure 2a: Deadlook in two dimensions… Now assume for a) simplicity, b) consistency with Tsebelis and without c) (much)1 loss of generality that these two dimensions are orthogonal to each other.

1 As the two dimensions become more and more collinear, the winset becomes smaller and eventually vanishes.

p1

p2

SQpolicy a

policy b

Figure 2b: … may disappear if actors link issues Note that figure 2b is consistent with figure 2a. That issue-linkage can improve the prospects for cooperation has since long been known (LITERATURE) and is not worth additional proofs.

Why does this matter? Because different veto player use these strategies with different probabilities.

Conclusion With proposition 1 being wrong, the veto player approach does not allow to derive hypotheses without having to conduct research on the preferences of actors. Even then the approach remains dubious as different veto players have different strategies available.

13: Federalism, Bicameralism, and ‘Multi-Level’ Governance 1. A Recapitulation of Lesson 12: Veto-Player and Empirical Findings 2. Why Federalism seems a good thing at a first glance: The Promises of Federalism 3. The Pitfalls of Federalism 4. When Federalism causes Deadlock: Bicameralism and Reforms 5. Is there a Trade-Off between too much and too little Government Autonomy? 6. If yes, is there an optimal Constitution?

The Empirics of Veto-Player Theory Recent Research showed that veto players reduce the number and scope of tax reforms (Hallerberg/ Basinger) reduce the reduction of tariffs (O’Reilly) reduce the number of Preferential Trade Agreements (Milner and Mitchell) reduce the number of memberships in International Organization (Minnich) reduce the extent to which governments adhere to the ‘rule of law’ (Andrews/ Montinola) increase inflation (Keefer/ Stasavage) and so on and so on. Or doesn’t it?

− endogeneity? − tested against the nil of no effect of veto players, not against the nil of bicameralism

or supermajoritarian decision-making − other problems?

Federalism Federalism is a system of shared power and decision-making between two or more freely elected governments with authority over the same people and geographical area. It grants and protects decision-making ability where results are most immediately felt -- in local communities, as well as at higher levels of government. USA: Quick Guide to Democracy Federalism is the theory or advocacy of federal political orders, where final authority is divided between sub-units and a center. Unlike a unitary state, sovereignty is constitutionally split between at least two territorial levels so that units at each level have final authority and can act independently of the others in some area. Citizens thus have political obligations to two authorities. The allocation of authority between the sub-unit and center may vary, typically the center has powers regarding defense and foreign policy, but sub-units may also have international roles. The sub-units may also participate in central decision-making bodies. Stanford Encyclopedia of Philosophy

Taxonomy of Federalism Federations versus Confederation (well, the US case) Inman Rubinfeld

Discuss: Which way to go?

Why Federalism is a good thing… … in theory. Federalism developed as a response to the ancient question of how to link separate political communities together in order to pursue effectively objectives unobtainable alone, but without submerging their own identities. The most pressing of these aims were normally to overthrow an oppressor or to defend against a larger aggressor. Attempts were made to form leagues in Greece, particularly in the 3rd and 4th centuries, and in mediaeval Italy, for example, but these tended to be short-lived. (Simple Guide to Federalism)

Subsidiarity From Wikipedia, the free encyclopedia.

Subsidiarity is the idea that matters should be handled by the smallest (or, the lowest) competent authority. The Oxford English Dictionary defines subsidiarity as the idea that a central authority should have a subsidiary function, performing only those tasks which cannot be performed effectively at a more immediate or local level. The concept is applicable in the fields of government, political science, cybernetics, and the management of large organizations. Subsidiarity is, ideally or in principle, one of the features of federalism.

Federalism, Subsidiarity and the Joint-Decision Trap In principle, all political decisions should be made on that level, which can most effectively deal with the problem. In practice, many decisions are related to more than one level. For instance, tax policies affect the federal level, the state level, the regional level, and the city level.

Most federal systems have ‘resolved’ tensions between various political levels by introducing a ‘joint responsibility.’ In terms of Tsebelis: Each level is given some veto-rights. Sounds nice, as this ensures that lower level have a voice in the decision-making process. But it leads to a huge status quo bias. Discuss

Example for the Joint Decision Trap of Federalism: The Common Agricultural Policy From Wikipedia, the free encyclopedia.

The Common Agricultural Policy (CAP) is a system of European Union agricultural subsidies which represents about 44% of the EU's spending (€43bn scheduled spend for 2005 [1]). These subsidies work by guaranteeing a minimum price to producers and by direct payment of a subsidy for crops planted. This provides some economic certainty for EU farmers and production of a certain quantity of agricultural goods. Reforms of the system are currently underway including a phased transfer of subsidy to land stewardship rather than specific crop production from 2005 to 2012.

The CAP is often explained as the result of a political compromise between France and Germany: German industry would have access to the French market; in exchange, Germany would help pay for France's farmers.

For many decades, the CAP is known to be inefficient. In principle, European consumers pay four times for its inefficiency: In their role as consumers:

prices for agricultural products are above world market prices in Europe in their role as tax-payers in the production process:

agricultural producers are heavily subsidized in their role as tax-payers in international trade: exports of agricultural products are subsidized in their role of tax payers in international compensation:

the EU buys-out countries that litigate at the GATT/WTO Hence: the CAP is presumably the most inefficient policy in the world. Unfortunately, it can be changed only by unanimity.

Is trade-Off between too much and too little political autonomy of the government? Is there an optimal constitution?

14: Presidentialism, Parliamentarism, and the Fate of Democracy 1. What Difference does Presidentialism make? 2. Are Presidential System more likely to become Autocracies?

Presidential Systems President and parliament have competing claims to legitimate decision-making.

Conflict emerges, which may destabilize the democracy. Presidents cannot be dismissed – not even by supermajoritarian vote of the parliament. Presidents thus enjoy (and exploit) more political autonomy and less control than governments which are responsible to the parliament. Presidential systems are more likely to lead to policy volatility. The role of the opposition is much weaker in presidential systems.

This may lead to the opposition seeking non-parliamentary ways of resistance. Parties have a less important role in presidential systems. It is therefore more likely that outsiders to the political system will win political control over the chief office than in parliamentary systems.

Advantages of Presidential Systems Greater choice for voters, as voters can ensure divided government. Greater accountability, as political authority is clearly defined. Greater independence of the MPs, as their choice does not affect the stability of government. -> less party discipline

Presidentialism and Political Stability

ENP: Effective Number of Parties Source: Samuels/ Eaton 2002

Presidentialism in Eastern Europe Choice of presidentialism influenced by relative strengths of communist parties. And Latin America presidential systems may have larger deficits.

Source: Neto/ Blanco/ Borsani 2001

15: Westminster, Consensus Democracy and Patterns of Democracy: Corporatism Reconsidered Two models of democracy:

Westminster Concentration of Executive Power Cabinet Dominance 2-Party System (Majoritarian Voting) Disproportial Effects of Elections (Strong Majority) Interest Group Pluralism Unitary and Centralized Government Unicameralism Weak Constitution Dependent Central Bank

Consensus Democracy Broad Coalitions Executive-Legislative Balance of Power (Government dependent on parliament and vice versa) Multiparty System Proportional Representation Interest Group Corporatism (Central organized labor unions and business associations) Federalism Bicameralism Constitutional Rigidity (Strong Courts) Central Bank Independence

Lijphart sums up Page 248 Do Consensualism and Corporatism make a difference? Page 266

15: Corporatism and Inflation 1. Inflation 2. Three Types of Wage Negotiations 3. Wage-Inflation-Spirals 4. Government-induced versus Corporatism-induced Inflation

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Three Types of Wage Negotiation Individual-Firm (Enterprise Level) Sectoral Union – Sectoral Employer Association (Sectoral Level) National Union – National Employer Association (sometime with government involvement) (national level)

Excerpt from Calmfors & Driffill

Outcome Enterprise Level: Moderate wage increase, dependent on post-tax profits of corporations sectoral level: relatively high wage increase dependent on power of unions national level: moderate wage increase dependent on power of union + degree to which negotiators ‘internalize externalities’

Why is inflation higher in countries with decentralized negotiations between unions and employer organizations?

Why is inflation higher in countries with decentralized negotiations between unions and employer organizations? Because unions cannot (never) negotiate real wage increases but only nominal wage increases. This implies that corporations (have to) raise prices as inflation increases, which implies inflation, which leads to higher demands of the unions, which causes even more inflation, and so on… Why do centralized unions demand moderate wage increases? …, because they correctly anticipate the inflationary effect of wage increases AND internalize this effect. Why do decentralized unions do NOT demand moderate wage increases?

Even though they also correctly anticipate the inflationary effect of wage increases, they do not internalize this effect, because each wage increase negotiated by a single union on inflation is small.

therefore there is a competition between unions in countries with decentralized wage negotiations. Workers will receive a relatively high net pay rise, if they work in a sector which union has negotiated a relatively large wage increase. Workers will receive a relatively low net pay rise, if they work in a sector which union has negotiated a relatively small wage increase.

16 Central Bank Independence CBI is theoretically related to corporatism. While corporatism is believed to increase inflation, CBI aims at lowering inflation. Some hypotheses: CBI lowers inflation, because central bankers have no incentive to manipulate the political business cycle. CBI lowers inflation because central bankers are committed to reduce inflation. CBI lowers inflation because unions and employers anticipate anti-inflationary policies when negotiating wages.

CBI lowers inflation because unions and employers anticipate anti-inflationary policies when negotiating wages. A Dichotomy of Central Banks Iversen distinguishes between accommodating and non-accomodating central banks. Accommodating is defined as “expansionary monetary policies in the present of high wage increases”

Non-accomodating is defined as “restrictive monetary policy in the presence of high wage increases.”

What are the consequences of accommodating and non-accomodating monetary policies on the results of wage negotiations?

What are the consequences of accommodating and non-accomodating monetary policies on the results of wage negotiations? Low wage increases: non accommodating and accommodating central banks respond identically (in technical terms: pooling equilibrium) High wage increases (separating equilibrium): Accommodating central banks will implement expansionary monetary policies Outcome: high inflation Non-Accomodating central banks will implement restrictive monetary policies Outcome: High Unemployment

Conditional effects (Keefer/ Stasavage)

… because reversal of CB’s decision is less likely.

… because ??? Not understandablke in original text.

… because with multiple veto players CBI is less easy to abandon.

CBI not robustly related to political polarization.

And how this non-finding was later reported (APSR 2002)

16: Government Spending

1. Patterns of Government Spending 2. Theories of the Increase in Government Spending

Australia

2224

2628

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ovex

pend

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govshare govexpend

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govshare govexpend

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3540

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40go

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Finland

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5060

govs

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/gov

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govshare govexpend

France

3040

5060

70go

vsha

re/g

ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

Germany

3035

4045

5055

govs

hare

/gov

expe

nd

1970 1975 1980 1985 1990 1995year

govshare govexpend

Ireland

2530

3540

45go

vsha

re/g

ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

Italy

2030

4050

60go

vsha

re/g

ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

Netherlands

3040

5060

70go

vsha

re/g

ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

New Zealand

2530

3540

govs

hare

/gov

expe

nd

1970 1975 1980 1985 1990 1995year

govshare govexpend

Norway

3540

4550

55go

vsha

re/g

ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

Portugal

2025

3035

40go

vsha

re/g

ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

Spain

1020

3040

50go

vsha

re/g

ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

Sweden

4050

60go

vsha

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ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

Switzerland

2025

3035

40go

vsha

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ovex

pend

1970 1975 1980 1985 1990 1995year

govshare govexpend

UK

3035

4045

govs

hare

/gov

expe

nd

1970 1975 1980 1985 1990 1995year

govshare govexpend

USA

3035

4045

govs

hare

/gov

expe

nd

1970 1975 1980 1985 1990 1995year

govshare govexpend

FranceBelgium

NetherlandsSwedenFinland

ItalyAustria

GermanyDenmark

NorwaySpain

PortugalUK

CanadaIreland

New ZealandSwitzerland

USAAustralia

0 10 20 30 40 50 60

percent of GDP

B

1995

Increase of Government Expenditure over Time

3840

4244

4648

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1970 1975 1980 1985 1990 1995year

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25

30

35

40

45

50

55

60

65

70

US

UK

Austria

Belgium

Denmark

France

GermanyItaly

Netherlands

Norway

Sweden

SwitzerlandCanada

Finland

Ireland

PortugalSpain

Australia

New Zealand

19

95

1973 Across Countries

Competing Explanations Unemployment Aging Change in Productivity ‘Globalization’ Ideology

1995

510

1520

25un

emp

30 40 50 60 70govexpend

1975 Unemployment Theory:

02

46

8un

emp

20 30 40 50 60govexpend

An increase in unemployment causes an increase in government expenditure, because more voters demand unemployment benefits and transfers increase if an unemployment transfer scheme exists. Comment: Unfortunately, an increase in government expenditure also causes an increase in unemployment as private investment and/or private consumptions declines. Moreover, with little exceptions, OECD countries experienced similar shocks. Yet, unemployment did not rise similarly. Rather, unemployment is a consequence of the welfare state, i.e. generous unemployment transfers.

Aging Theory: Similar to unemployment. An increase in the number of pensioners increases the demand for generous public pension schemes. (three-generation models demonstrate that majority of voters is in favor of public pension schemes once they exist) Comment: very little empirical evidence for this theory, increase in public pension schemes does obviously not explain the increase in government spending – at least not the variation across countries.

Change in relative productivity. Theory: voters’ demand for the relative share of public and private goods is constant over time. However, most public goods are in fact services, most private goods are manufactures goods. Since the increase in productivity tends to be higher in manufacturing than in services, the relative costs of public good provision increases over time. Comment: smart theory, cannot explain the huge variation across countries. Shall we believe that low govspend countries had lower increases in industrial productivity?

Globalization Theory 1 (compensation theory): Globalization increases demand for social transfers as likelihood of unemployment and economic volatility increase. Comment: theory wrong. Larger markets are less volatile and trade does not stimulate unemployment – or only a tiny little bit. Theory 2 (efficiency theory): Globalization and particularly tax competition reduces governments ability to effectively provide inefficient government services: capital flight in case of high government expenditure. Comment: tax competition has not led to a decline in government spending. Rather, taxes on mobile factors have been reduced, taxes on immobile factors have been increased by governments.

Ideology Theory: Left parties provide more public goods than conservative parties because of voter alignment. Most individuals with below average income vote for left parties, these voters demand more redistribution. Comment: Theory not wrong, however, historical time heavily intervenes. In the 1970s, all parties favored redistribution, in the 1990s only a few (left-wing) parties favored redistribution. On average, their might be a partisan effect, but impact of left government on spending varies largely over time. (Even left parties learn … ;-)

16: Tax Competition

1. The Logic of Tax Competition 2. Country Size 3. Empirical Evidence 4. Why has tax competition not eliminated taxes on mobile capital?

In technical terms: “A striking feature of international tax competition is that independent jurisdictions fully or partially share a mobile tax base. As a consequence, if one country reduces its tax rate strategically to attract mobile capital it provokes an immediate inflow of capital, and this, in turn, creates a fiscal externality (i.e., a shrinking tax base) in other countries (see Wildasin 1989). In the (Nash-)equilibrium, governments are left in a situation where tax rates (on capital and labor) are set at comparably low levels.” Hence: the logic of tax competition depends on capital mobility. (which in turn leads to the question how mobile capital actually is…)

Basinger and Hallerberg 261

To attract a mobile factor of production, one government might reduce its use of a policy instrument that lessens the rate of return on that mobile factor, such as high tax rates or restrictive environmental standards. This policy change creates a negative externality for competitor states or countries that must enact their own reforms to maintain competitive parity. In gametheoretic terms, the states are presumed to face an inescapable “Prisoner’s Dilemma” in which every state has a dominant strategy to make its market more attractive than its neighbors’ markets. In the game’s unfortunate equilibrium outcome, the mobile factor may remain distributed the same as before barriers fell, but all countries and their citizens are in a worse condition, whereas owners of the mobile factor of production reap increased rewards.

Which tax bases are mobile? -- savings -- corporate profits -- corporations? (holdings) hence: governments should remove withholding taxes (capital earnings taxes) and corporate profit taxes

The codes used in the formulas correspond to the OECD classification in the OECD Revenue Statistics: 1100 … Taxes on income, profits, and capital gains of individuals; 1200 … Corporate taxes on income, profits, and capital gains;

Is tax competition ‘good’ or ‘bad’? Discuss!

A view on Tax rates on Mobile Capital (Various Sources)

0

10

20

30

40

50

6019

65

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

oecd_gross oecd_net

corp aetr

Has ‘globalization’ removed taxes on mobile capital bases? The empirical evidence for the race-to-the-bottom model, however, is weak.Vogel has found that the model is dissonant with actual trends in environmental regulation, and the same is true for tax policy—capital tax burdens have increased even as capital became more mobile, with the overall

share of revenues provided by corporate income taxes rising from 7.7% in 1975 to 8.4% in 1996 (Genschel 2000). Why not?

The Effect of Country Size Small countries should act more aggressively in tax competition, because for them the tax base effect is more important than the tax rate effect. In large countries, the tax rate effect is more important than the tax base effect. The Effect of Veto-Players Hallerberg and Basinger argue that the extent of tax cuts depends on the number of veto-players (actors that can veto reforms). The more veto-players, the lower tax cuts. The Effect of Budget Constraints Governments in countries with budget deficits are less likely to reduce tax rates (Plümper, Winner, Troeger).

1. Estimation Results

CTAXi LCTAX CTAX/LCTAX independent variablea) CTAX-i 0.604 ** -0.923 *** 1.434 ***

(0.312) (0.236) (0.399) RIGID 0.344 *** 0.321 *** 0.118 # (0.085) (0.039) (0.083) EQUITY 0.147 *** 0.036 *** 0.053 **

(0.052) (0.010) (0.027) SIZE 0.430 *** 0.069 *** 0.356 ***

(0.039) (0.015) (0.032) GDPPC 0.368 *** 0.336 *** -0.007 (0.047) (0.021) (0.043) Observations 467 467 467 Cross sections 21 21 21 R2 0.944 0.954 0.951 Country effects: χ2(20) 3846.70 *** 1330.20 *** 3391.17 ***

Excluded instruments:b) F(DF1,DF2) 37.88 *** 13.23 *** 32.88 ***

(4,338) (2,440) (2,440) Wu-Hausman test:c) F(DF1,DF2) 2.00 # 27.44 *** 7.14 ***

(1,440) (1,440) (1,440) Sargan test:d) χ2 (DF) 4.16 0.00 0.36 (3) (1) (1)

Notes: Standard errors in parentheses. *** significant at 1%; ** significant at 5%; *

significant at 10%; # significant at 15%. a)Constant and country effects not reported. b)F-Test for excluded instruments. c)Wu-Hausman F-statistic (H0: regressor is exogenous (i.e., OLS is consistent and efficient)). d)Sargan-Test for overidentifying restrictions.

Is tax competition good or bad? Bad, if we believe that governments are social welfare maximizers, the provide the optimal amount of public and private goods. Good, if we believe that governments tend to overtax the society, provide useless benefits to a small minority of important voters and influential individuals.

17: Monetary Policy in Open Economies Exchange-Rates Exchange-Rate Regimes Mundell-Fleming Fear of Floating Evidence Currency Unions External Effects

Exchange Rates The Dollar/Euro Exchange Rate

The Yen/Dollar Echange Rate

Dollar/Yuan

What is an exchange-rate? An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own (and vice versa). What drives exchange-rates?

…in the short run? we don’t know or: alternatively

sentiments rumors

expectations about the expectations of other investors events (shocks)

… in the long run? the relative ratio of productivity growth and inflation expectations about productivity and inflation

policies

Exchange-Rate Regimes Flexible Exchange-Rate

the market decides on the relative value of the currency Managed Float

in principle the currency floats, but the government may under certain circumstance intervene

Fixed Exchange Rate Fixed to Key Currency (Dollar, Euro, Yen?) Fixed to Currency Basked

the government(s) has/have the obligation to intervene important: parities, bandwidths

Currency Board Value of Issued Money held in Reserves Dollarization

Introduction of Dollar/ Euro/ Franc/ Pound as SOLE Means of Payments

Currency Union

Introduction of Common Currency (and common monetary policy)

Why do some countries peg their currency, and other float? Advantages of stable exchange-rates: stable expectations no need to insure against exchange-rate risks

(futures, hedges,…) low transactions costs to trade more trade (Andrew Rose) higher economic growth (?) Disadvantages of fixed exchange-rates risk of severe misalignment speculative attacks on exchange-rate peg reduction in monetary policy autonomy

How are exchange rate regimes and monetary policy are related? Why does the exchange-rate and the exchange-rate regime matter for monetary policy?

Mundell-Fleming theorem (unholy trinity): Government can only reach two of the following three policy goals simultaneously: stable exchange rates absence of capital controls monetary policy autonomy

De Facto Monetary Policy Autonomy: The Fear of Floating Literature The New Standard?: Fear of Floating Empirical observation: ‘Dirty’ Float Explanations: a) Monetary authorities stabilize the exchange-rate to prevent an increase in the value of debt denominated in foreign currency to their GDP (or to their tax revenue). b) Monetary authorities stabilize the exchange-rate to prevent exchange-rate pass-through thereby keeping the inflation rate down. Hence: There is no clear trade-off any more: Pegging countries largely surrender monetary policy autonomy (degree depends on bandwidths of the peg and ease of realignment). Floating countries do not necessarily allow their currency to freely float but stabilize the exchange-rate to the key currency/ the key currencies.

De facto monetary policy autonomy is a continuum [0,1].

Empirical Evidence for Fear of Floating Abundant: Calvo and Reinhardt (QJE 2002): Empirical Evidence of ‘Dirty Float’ Shambaugh (QJE 2004): Pegged countries stabilize exchange-rates more than floating countries, but much additional evidence of dirty float. Obstfeld, Shambaugh and Taylor (NBER 2004): Narrative of Fear of Floating Campa and Goldberg (RES 2005): Evidence for Exchange-Rate Pass-Through Hausman, Panizza and Stein (JDE 2001): Evidence for Borrowing – Float Hypothesis Frankel, Schmuckler and Serven (NBER): Transmission of Interest Rates And many more..

… and even more to come soon, I guess.

di Giovanni/ Shambaugh

18: The Political Economy of Monetary Unions Why monetary unions?

Advantage: Reduction in transaction cost of trade. Andrew Rose for empirical evidence that common currencies increase trade. Disadvantage: Almost complete reduction in monetary policy autonomy.

Which countries then are more likely to join a currency union? neighboring countries small, open countries countries with independent central banks

The Intuition of the Argument Monetary authorities in floating countries stabilize the exchange-rate to key currency areas (in the presence of competing key currencies). Since key currencies float with respect to each other, monetary authorities may need to stabilize to more than one key currency simultaneously. They ‘weight’ the importance of key currencies. Direction of capital flows (currency conversion flows) matters since they determine exchange-rate effects. Share of both currency unions from key currency areas matters because of exchange-rate pass- through effects. How do currency unions enter the equation?

The establishment of a currency union increases the size of the key currency area, increases the attractiveness of the union’s currency for investors. Accordingly and in the absence of intervention, the elasticity of the exchange rate to changes in the real interest rate difference increases.

19: Capital Mobility, Location, and the Environment

Vernon’s Product Life Cycle products (industries) run through a life cycle: 1. period: invention, high skill-intensity, patents, monopoly ? location: most advanced country 2. period: maturing, mid skill-intensity, patents expired, fierce competion location: advanced countries 3. period: old, low skill-intensity, no patents, potentially labor intensive production location: developing country

time since 'birth' of an industry

skill intensity

number of firms

Krugman, Fujita, Venables most industries produce positive externalities to their competitors i.e. by enhancing the sector-specific skills of the workforce

as a consequence, the are advantages of ‘clustering’ competing corporations choosing the same location regardless of the availability of raw materials examples? Silicon Valley software industry in India else?

… to sum up: Corporations chose the location where they maximize profit (so far, so trivial) in doing so, they often (but not always) slice-up the product chain factor endowment, market access, and agglomeration seem to be the driving forces And what about policies? environmental policy child labor labor rights social security systems else

Flows and Stocks of FDI (Source: UNCTAD, excerpt) YEAR 1980 1990 2000 2001 2002 2003 2004 ECONOMY CATEGORY World FDI inflows 55,108 207,878 1,396,539 825,925 716,128 632,599 648,146 FDI inward stock 530,244 1,768,589 5,786,029 6,197,711 6,703,607 7,987,077 8,902,153 FDI outflows 53,743 238,681 1,239,149 743,465 652,181 616,923 730,257 FDI outward stock 570,125 1,785,264 6,148,284 6,564,217 7,288,417 8,731,240 9,732,233 Developed economies FDI inflows 46,629 172,067 1,134,293 596,305 547,778 442,157 380,022 FDI inward stock 398,200 1,404,411 3,976,356 4,265,471 4,810,641 5,816,292 6,469,832 FDI outflows 50,407 225,965 1,092,747 662,199 599,895 577,323 637,360 FDI outward stock 496,197 1,637,760 5,257,261 5,673,530 6,368,560 7,727,178 8,610,146 Developing economies FDI inflows 8,455 35,736 253,179 217,845 155,528 166,337 233,227 FDI inward stock 132,044 364,057 1,739,726 1,831,112 1,764,474 2,007,962 2,232,868 FDI outflows 3,336 12,701 143,226 78,571 47,775 29,016 83,190 FDI outward stock 73,927 147,313 868,920 856,230 861,568 927,442 1,035,676 Developed economies: FDI inflows 22,725 56,004 380,798 187,124 92,838 63,183 102,152 America FDI inward stock 137,209 507,754 1,469,583 1,557,744 1,564,196 1,652,271 1,777,678 FDI outflows 23,328 36,219 187,301 160,901 161,704 140,859 276,747 FDI outward stock 239,158 515,328 1,553,886 1,711,045 1,875,764 2,101,078 2,387,982 Developed economies: FDI inflows 21,569 104,304 722,762 393,898 427,560 359,369 223,400 Europe FDI inward stock 239,034 800,751 2,292,922 2,501,888 2,980,555 3,819,536 4,258,547 FDI outflows 24,128 138,936 866,090 451,336 396,868 390,021 309,498 FDI outward stock 234,625 882,899 3,324,128 3,553,352 4,077,628 5,141,402 5,658,814 Developing economies: FDI inflows 442 22,614 145,725 108,583 92,009 101,278 147,545 Asia FDI inward stock 50,878 183,849 1,064,078 1,052,559 1,006,823 1,131,045 1,278,608 FDI outflows 1,056 10,945 81,071 51,967 35,994 17,231 69,422 FDI outward stock 19,418 68,178 612,305 585,816 573,399 623,068 717,997

Interpretation? Much FDI is directed to gain market access. ‘Cheap labor’ and ‘absence of environmental regulation’ arguments cannot explain the bulk of FDI. For example, China attracts less FDI than Britain. … and FDI is less important in China than it is elsewhere…

Source: UNCTAD Factors Determining Pollution Level

i.e. Nitrogen Oxygen (NOx) Sulfur Dioxide (SO2) Suspended Particles

The Environmental Kuznets Kurve Pollution

Per Capita Income5000-8000$

per capita

Starting from low income levels, an increase in GDPC is associated with an increase in pollution, starting from higher income levels, an increase in wealth is associated with a decline in pollution.

Reasons for the Kuznets Curve: -- voters in richer countries are environmentally more conscious -- richer countries have much larger service sectors -- else? What about: Dirty industries ‘migrate’ to poor countries with low environmental standards? Do they?

Grether/ de Melo “First, aggregate comparisons of output and trade trends based on a classification of pollution industries based on US emissions revealed very marginal delocalization to the South. Second, firm-level estimates of FDI location choices by-and-large found at best marginal evidence either of location choice in the US in response to cross-State differences in environmental regulations, or of location choices by multinational firms across developing countries in response to differences in environmental regulations.” In other words: There is much evidence for the fact that industries in poorer countries are relatively dirty. Yet, there is remarkably little evidence for corporations ‘delocating’ to pollution havens.

Trade and the Environment The Frankel/ Rose Model

TradePer CapitaIncome

+

Democracy

- (?)Environmental Regulation

+

+/-depending on GDPC

Pollution

-

+

Accordingly: the influence of trade on pollution is ambiguous and presumably conditional. Why?

Findings: “We confirmed the pattern of the environmental Kuznets curve, whereby growth eventually has a beneficial effect on pollution, after the initial adverse relationship at low levels of income. Trade accelerates the growth process. However the primary emphasis of the paper was on the effect of openness for a given level of income. Here we found little or no evidence of the race to the bottom hypothesis. To the contrary, a

higher ratio of trade to income, for a given level of income, seems if anything to reduce air pollution.” (Frankel/ Rose 2002: 26-27)

20: Political Integration and the EU The members of the European Union have transferred to it considerable sovereignty, more than that of any other non-sovereign regional organization. In certain areas the EU begins to take on the character of a federation or confederation. However, in legal terms, member states remain the masters of the Treaties, which means that the Union does not have the power to transfer additional powers from states onto itself without their agreement through further international treaties. What is the EU doing? Why have members 'transferred sovereignty'? At what cost? Why is there no other political entity like the EU?

Membership 23 July 1952 Belgium, France, West Germany, Italy, Luxembourg, The Netherlands (founding members) 1 January 1973 Denmark, Ireland, United Kingdom 1 January 1981 Greece 1 January 1986 Portugal, Spain 3 October 1990 East Germany reunites with West Germany and becomes part of the European Community 1 January 1995 Austria, Finland, Sweden 1 May 2004 Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia

EU institutions The functioning of the European Union is supported by several institutions: * The European Parliament (732 members 750 max.) * The Council of the European Union (or 'Council of Ministers') (25 members) * The European Commission (25 members) * The European Court of Justice (incorporating the Court of First Instance) (25 judges (& 25 judges of CFI)) * The European Court of Auditors (25 members) There are several financial bodies: * European Central Bank (which alongside the national Central Banks, composes the European System of Central Banks) * European Investment Bank (including the European Investment Fund) There are also several advisory committees to the institutions: * Committee of the Regions, advising on regional issues

* Economic and Social Committee, advising on economic and social policy (principally relations between workers and employers) * Political and Security Committee, established in the context of the Common Foreign and Security Policy, monitoring and advising on international issues of global security. Codecision

There is plenty of research on who rules in the EU. But let's take a step back and ask: Why does it exist? What is it doing?

The fundamental trade-off… On the one hand… …the EU reduces the barriers to trade, capital flows, and the movement of persons. On the other, however, … …it reduces the political autonomy of the member countries. Why is the reduction of barriers to certain types of mobility beneficial to governments/countries? Why is the loss of political autonomy costly to governments/countries?

Gains from political integration: free trade free movement of capital free movement of labor free movement of ideas abolition of non tariff barriers to trade i.e. different standards monetary integration reduction in uncertainty

-> economies of scale -> increase in competition -> efficiency -> comparative advantage

Costs of Political Integration loss in political autonomy -> inappropriate standards -> adjustment costs -> reduction in speed of adjustment to exogenous shocks -> potential increase in strengths of right-wing/Anti-European party -> else?

A non-functionalistic Theory of Political Integration Why is there an increase in political integration since WW2? What countries are most likely to join a political integration area? Does political integration need to have a strong regional component?

A non-functionalistic Theory of Political Integration Why is there an increase in political integration since WW2? - countries became similar (regulatory competition, convergence) - increasing trade openness and capital mobility reduced political autonomy anyway however: this also led to an increase in competitiveness of small political entities

What countries are most likely to join a political integration area? - small countries - open countries - countries that already share similar rules and regulations

Does political integration need to have a strong regional component? not necessarily, but: - neighboring countries seem to be more likely to share common policy preferences - neighboring countries trade more, which makes political integration more attractive - coordination costs seem to be smaller - else?