Kelvin Teo
Let’s begin with a hypothetical scenario.
A country is faced with a recession that struck since the last one during the previous decade. Unemployment rate is more than 10%,with more than 40% of the current work force receiving salary cuts. And there are others having issues finding regular employment; they could be working during certain days but on others, they are unable to find work. Bankruptcy is also at an all time high. Macroeconomic indicators do not paint a rosy picture either. Gross domestic product figures declined.
The country is currently in the midst of an election to select the next President. Two presidential hopefuls came up with their list of solutions for the economy. Candidate A proposed increased government spending in financial assistance packages for the people, for example, setting up an unemployment relief fund that assists households whose working members have lost their jobs, and another separate fund that provides handouts to the lower percentile of income earners. He also suggested setting aside another portion of funds to be channelled to ailing companies to help them break even. He called for increased healthcare expenditure to offset the costs of healthcare for those most severely affected by the crisis especially the jobless, irregularly employed and elderly. He also promised to set up a school assistance fund to provide financial assistance to students from low income households.
Candidate B proposes less than candidate A. He suggests setting aside funds to be channelled to ailing companies and a school assistance fund to provide financial assistance to students from low income families.
Candidate C on the other hand favoured tax cuts – reductions in both progressive (taxed according to size of income) and regressive (valued added tax, goods and services tax) taxes based on the belief in their immediate impact. He reasoned that the cuts will have immediate benefits on businesses and individuals. With regards to government spending, he advocates reduced government spending, since tax returns will be low given the current unemployment rate and salary cuts that drive down income and consumption, in addition to the tax cuts he is advocating. He is calling for a cautious fiscal policy, advocating cuts in defence budget.
Thus, the big question is which candidate is favourite to win the elections after each presented his proposal to the electorate?
The bets are on candidate A to win the elections. In the mind of a rational voter, he will want to maximise his benefits versus costs, balancing both variables in an outcome that will bring maximum advantage to him. The outcome will be his final voting decision in this scenario. The outcome that is considered the most advantageous will be the considered a rational choice, as dictated by the rational choice theory. To a voter who is from the low income group and is irregularly employed, what candidate A offers appears to be more advantageous as compared with his electoral rivals B (more so) and C (even more so). He will be assured of a financial handout, his healthcare costs will be borne by the government and his kids will be financially assisted in school. The benefits that candidate C is offering is considered modest in comparison with B and more so with A – citizens pay less consumption and income taxes.
Those adhering to strict rational choice theory do not examine the biological, psychological, sociological and moral bases of their decisions. They do not consider the ethical and future implications of their decisions, which led to the Nobel Laureate economist, Amartya Sen calling people who followed this approach “rational fools”. And yet politicians seeking popular support make promises in their proposals appealing to voters’ sense of rational choice.
For astute observers of different schools of economics thought, what candidate A offers is more in line with the Keynesian school (public spending during recession to keep unemployment rates down and prevent further economic deterioration) whilst candidate C’s position would be similar to what an economist from the Austrian school would have advocated. The purpose of this article is not to compare the differences between the schools, but is rather aimed at describing the nature of economics-related decisions in the short and long term.
Regardless of which economics school one is from, one will generally agree that the decision taken by a government to spend requires deliberation, and issues to be considered are tax returns to the government which will determine the size of war chest to spend, how much will be spent plus areas of dedicated expenditure, and size of the country’s reserves should the need to tap into it arises. Even the decision on how much to spend and what areas to spend on requires careful deliberation, for example, deciding which areas to momentarily cut spending and channelling to other areas of need.
Yet, research on The Aftermath of Financial Crises by economists Kenneth Rogoff and Carmen Reinhard from Harvard University and University of Maryland respectively has shown that countries ended up with the issue of mounting sovereign (public) debts after attempting to cope with a recession. In their research, they tracked the cumulative increase in European, Asian and South American economies’ public debt for three years following the crisis. The authors attributed the rising debt to declining tax revenues and “over-ambitious countercyclical fiscal policies”, which in simpler terms refer to huge surge in government spending. A sovereign debt crisis places the country at risk of default. Such crises have largely transpired in the US and Europe during recent times.
This article will attempt to explain the possible mechanistic roles of politics in the run up to a sovereign debt crisis, by expanding on the view of impact of rational choices voters may make, and the provision of such choices by politicians to appeal to voters. Politicians have one single raison d’être to be elected to office or to be re-elected during the subsequent round. While the opening scenario is in the context of a run-up to an election, a similar one can happen when the politician is in office and he gives either of the proposals as suggested by candidate A or B (though more likely A) in the hope of winning over the voters’ support so that he can be re-elected.
Now, we spoke earlier of the rational choice theory, where the voter wants to maximise his gains and minimise his costs, and such a decision may be made without societal and ethical considerations. Amartya Sen termed such rational individuals “rational fools”. To take the debate to the next level, we should cast the discussion on the basis of impact of such “rational” choices, both immediate and in the long-term. We only explore two different impacts that are relevant to this article – 1) large short term gains, and long term loss 2) small or moderate short-term gains, and long term gain. For definitions, a decision that results in large short term gains, and long term loss is an irrationally rational decision, i.e. a short term gain but long term pain. A decision that results in small or moderate short term gains but gains in the long-term is a rationally rational decision. An example of huge short term gains is financial assistance packages, coverage of healthcare expenses and financial assistance of schooling kids. An example of a long term loss is the onset of a sovereign debt crisis with the possibility of a default due to excessive government spending.
An irrationally rational decision can produce a very similar impact encountered in tragedy of the commons. The provision of publicly available resource, such as a grass patch, will lead to agents maximising their self-interests. Hence, if it was a community of cattle owners, every cattle owner will lead his cattle to graze on the grass patch, eventually depleting this publicly available resource. That being said, however, short term huge gains and long term loss is perhaps worse, with the agent staring at a bleak future.
The situation of mounting sovereign debts after tackling a financial crisis with possibility of default could come about due to reduced tax avenues and ambitious government spending programmes. Politicians, with their interests to win voters inevitably appeal to voters’ sense of irrational rational decision-making, with the allure of huge short-term gains, which will require huge spending. However, such ambitious spending result in increased likelihood of mounting sovereign debts and subsequently, risk of default, which can result in a long-term pain. You compare that with another politician who suggests modest coping strategies such as tax cuts, and frugal fiscal policies like cutting government spending in a less important area and diverting it to another important area of need. Although the latter will only bring about modest gain for the voters, but at least his strategy does not involve ambitious government spending, and overall, is less likely to result in a significant public debt and possible default, which is a better long-term outcome.
Unfortunately, politicians in general have their self-interests, and voters may be lured by huge short-term benefits. Wouldn’t it be better if there are more rationally rational decision-makers with the long-term picture in mind than irrationally rational ones?
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Photo courtesy of The Financial Regulation Forum
Hi Kelvin,
If you complicate a simple situation, you can justify intervening on just about anything. Conversely if you simplify a complicated scenario enough, you can justify any theory by leaving out important assumptions.
Firstly you assume that it is a recession, not a depression. That may be clear only in hindsight.
You also assume that: 1) tax savings translate to discretionary spending, 2) discretionary spending improves the economy, 3) government spending on public goods (defence) is inherently wasteful
Let me give you a counter for every one of these embedded assumptions: 1) consumers may cut discretionary spending in a recession on poor sentiments whether you implement one-time tax cuts or not, 2) In an open economy, increased private consumption could result in greater imports which is inherently inflationary and does little to the unemployment conundrum, 3) most of the time defence contractors create jobs domestically, and cutting budgets could result in cutting skilled local employment.
So will tax cuts and reduction in fiscal spending improve the unemployment situation?
However I do agree that discretionary spending on military hardware is generally wasteful and can be reduced depending on geopolitical considerations. But it will be difficult for a politician to make such a recommendation especially when defence spending remains opaque.
Sometimes folksy memes like ‘spending within your means’ worsens an already bad situation on an aggregate level, and the solution could well be counter-intuitive. In a closed-economy, if my company store isn’t doing well, the solution may well be to hire more staff so that they are paid with goods from the company store.
If you frame individuals as short sighted and selfish, politicians as perversely incentivized (not untrue), then of course your conclusion may well be valid. If high unemployment is the problem that needs to be resolved, then only candidate A’s package improves the situation, but not by very much.
As for candidate C, how is it that voters who chose “Mr Tax Cuts” isn’t short-sighted and ‘irrationally rational’?
Actually Jonas, I can see the merits of your arguments. But I did provide extremes.
Candidate B is between candidate A and C. The problem has been that if politicians promise too much in terms of policy and spending too much, the risk of a sovereign debt default is high.
But, if you go by rational choice, even A will have an advantage over B. But, you see, government spending as it is is a vote clincher.
As it is, I am not so much in addressing the technicalities of tax cuts versus stimulating aggregate demand or Keynesian versus Austrian, but rather alluding to the fact that politicans have their self interests, and voters have theirs, and an unrealistic government spending programme is going to increase the likelihood of a sovereign debt default.
Candidate A was framed in the context of an unrealistic and ambitious spending programme, while B is intermediate. And these come about as a result of self interests.
You mentioned: “If you frame individuals as short sighted and selfish, politicians as perversely incentivized (not untrue), then of course your conclusion may well be valid. ” –> this actually summarises what I have written
BTW, the gist of my article follows after Kenneth Rogoff and Reinhardt’s research on Aftermath of financial crisis.
I am trying to propose a mechanism by expanding the idea of rational choice theory, in which political and voter interests intersect, and result in unrealistic spending programmes that will bring about sovereign debt crisis.
Do you have any other mechanism in mind?
Thanks for replying Kelvin.
Regarding your second comment on the inspiration drawn from the NBER paper, I do think it explains the political dynamics of big surges in fiscal spending to combat recession. That paper also mentioned the collapse of tax revenues as another reason for increased sovereign indebtedness after a banking crisis. To a certain extent, it is also applicable to a recessionary scenario. But the key theme of the study I feel tried to explain that countries that experienced a banking crisis found it necessary to implement fiscal spending programs to address the sharp decline in money supply when large capital outflows occurred. This is in spite of lower tax collections, and therefore would naturally lead to worsening international creditworthiness.
I find your perspective on the paper is refreshing, and could potentially explain voter/politician behaviour in the context of a recessionary environment. Indeed I do agree that “vote-buying policies” can lead to increasing the chances of a politician being elected. And bad policies can worsen a nation’s fiscal position by funding through overseas borrowing, which incidentally becomes more expensive at a time when borrowing becomes necessary. However I disagree that:
1) spending programs (however in your example it appears to be expansion of entitlement programs, which I see as a departure from a Keynesian prescription) is considered ‘vote buying’ while tax cuts are not,
2) countries can only rely on borrowing in foreign currencies to fund fiscal deficits, and
3) the need to maintain international credit standing trumps domestic concerns, culminating in an austerity program that could adversely impact the lives of even more people who may well be largely blameless for the calamity.
You strategically chose to focus on 1) entitlement programs (as opposed to jobs creation), 2) foreign currency denominated debt (against dipping into reserves, domestic borrowing, printing press, etc), and 3) defence spending (instead of teachers, policemen, firemen) which I feel unjustifiably frames monetary policy as a victim of populist politics. Therefore my concluding remark in my first comment that a tax cut is as much a short term ‘vote-buying’ strategy as increasing discretionary fiscal spending.
Dear Jonas:
With regards to vote-buying, I do not disagree that tax cuts can be vote buying, but I think it is less vote buying that all the full range of grants, subsidies and what-not.
I do apologise for my narrow focus.
But let’s try another scenario.
Say now, voters vote for three policies -
Health subsidy for all diseases ONLY, including preventable types of diseases (which is more expensive), Health subsidy for unpreventable disease ONLY (genetic diseases for example, in this case, preventable diseases are NOT subsidised) + financing preventive healthcare (which is less expensive than the former), and the last one is mere Financing preventive healthcare.
I am going to say that health subsidy for ALL diseases will appear most attractive to voters on first thought, but it will be this MORE rational rational types will think Health subsidy for unpreventable diseases and financing preventive disease will be a better package.
Because if preventable diseases can be prevented, it will save the healthcare system a whole lot of money, you can read the cost-benefits analyses of preventable diseases investment. But people being rational agents will want to cover their bases and vote for subsidies for any diseases only.
However, it will be the more far-sighted people that will vote for B – preventive healthcare plus subsidising unpreventable diseases.
My point is that there are many circumstances that rational/irrational perspectives that I was elaborating on can be applied. I think the discussion, especially where the economy and government budgeting is concerned will be more complete with a pay-off matrix, both short- and long- term.
To further the discussion, the reason why I frame tax cuts as on a lower buying magnitude is because of administrative factors.
Because tax returns are done annually. Say a crisis happens in January and tax cuts are recommended, but the tax returns are only done in december. A politician that suggests an immediate handout is going to garner more votes due to the human nature of instant gratification of money in one’s pockets immediately.
Hmm… I am in the opinion that “more is better” candidates will not necessarily be the top choice among voters. Ultimately it depends on voter composition; if we make a simplified and hasty generalization segregating voters by social classes, the poor would support more and comprehensive entitlement programs while the well-to-do and possibly the middle class may prefer income tax cuts instead. Why not since it is more fungible and translates directly to larger discretionary income or savings for them.
Consider a candidate that offers an egalitarian, flat rate ‘Grow and Share’ dividend for everyone at a multiple of nominal GDP growth rate, first payment 3 months after elections. Not a lot of timing difference there, but obviously the relative magnitude between candidates would be a selling point. This time another group might howl bloody murder and inequity.
A Roman judge widely regarded as wise and just had a habit of asking “Cui bono?” (Who benefits?)