Macroeconomic Performance
Why Politics Matters

At a lunchtime meeting on 25 October, held to mark the launch of issue no. 13 of Economic Policy, Vittorio Grilli presented the results of his recent research into the relationship between political institutions and macroeconomic policy formation. Grilli is Woolwich Professor of Financial Economics at Birkbeck College, London, and a Research Fellow in CEPR's International Macroeconomics programme. His talk was based on his article `Political and Monetary Institutions and Public Financial Policies in the Industrial Countries', written jointly with Donato Masciandaro and Guido Tabellini, in issue no. 13 of Economic Policy . The meeting formed part of the Centre's research programme on Financial and Monetary Integration in Europe, which is supported by the Commission of the European Communities under its SPES programme and also by the Ford Foundation. The views expressed by Professor Grilli were his own, however, not those of the above organizations nor of CEPR, which takes no institutional policy positions.
Grilli first noted that the industrialized countries have pursued remarkably different public debt policies since World War II. At the end of the 1980s, their debt/GNP ratios ranged from about 10% in Switzerland to more than 100% in Belgium. The OECD economies are similar and highly interconnected, so neither different macroeconomic policy responses to disturbances to their national economies nor public finance principles of optimal taxation can adequately explain these differences. Moreover, the positive trend of many of these countries' public debt since World War II contradicts the common belief that budget deficits have only smoothed the effects of temporary shocks.
Grilli maintained that differences in OECD member countries' public debt policies may be explained better by constitutional differences that affect economic policy formation in the various democratic regimes such as their electoral processes and political traditions than by their responses to different shocks. The possible relationship of divergences in inflation performance to different fiscal policies is central to the debate over Europe's economic and monetary union: if large deficits or certain types of political system lead to inflation, then establishing a monetary union of countries with dissimilar fiscal policies could cause major difficulties. Grilli proposed that differences in industrialized economies' monetary stability may be explained in terms of the degrees of independence enjoyed by their national central banks. If institutional and political systems have significant and independent effects on the determination of economic policy, then waiting for further convergence of member states' monetary and fiscal policies before implementing the union would be mistaken: indeed, complete convergence could only be achieved by a full political and monetary union.
Grilli found three main results. First, representational rather than majoritarian parliamentary or Presidential democracies and those with fractionalized party systems account for most large national public debts: they tend to produce relatively short-lived governments, which are prone to large budget deficits. Second, countries that rely heavily on monetization as a source of revenue (the `inflation tax') also have high public debts; but the converse does not hold. Monetization provides only trivial revenues to many high-debt countries with highly independent central banks, which typically enjoy low inflation irrespective of their budgetary positions. Third, the real economic performance of countries with relatively independent central banks is just as good as those whose central banks are subject to tighter political control. Having an independent central bank is therefore almost tantamount to a `free lunch': it delivers the benefits of low inflation with no significant costs to real economic growth or the variability of output.
Grilli maintained that these findings have important implications for the feasibility and sequencing of the European Community's monetary integration. First, monetary integration need not be subordinated to the prior achievement of fiscal convergence. If the EC member states adopt the constitution proposed in the current draft statutes of the European Central Bank, it will be one of the most if not the most independent of all OECD central banks. This should insulate the common European monetary policy from the accommodative pressures stemming from the fiscal deficits of certain member countries.
Second, accompanying the proposed monetary integration with some budgetary rules that would be binding on national governments may be in the best interests of the high-debt countries. Debt accumulation in representational democracies has probably been due to domestic political distortions, which may be offset by binding and welfare-improving external rules. As with monetary policy, fiscal authorities may benefit from an international agreement to `tie their hands'.
Grilli concluded by warning that causation between institutional structure and economic policy decisions may run both ways. The terms of the statute that establishes a central bank and even the constitutional structure of a country can evolve and change over time. Institutional arrangements are endogenous and may be affected by economic performance. Such feedbacks occur only over long periods of time, however; in the short-to-medium run, causation runs from politics to policies.