MONETARY UNION: Introduction

This paper explores the gains to monetary union. While the adoption of a common currency will soon be a reality for much of Western Europe, understanding the motivation for a monetary union and designing optimal monetary and fiscal arrangments within such a union remains an open challenge to economists.

The relatively informal debate on monetary union has identified a number of potential gains. Following the European Commission’s 1990 report on a common currency in Europe (Emerson et al. [1992]) it is convenient to focus on two types of benefits: efficiency and stability.

Within the first category, the European Commission, as well as numerous other economists, emphasize the savings of transactions costs under a common currency system.1 The Commission’s report estimates these gains at nearly 0.5% of European Community GDP. Apart from these direct savings, it is also argued that there are farther gains from a more efficient price mechanism, increased competition and larger, more integrated markets. Included in the second category is the stability of prices and output. In particular, the aims of reducing the levels of both inflation and unemployment as well as their variability are identified in the report.
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SCOPE OF GOVERNMENT: Closing remarks 2


Under the plausible assumption that binding policy commitments cannot be made, pre-electoral announcements influence post-election choices only if they are self-enforcing, due to reputational concerns of some form. But whose reputation is more important? Generally speaking, we believe that the collective reputation of political parties is more important than the individual reputation of single politicians. But this raises another difficult question: how should the collective choices of political parties be modeled fully?

In our analysis, as in virtually all of the literature, there is no meaningful distinction between a party and a politician. On a final point, our models were designed to shed light on the stark cross-section variation in the data on government spending. Would similar models be useful in shedding light also on the stark time-series variation we observe in the same data, particularly the well-documented growth of government and the expansion of transfer payments in the last 30 years? This is far from obvious.

We intended this lecture to illustrate how we—as economists—might embark upon new research on comparative politics. We believe such research should rely on solid theoretical foundations and aim at strong empirical content. In our view, the theory is challenging, but doable. Indeed, researchers have recently made progress in understanding the consequences of different rules for allocating decision-making authority over legislation and government formation.

Empirical content is essential, in more than one way. Constitutions across the world provide a great deal of observable variation that can provide precise empirical guidance when formulating extensive-form game theoretic models. This may help avoid the ”with-the-right-assumptions-you-can-prove-anything-critique”, sometimes launched against game-theoretic research in Industrial Organization. Moreover, the theory can, and should, be formulated to yield predictions over observable policy variables. New or better data on political institutions or measures of government performance may be necessary; but a strong theoretical backing would greatly facilitate primary data collection. Collaboration between economists and political scientists on the boundary of our disciplines is also essential. Fortunately, such collaboration has become more frequent in the last few years.

To us, what lies ahead is a wide-open research agenda. In this lecture, we suggested a possible approach, by deriving testable predictions from some simple theoretical models. Even though the empirical results we presented are preliminary, we think they are encouraging enough to proceed. We hope to have convinced other economists that more research on comparative politics is both worthwhile and exciting.

SCOPE OF GOVERNMENT: Closing remarks

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Here, the results are more fragile, and do not always confirm the visual impression from Graph 4. The majority dummy, as well as MAJORIT, has a negative estimated coefficient in all specifications but one. The estimate is generally around -1.5, suggesting that majoritarian elections are associated with a supply of public goods which is about 1.5 percentage points lower. This, again, is not a negligible difference, considering that the average in the sample is just above 8 per cent.

But the estimated coefficient is statistically significant only when the majoritar-ian dummy is interacted with the presidential dummy, or when the continental dummies are included. Inspection of the residuals reveals the existence of a large outlier country, Botswana, a majoritarian parliamentary system with large spending on public goods. When this country is excluded from the sample (or when the dummy for Africa is included), the estimated coefficients and the t -ratios on the MAJ dummy and on MAJORIT become more negative, as predicted by the theory, and are statistically significant at the 5% level.
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SCOPE OF GOVERNMENT: Evidence 4

Regression analysis

Table 1 gives a selected set of results from cross-country regressions on government size. All equations are estimated with OLS. The dependent variable is total expenditures, either by central government (columns 1-5), or by general government (columns 6 and 7). All regressions include the parsimonious set of control variables described in the previous subsection, called XB. We also exploit a set of extended controls XE, that also adds the (log) of population size and our measure of centralization to XB (column 4). Reading here Finally (in column 5), we include a set of dummy variables C for the OECD, Latin America, Asia and Africa.

The table displays the regression coefficients for dummy variables reflecting the political system; PRES is set to 1 for presidential and 0 for parliamentary regimes, MAJ is set to 1 for majoritarian and 0 for proportional elections, MAJPRES is set to 1 for presidential regime cum majoritarian elections and 0 otherwise, and so on. Numbers within brackets are t-ratios for a test of the null hypothesis that the corresponding regression coefficient is equal to zero. These are estimated using White’s (1980) consistent estimator.24 Finally, we list the number of observations and the adjusted R2 for each regression.
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SCOPE OF GOVERNMENT: Evidence 3


Graphs 1 and 2 in the Introduction display the residuals generated by regressions of the size of government and public good provision against the parsimonious controls XB and ZB defined above. What is the pattern of these residuals across different political systems?

Before answering this question, it is useful to recall the hypotheses suggested by the theory. Consider first the size of government. The post-election politics model of Section 4 suggested that presidential regimes should be associated with smaller governments, ceteris paribus. We should thus observe predominantly negative residuals for presidential regimes and predominantly positive residuals for parliamentary regimes. The pre-election politics model of Section 3 had no immediate prediction, but an extension with distortionary taxes suggested that majori-tarian elections should be associated with larger governments, ceteris paribus. If this is correct, we should expect negative residuals for countries with proportional elections and positive residuals for those with majoritarian elections.
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SCOPE OF GOVERNMENT: Evidence 2

The primary source for this information is Shugart and Carey (1992, ch. 8). Altogether, we end up with 39 parliamentary democracies, indicated by solid on the map, and 25 presidential democracies, indicated by striped on the map. Many, but not all, presidential democracies are found in Latin America. A complete and detailed data set of our regime types, electoral rules and other data is under preparation and will be made available soon.

As noted in the Introduction, government size is measured as total expenditures of central government in percent of GDP, averaged over the period 1988-92. The primary data source is IMF’s Government Financial Statistics, but we have also collected data from other sources. We rely on data for central government, rather than general government, since they are available for a larger number of countries. Such data admittedly do not take variation in decentralization to local governments into account, a problem we try to remedy by including measures of centralization among our control variables. Anyway, the theory assumes decisions to be under centralized political control, which better fits central (rather than general) government expenditures. Data on public goods expenditure are not directly available. We create such measures by aggregating data on expenditure categories which, a priori, should have a high public-good content. Thus, our measure of public goods is the sum of expenditures on transportation, education and order and safety, also in percent of GDP. We also experiment with broader measures of spending on public goods.
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SCOPE OF GOVERNMENT: Evidence


In this section, we present some empirical evidence on the size and scope of government. In particular, we confront some of the predictions from our two models with cross-country data. We start by briefly describing our sample and our classification of political systems. Next, we turn to residuals from cross-country regressions of the size of government and public goods provision onto socio-economic control variables, asking whether these residuals differ systematically across regime types and electoral rules. Finally, we present results from regression analyses, where characteristics of the political system enter among the independent variables explaining government expenditure website.
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SCOPE OF GOVERNMENT: Post-election politics 5

What does the equilibrium look like? As bargaining power here is more equally shared among the coalition partners, the final allocation splits welfare more equally among voters in the majority coalition, as well as among their politicians. In particular, the equilibrium allocation of redistributive transfers and public goods must be jointly optimal for voters in the majority coalition. This generally leads to redistribution in favor of a majority, and the benefits of the public goods for the majority are internalized. That is, we have:
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SCOPE OF GOVERNMENT: Post-election politics 4


Last, what about equilibrium taxes? Recall that taxes are proposed by the taxation committee, at = ae. The voters of this legislator do not benefit from additional tax revenue beyond what is necessary for financing the equilibrium supply of the public good and minimum rents. Additional taxes go either to redistribution for district i = ae, or to rents for the politicians. These voters thus want to keep taxes at a minimum. Likewise, legislator at has only limited claims on tax revenue. He is therefore pleased to satisfy his voters and go along with low taxes, so as to earn re-election. In other words, neither at, nor the voters re-electing him, are residual claimants of a larger budget. As a result, equilibrium taxes are relatively low and unambiguously:

t < 1. That is, voters exploit the separation of powers to discipline politicians and enforce a small size of government website.

We can summarize these results as follows. Presidential regimes induce strong competition among the voters, implying redistribution towards a minority. This, in turn, raises the opportunity cost for public goods which are severely underprovided.. Voters not benefiting from the minoritarian redistribution demand low taxes. Presidential regimes, with their separation of powers, also entail strong competition between incumbent politicians. This conflict can be exploited by the voters to limit the agency problem. Together, these features imply relatively low taxes and a small size of government.
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SCOPE OF GOVERNMENT: Post-election politics 3

Any majority is free to form. If the proposal is approved by at least two politicians, it is implemented. Otherwise an exogenous status quo tax rate, ts, in enacted. Next, ae proposes an allocation of expenditure, subject to the budget determined in the previous node of the game. Again, a vote is taken, and any majority can form. An exogenous default allocation (unattractive for the voters) is implemented if the proposal is rejected. Finally, having observed everything that has taken place before, voters decide whether or not to reappoint the incumbent politician in their district.

This game has a unique subgame-perfect equilibrium. We now discuss its properties, without formally deriving any of the results. In doing so, we focus on the central trade-offs that must be resolved by the optimal choices of incumbent legislators and voters. A formal derivation is provided in Persson and Tabellini (1998) and, for a more general infinite horizon model, in Persson, Roland and Tabellini (1998a).
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