The political economy perspective

Political economy originally denoted the analysis of production, buying and selling, and their relations with law, custom, and government. It emanated from the discipline of moral philos-ophy and was developed in the 18th century as the study of the economies of states. In the late 19th century, the term “political economy” was replaced by the term economics, used by those seeking to lift the study of economy on a mathematical foundation rather than relying on the structural relationships of production and consumption. Today, “political economy”

refers to an interdisciplinary approach understood as the economic analysis of politics. This is the meaning of the term that is referred to in the remainder of this dissertation.

Within the political economy literature one distinguishes between two distinct but related fields: social choice and public choice. Social choice theory represents a theoretical framework for measuring individual interests, values, or welfares that are aggregated for the purpose of collective decision. It dates back to Condorcet’s formulation of the cyclical voting problem that later inspired Arrow’s (1951) famous “impossibility theorem”. Typically, a set of appar-ently reasonable axioms are used to construct a social welfare function (or constitution) and to derive the implications of those axioms.

On the other hand, public choice theory involves the use of modern economic tools to study problems that are traditionally in the province of political science.⁷ Or as Tullock (1988) put it, public choice is “the invasion of politics by economics”. From the perspective of political science, it may be classified as the subset of positive political theory dealing with individuals whose material interests predominate. In particular, public choice studies the behavior of politicians and bureaucrats as self-interested agents and their interactions in the social system. In some cases, the behavior of political actors is even investigated under alternative constitutional rules. An important assumption for the theory of public choice is that most voters are not able to fulfill their monitoring function due to the public good character of information about politics.

One may argue about the exact birth date of public choice theory and the question what contribution was the very first one in this field. A typical suggestion is Arrow’s (1951) and Black’s (1948) insight that democracy, based on the principle of majority rule, is inherently unstable since the associated aggregation of individual preferences runs into basic problems of consistency. However, long before Arrow’s and Downs’ contributions, the Swedish economist Knut Wicksell (1851 - 1926) analyzed the efficacy of majority rule and contrasted it with the unanimity rule as a benchmark.⁸ Nowadays, Wicksell is remembered as the most important

7Public choice theory is commonly associated with George Mason University, where Gordon Tullock and James M. Buchanan are currently faculty members. Their early work took place at the University of Virginia and Virginia Polytechnic Institute and State University. Hence, the “Virginia school of political economy” is often referred to in this context.

8The core of this work emphasized consensus and unanimity in place of majority rule as a standard of governance and became the guiding framework for the theory of public choice and constitutional economics.

Wicksell recognized that a shift from unanimity to approximate unanimity creates a tradeoff. True unanimity

precursory figure of the public choice school and therefore his work precedes the birth date of public choice theory.

Given that the theory on the cyclical voting problem identified by Arrow and Black draws heavily on the methods of social choice, it might seem inappropriate to classify these findings as the first contribution to public choice theory. Instead, one can argue that Downs’ (1957) fundamental insight that “parties formulate policies in order to win elections, rather than win elections to formulate policies” (p.28) was the first original contribution to public choice theory. In a Downsian world, voters act rationally in a sense that they vote for the party that he or she believes to offer the greatest personal benefits. Party manifestos serve as a source of information to evaluate and compare these benefits across parties. Since collecting and processing this information is costly, each voter may confine this evaluation to those areas where differences between parties are largest. Downs’ main contribution can be summarized as improving the understanding of party competition and voter’s rational ignorance.

In addition, Downs made a contribution to spatial voting by means of the so-called

“Median Voter Theorem”.⁹ In particular, the model illustrates the stylized fact that electoral competition between political parties often creates a bias towards centrist policies. Parties seek to place themselves on a political position where they maximize the number of voters located closer to them than any other party along an ideological spectrum. This theory has strong empirical support (Congleton and Shughart, 1990; Congleton and Bennett, 1995;

Poole and Daniels, 1985), while it has been criticized for its lack of predictive power for multi-dimensional issues and multi-peaked preferences (Black, 1948; Plott, 1967).

Apart from casting their vote, individuals can express their preferences by joining forces with like-minded individuals to form interest groups. However, Olson (1965) pointed out that the formation of interest groups and collective action may be hindered by the free-rider problem known from the theory of public goods. Also, he argued that two conditions make the formation of interest groups more likely: a small number of persons that act collectively and the existence of “selective incentives” to penalize free-riders and/or to reward those who contribute their share of the cost of collective action.

While collective action can be beneficial to individual group members, since they are more likely to achieve their goals, there is also a reason why collective action may have negative effects based on Tullock’s (1967) seminal work on rent-seeking. Broadly, one can say that when rents are available, interest groups may try to influence the government in the formulation of policies. These efforts can take the form of lobbying activities or explicit

ensures that people do not have to pay taxes for activities they are not willing to support. But it would also prove costly to work out arrangements for collective support. He concluded that a slight movement away from unanimity is a reasonable compromise. These reflections can be found in Wicksell’s bookInvestigations in the Theory of Public Financepublished in 1896.

9This theory is based on Hotelling’s (1929) finding that a street with two shops will find both shops right next to each other at the halfway point. In this way, each shop will serve half the market.

monetary transfers. However, since these expenditures do not increase the resources available in a society, rent-seeking expenditures are a social waste.

One of the key propositions in public choice is that the formulation of public policy and in particular the spending behavior of the government is strongly influenced by election dates.

Nordhaus (1975) contended that political parties act purely “opportunistically” by creating desirable economic conditions before elections through expansionary monetary policy and deficit spending. These manipulations create macroeconomic cycles that may aggravate busi-ness fluctuations. Hibbs (1977) argues in favor of a “partisan approach” to political busibusi-ness cycles. In particular, he assumes that politicians manipulate the economy to favor their clien-tele. Left-wing parties representing the poor prefer low unemployment and high inflation, while right-wing parties representing the rich prefer the opposite combination. Hence, this theory suggests a relationship between the ideological position of a party and macroeconomic variables, while constant changes in the government should induce a business cycle.

Other notable contributions to the theory of public choice not reviewed here for brevity are: the theory of bureaucracy by Niskanen (1971), Brennan and Buchanan’s (1980) portrayal of a Leviathan government that exploits the fiscal commons, as well as Buchanan and Tullock’s (1962) contributions to constitutional political economy. While the first articles on public choice theory were published in the 1950s, it took nearly three decades until this field became established and well-recognized. Even in recent years, different kinds of criticism have been directed at this school of thought. Political scientists such as Green and Shapiro (1994) claim that public choice only represents a restatement of existing knowledge in rational choice terms and therefore does not allow for any new insights. Moreover, representatives of the Chicago school argue that individuals reach Pareto-efficiency with regard to political decisions and that the institutions that are in place are the most efficient ones (Wittman, 1995).

Some authors have even reflected on a possible replacement of public choice theory by a new paradigm. The result of this discussion has been that “Political Economics” does provide an extension of public choice theory in some directions but does not displace the entire set of theories (Alesina et al., 2006; Blankart and Koesters, 2006; Ursprung, 2003). Despite these attacks one has to acknowledge that public choice theory has greatly contributed to our understanding of politics and that many of the hypotheses that are put forward have some empirical support. These findings will be discussed in more detail in the next section.