Is good economics always good politics? Not really…

A brilliant food for thought paper from Acemoglu/Robinson duo. It is titled as – Economics versus Politics: Pitfalls of Policy Advice and is to feature in Journal of Econ Perspectives. As it features in JEP, it is in plain English which is such a  relief. One can only be in awe of the amount of research and writing the duo does. It is not a joke..

The new paper looks at a very important issue of econs advising government. Most econs prefer to stick to economics without bothering about political consequence. The adage is ” good economics means good politics”. So don’t bother about political consequence. Right.

Wrong. The authors say we should be mindful of the political consequences as well:

The fundamental approach to policy prescription in economics derives from the recognition that the presence of market failures like externalities, public goods, monopoly, and imperfect competition creates room for well-designed public interventions to improve social welfare. This tradition, already clear in Pigou (1912), was elaborated by Samuelson (1947), and still provides the basis of most policy advice provided by economists. For example, the first development economists in the 1950s used market failure inspired ideas as the intellectual basis for the need for government intervention to promote development in poor countries (Killick 1978).

Though belief in the ability of the government or the effectiveness of aid has waxed and waned, current approaches to development problems have much in common with this early tradition, even if they have become more sophisticated: in recognizing second-best issues, for instance, by incorporating informational frictions explicitly in policy design (for example, Townsend, 2011); in highlighting the specificity of the appropriate policy depending on context (for example, Rodrik, 2007); and in emphasizing the role of rigorous empirical methods in determining which sorts of interventions can be effective (for example, Banerjee and Duáo, 2011). But in all of these approaches, politics is largely absent from the scene. 

There are three reasons for this ignorance of politics approach:

This neglect of politics is often justified implicitly or explicitly in one of three ways. The first is to maintain that politicians are basically interested, or induced to be interested, in promoting social welfare, for example, because socially efficient policy is what helps politicians to stay in power or get re-elected in models like Whitman (1989, 1995) and Mulligan and Tsui (2006, 2008). 

The second is to view politics as a random factor, just creating potentially severe but unsystematic grit on the wheels of economic policymaking (for example, Sachs, 2005, or Banerjee, 2012, argument that the Liberian dictator Samuel Doeís economic policies were disastrous because he did not understand what was involved in being president”).

The third justification recognizes that political economy matters, but maintains that ìgood economics is good politics, meaning that good economic policies necessarily relax political constraints (for example, Boycko, Shleifer and Vishny, 1995, and Banerjee and Duflo, 2011, in particular, p. 261, or Sachs et al., 2004). The implication is the same as the first two views: one could unwaveringly support good economic policies, assured that they will not only solve market failures but also unleash beneficial political foresee whatever those may be.

The paper shows this is not right:

In this essay, we argue not only that economic advice will ignore politics at its peril 1but also that there are systematic forces that sometimes turn good economics into bad politics, with the latter unfortunately often trumping the economic good. Of course, we are not claiming that economic advice should shy away from identifying market failures and creative solutions to them, nor are we suggesting a blanket bias away from good economic policy. Rather, our argument is that economic analysis needs to identify, theoretically and empirically, conditions under which politics and economics run into conflict, and then evaluate policy proposals taking this conflict and the potential backlashes it creates into account. 

Our basic argument is simple: the extant political equilibrium may not be independent of the market failure; indeed it may critically rest upon it.

They point to one example of trade unions. Econs usually think of them as bad and want them to go. However, trade unions also have some advantages as well. Deunionization could make the existing corporates even more powerful:

 Faced with a trade union exercising monopoly power and raising the wages of its members, most economists would advocate removing or limiting the unions ability to exercise this monopoly power, and this is certainly the right policy in some  circumstances. But unions do not just influence the way the labor market functions; they also have important implications for the political system. Historically, unions have played a key role in the creation of democracy in many parts of the world, particularly in Western Europe; they have founded, funded and supported political parties, such as the Labour Party in Britain or the Social Democratic parties of Scandinavia, which have had large impacts on public policy and on the extent of taxation and income redistribution, often balancing the political power of established business interests and political elites.

Because the higher wages that unions generate for their members are one of the main reasons why people join unions, reducing their market power is likely to foster de-unionization. But this may, by further strengthening groups and interests that were  already dominant in society, also change the political equilibrium in a direction involving greater efficiency losses. This case illustrates a more general conclusion, which is the heart of our argument: even when it is possible, removing a market failure need not improve the allocation of resources because of its impact on future political equilibria. To understand whether it is likely to do so, one must look at the political consequences of a policyó it is not sufficient to just focus on the economic costs and benefits.

The paper goes on to provide a framework where an economic equilibrium could unsettle the political equilibrium which could then lead to poor economic outcomes as well. There are several examples as well to show all this from Africa to Russia Privatization to current crisis.

On current crisis the story is like this. The economic wisdom was deregulate financial sector as much as possible. This had political consequences as it led to rent-seeking with fin sector becoming even more powerful…

The experience of financial deregulation over the past 30 years in the United States, as analyzed by Johnson and Kwak (2010), provides an illustration of how economic policy designed with a disregard for political implications can be injurious to social welfare. The system of financial and banking regulation which emerged from the Great Depression had many features that were irrational from a purely economic viewpoint. These included the prohibition of interstate banking and the separation of commercial from investment banking. Jayaratne and Strathan (1996), among others, found that the removal of some of these banking restrictions spurred rapid economic growth. Such reforms are akin to those directly addressing market failures in the sense that they were removing distortions partly introduced by previous policies. But, in common with the other economic policies with potentially counterproductive political consequences, these reforms also tended to strengthen an already powerful constituency, the financial sector. 

Financial deregulation started small, for example, ending fixed commissions on stock trading in 1975. Then in 1980 Regulation Q, which limited interest rates on savings accounts, was abolished. As Johnson and Kwak (2010) argue, while the banking and financial services industry was not powerful enough at this time to get all the deregulation it wanted, it was strong enough to block new regulation. This was relevant because considerable financial innovation was starting to take place: as one example, Salomon Brothers originated interest rate swaps in 1981.

As these new financial instruments developed, and as regulations that limited what financial services banks could perform were incrementally  relaxed during this time by regulators and courts, the financial sector became bigger and more profitable. Between 1980 and 2005, financial sector profits grew 800 percent in real terms, while nonÖnancial proÖts rose by 250 percent (Johnson and Kwak, 2010, Chapter 3). Between 1998 and 2007, financial sector profits were on average about 30 percent of total profits in the private sector. During this period, the Önancial sector went from 3.5 percent to almost 6 percent of GDP.

As the banks got bigger and more profitable, they also became more assertive and influential. They started to lobby more and contribute more to political campaigns. While in 1990 the financial sector donated $61 million dollars to political campaigns, by 2006 this was $260 million (the industry which was the next largest donor, health care, gave only $100 million in 2006). Of course, rising wealth and campaign contributions were not the only source of rising political power for the financial industry. There was a revolving door between Wall Street and executive appointments in Washington as well. As Johnson and Kwaak (2010) point out, there was also an intellectual revolution in academic finance involving the pricing of derivative financial instruments and a body of studies arguing for deregulation, all of which was interpreted as bolstering the financial sector’s position. 

They say their paper is not the first to point the importance of political economy. Though, no one has made the argument of linking economic reforms with strengthening the interest groups which the reform should actually weaken:

We are of course not the first ones to point out that the political economy of economic policy matters, nor that a standard cost-benefit framework for the analysis of policy is inadequate because it leaves out politics. Since the 1980s, a vibrant literature in political economy has sought to develop positive models of how policy actually gets chosen, which involves modelling  politics and the decision-making process (for overviews, see Drazen, 2000; Persson and Tabellini, 2000; Besley, 2007; Acemoglu and Robinson, 2006). That being said, existing political economy analyses either do not focus on this question or else emphasize that, if politically possible, market failures should be removed. Dixit (1997) and Drazen (2002) have argued that policy (or institutional) advice must be given in a way that takes seriously the constraint that policy is chosen as part of a political equilibrium implying that policy advice should be tempered by what is incentive compatible for politicians.

Nevertheless, to the best of our knowledge, our main argument in this paper has not been made before. Our argument is that economic policy should not just focus on removing market failures and correcting distortions but, particularly when it will impact the distribution of income and rents in society in a direction that further strengthens already dominant groups, its implications for future political equilibria should be factored in. It thus calls for a different and explicitly political economy based framework for the analysis of economic policy.

Much of the conceptual, theoretical and empirical foundations of such a framework remain areas for future work.

The last bit is really interesting. Looking forward to such papers..

It is pretty fashionable actually to see econs (and wannabe econs) say on TV ” Good economics is good politics”. It is even funnier to see politicians defending their decisions based on this.

One only wonders whether any of the speakers have even evaluated any of the political consequences. The problem with econs and economic advice is that all this is analyses from a very narrow prism. Very little thought is made towards politics, society, environment etc. These are usually dumbed as softer issues economists are not supposed to look at.

However, I always have a doubt on econ advise no matter which hat it comes from – political economy one or pure economy one. Econs should be more humble and think themselves as students of economics and not saviors. There have been plenty of bad advise given in the past which should be humbling to say the least. The whole idea is economics is just one of the things that matters in this society. However, importance given to  econs makes them supremely overconfident of what they can achieve.  This leads to policies which econs think are real value but society does not really think so…

The paper also has fab reference list..

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