Economic irrational rationality of politics

Kelvin Teo

US federal government credit rating downgraded by Standard & Poor's from AAA to AA+

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?

Photo courtesy of The Financial Regulation Forum