How does an election year change the way we think about macroeconomics?Public choice theory is the idea that the state is made up of individuals who maximize their self-interest. Elections are an important consideration for politicians. The idea of a “political business cycle” assumes that certain types of policy measures are taken before and after elections and have an impact on the macroeconomy. Our ability to understand these phenomena helps us better interpret economic conditions and developments.
Fiscal policy and monetary policy, the most important macroeconomic instruments, are the first base when considering political business cycles. Patterns of this nature have been identified in developed countries. In the past, central banks tended to cut interest rates before elections because they believed voters could be fooled by a temporary rise in economic activity and that there was a lag before inflation appeared. Similarly, there is an incentive to increase spending before an election.
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Opportunities for such actions are limited by market and institutional developments. In developed countries, governments fear the wrath of bond markets. Large deficits are immediately punished by higher interest rates, which cripples the entire economy. This will control the temptation for such behavior. Regarding monetary policy, political business cycles are one of the reasons for ending the old style of monetary policy, which had the “mystery” of central banks, where central bank officials had discretionary powers to do as they pleased. It became one. As long as there is an inflation target backed by a properly constituted monetary policy committee, this concern will be resolved.
These issues play out differently in developing countries. As the quality of institutions deteriorates, economic policy decisions are more likely to be made with an eye toward re-election. However, there is another set of constraints. In conditions of financial repression, fiscal policy does not care what the bond market thinks. However, whether the economy is good or bad, fiscal policy has little room for maneuver. In the face of the pandemic, developed countries had the fiscal flexibility to mount a large-scale fiscal response. Given the difficulties of fiscal policy strategies, developing countries have limited fiscal policy flexibility, both in the face of a pandemic and in the face of elections.
Although most countries now have a formal system of inflation targeting, in many developing countries this institutional system is not yet well established and central bank staff have some authority to think about the purpose of elections. have. However, they are torn between four ways to support the ruling party. Is it best to stabilize foreign investors by sticking to the inflation target? Is it better to impress voters (who may have money illusions) by controlling inflation? Lower interest rates and a weaker exchange rate are better to support export demand? Or are high interest rates and higher exchange rates that support masculinity the best thing to do? There is no clear answer.
Here is one possible pathway for election-related impulses to the macroeconomy. In the world of infrastructure construction, if a project is started with 1,000 workers, this is expansionary, and when the project is completed, these 1,000 workers are out of a job. The start and end of construction on a project is usually a random event. Sometimes an old project is completed (this is reductive) and a new project is started (this is expansive). These events occur randomly and have a negligible final impact on the macroeconomy as a whole.
However, consider the potential for political and business cycles in project completion. Suppose that many projects are completed within a year before the election. In this case, the proliferation of projects will result in the loss of livelihood for many construction workers. This will be contractile.
When such behavior exists, it can serve as a conduit for political business cycles. If so, demand would be relatively weak during the election year and the year following, due to a high concentration of project completions.
A second path to political business cycles may lie in economic policy uncertainty. There are many industries where support from the Indian state is important for business plans and investment projects. Changes in the ruling system, including changes in ministers and senior officials, can lead to changes in policy and behavior toward civilians. If a certain percentage of companies feel that their industry or company is exposed to such risks, they will proceed with caution in investing in the pre-election period. This could give a second path to the political business cycle. Bagow and Altaf (2022) support this idea by studying the 2009, 2014, and 2019 Lok Sabha elections.
Neither of these two causal paths (completion of investment projects and non-random placement of firms/industries facing policy uncertainty) have an effect on the economy as a whole. But even if these problems only concern 10 to 20 percent of the economy, they can add up to become economically significant procyclical drivers. These direct effects will ripple through the economy through multiplier effects (for example, construction workers who lose their jobs will buy fewer biscuits and clothes).
Mainstream economics literature on political business cycles emphasizes the major instruments of monetary and fiscal policy. These ideas do not easily transfer to the Indian context. The existing literature has some interesting ideas about political business cycles, such as loan forgiveness (Mahambare, et al., 2022). In this article, we consider whether old ideas (political uncertainty) and new ideas (non-random completion of infrastructure projects) matter. Each of these ideas affects macroeconomic conditions at a different set of dates relative to election day. Understanding them and taking a stand on each of these speculations will help form a view on India's macroeconomy in 2024.
The author is a researcher at the XKDR forum