Political economy can be understood in numerous ways, depending on the discipline of study. Economists and, more recently, some political scientists define political economy as the study of politics using economics. Yet within political science, it is more commonly understood as the study of the relationship between states and markets. The two approaches are not conflicting but can be quite dissimilar. Here, political economy is understood as the study of the interdependency of economics and politics, as this is the approach used by the majority of political scientists. This article emphasizes the interdependency of politics and economics and its impact on several aspects of political performance.
- Economic Preferences
- Formal Models of Political Party Competition in Two-Party Systems
- Formal Models of Political Party Competition in Multiparty Systems
- The Electoral System: A Critical Intervening Factor Between Preferences and Policies
- Types of Economy and the Origins of Formal Political Institutions
- Future Research in Political Economy
How economics and politics determine each other has been a driving question in political economy for centuries. According to John Roemer, Adam Smith was well aware of the mutual interdependency of economics and politics. In The Wealth of Nations, he discusses how politically determined tax mixes (a range of sources of income, with a mix of part-time jobs, self-employment, and full-time jobs) on wages and goods have diverse economic effects. The political causes of tax mixes, and of economic and social welfare policies, in general, are still at the heart of the study of political economy, especially as the provision of public services and goods has reached unprecedented levels. Scholars within the field of political economy study the impact of political competition on economic outcomes and in turn on how underlying economic conditions, such as income and skill distribution or the generosity of social insurance, affect political behavior and political competition. Common questions raised within the field of political economy are as follows: Why do taxes, state pensions, or levels of public debt vary between countries? Do political parties deliver distinguishable economic policies? Under what conditions do politicians raise taxes? In turn, how do economic policies and the underlying economic relations affect preferences for redistribution and institutional change, such as electoral system reforms?
Theoretical models and empirical research have come a long way in answering these questions. However, controversies still exist, primarily due to the lack of extensive data outside the relatively small group of the rich Organisation for Economic Co-operation and Development (OECD) countries. In the rest of this article, major theoretical and empirical contributions in the field of political economy are reviewed. The first part looks at how the economy shapes policy preferences. The second part is an examination of how the institutional characteristics of polities (their electoral and party systems) aggregate preferences into political action. Third, distribution and redistribution as direct outcomes of political competition are described. Finally, in the last part, causation from economics to politics is reversed to explain the origins of electoral institutions on the grounds of underlying economic relations.
Voters’ or political parties’ policy preferences are the starting point of formal political economy models. Relying on the assumption of self-interested actors who wish to maximize the utility they get from consumption and leisure, political economists commonly assume that voters with higher incomes prefer less redistribution than citizens with lower incomes. Similarly, personal income endowments determine voters’ preferences over macroeconomic outcomes such as inflation and unemployment. Kenneth Scheve has shown that those who have more savings prefer lower inflation, even at the cost of higher unemployment, in contrast to those who do not have savings.
Thus, the distribution of income in a society is a determining factor of fiscal, monetary, and tax policies. For example, the Meltzer-Richard model predicts that in societies with high levels of income inequality, taxes and, thus, redistribution should be higher than in societies with low-income inequality. Karl Marx and Friedrich Engels relied on similar assumptions since they believed that once workers were given the right to vote, dramatic redistribution would be achieved.
Yet reality is more complex than that. Among the economically developed countries, income inequality is highest in the United States and redistribution is among the lowest. Why is there not more pressure from voters to redistribute more? To start with, it is possible that some societies value economic equality more than other societies. Indeed, Alberto Alesina, Edward Glaeser, and Bruce Sacerdote show that there is a strong correlation between a nation’s belief that luck determines income and the levels of social spending as a percentage of the gross domestic product (GDP). In countries where people believe that the poor have been unlucky, social spending (and thus taxes) is higher. Thus, assuming that voters simply want to maximize their utility from consumption is too simplistic.
Similarly simplistic is the assumption that one’s vote is solely driven by financial position. Often voters care about other issues than redistribution, such as abortion, the environment, the role of women in the economy, and so no. If this is the case, then one’s income does not determine one’s vote, and in fact, it is possible that redistribution is not placed highly on the policy agenda of competing political parties. Another complication is that in unequal societies, rich voters are likely to have more political influence on political parties than poorer voters. For example, it is established that voter turnout is higher among high-income earners than among low-income earners.
Things get even more complicated when we take into account the underlying economic relations in a polity. Production systems can shape economic preferences independently of the distribution of income. Not all holders of capital prefer low redistribution, and not all workers prefer more redistribution. Redistribution preferences, and particularly preferences for social protection, are rather formed by the type of economic production. The varieties of capitalism approaches have moved the discipline forward by showing that preference formation among economic actors and citizens is not universal across different economic systems. The type of the economy and, particularly, the mode of production in an economy largely determine policy preferences.
In economies where workers are required to invest in firm- or industry-specific skills, employers have incentives to lobby for higher social protection and thus side with the trade unions. In contrast, in economies where workers have general skills and employers do not invest in their training, employers tend to lobby for lower social protection than the trade unions. More generally, it has been shown that distinguishing between general and special skills helps explain variations in the levels and type of social protection. For example, Torben Iversen and David Soskice show that citizens who have specific skills favor more generous unemployment insurance than do those who have general skills, as the latter can more easily switch and find jobs.
To recap, the discipline has made tremendous progress in identifying the factors that shape voters’ preferences. Yet this is only the beginning of putting together all the constitutive parts of a political-economic model. One still needs to study the conditions under which political parties are responsive to the existing distribution of preferences.
Formal Models of Political Party Competition in Two-Party Systems
Do citizens’ economic preferences affect policy outcomes? According to a view of democracy where the majority rules, economic outcomes should reflect the will of the electoral majority. In other words, if the majority of voters demands lower taxes, politicians should deliver lower taxes. However, one cannot assume this straightforward association; a number of issues need to be clarified, and most important, the role of political parties must be considered. Assumptions about the nature of political parties, whether they represent particular economic classes, interest groups, or simply their own interests, need to be made. Moreover, other characteristics of the political party system are also critical: How many political parties compete for office? Is political competition centered only on the question of taxes? And how are votes translated into parliamentary seats? Without taking all these matters into account, one cannot reliably predict policy outcomes given a certain distribution of preferences within the electorate.
Formal models of political party competition are relatively recent. Erik Lindahl was the first to show that the supply of public goods is determined by the relative power of political parties in a polity where two political parties represent two classes of citizens with heterogeneous marginal utilities over a public good. In his seminal paper, he briefly mentions the possibility of partisan policy outcomes as power shifts from one political party to the other. Nonetheless, Lindahl’s work did not lead to further development of bargaining models on the distribution of public goods until much later.
Instead, the most well-known formal model in political science is the median voter theorem. The theorem, popularized by Anthony Downs in his Economic Theory of Democracy, predicts that when two parties compete on a single policy dimension, they will both converge to the median voter’s most ideal policy point. If the policy under question is the level of income tax rate, then both parties will propose the tax rate that is preferred by the median voter. The result is easily explained: Parties are office seeking (which means that they are primarily driven by their objective to win office rather than by their ideology) and thus adopt whichever policy will win them the majority of votes. When voters’ preferences are normally distributed, the only reasonable position for parties to move to is the median.
The median voter theorem initiated a new era of research in political economy. For example, the Meltzer-Richard model of redistribution and theories of electoral business cycles rely on the median voter theorem. In practice, however, parties tend to diverge in their policy choices rather than converge. To start with, it is rare that parties will propose similar tax rates at elections. If anything, when elections are contested primarily on economic issues, social-democratic parties propose higher taxes for the delivery of better public services, while parties on the right propose lower taxes and smaller governments. Similarly, public opinion research testifies that voters identify with parties on the grounds of personal characteristics, such as their socioeconomic status, religion, and so on. For example, those with savings who prefer lower inflation tend to self-identify with right-wing parties, while those who prioritize employment over low inflation tend to identify with left-wing parties.
Donald Wittman proposed a model of party competition where parties are solely policy seeking: They compete on the premise of distinguishable policies. His model then predicts that parties will diverge in their policies as long as there is some level of uncertainty as to who the winner in the next election will be. While Wittman assumes that parties are exogenous (i.e., they are not the agents of citizens), his model has been the main alternative to the median voter theorem. Empirically, the literature has found evidence of partisan policy outcomes, for example, with respect to inflation and social spending, but these findings remain contested. It has been shown that policies are often conditioned by other economic and political institutions as well as by the underlying economic conditions, both domestically and abroad.
Formal Models of Political Party Competition in Multiparty Systems
While the median and partisan models of two-party competition discussed above have made the largest impact in the discipline with respect to party competition, the majority of democracies are multiparty systems. This means that the two most well-known models of political competition are not
suitable for the analysis of party competition in the majority of cases. More recently, new models of political party competition have been developed to include three political parties competing at elections. For example, David Austin-Smith and Jeffrey Banks developed a model where three office-seeking parties compete and coalition governments are formed after elections. Their model predicts that parties take divergent policy positions to attract votes, and as a result, governments consisting of a large and a small party deliver partisan policies. Another notable example is David Baron’s model of electoral competition of three policy-seeking parties. Baron’s model is a two-stage model: In the first stage, parties compete at elections, and in the second, postelectoral stage, they bargain over policy. The coalition governments that form as a result of this two-stage process deliver ideologically partisan policies.
Postelectoral bargaining in parliamentary democracies is of critical significance in policy outcomes in multiparty governments. Given that the majority of parliamentary countries do not form single-party governments, postelectoral bargaining delivers to a great extent the government’s future policy program. Models of government formation are prominent in the field of political economy. Not only do they address the important theoretical and empirical question of which government we should expect to form after elections have failed to provide a clear winner, they also provide predictions on the policy outcomes that one should expect in a given government, as the Austin-Smith and Banks and Baron models illustrate.
One of the most well-known models of government formation in multiparty systems is the Laver-Shepsle model, based on the concept of the core within the tradition of cooperative game theory. The Laver-Shepsle model predicts that policies will reflect the policy preferences of the ministers who hold the specific ministerial departments and who represent the median voter’s preference in that specific dimension. In other words, if the policy space is multidimensional, the party that represents the median voter in each dimension will control the relevant ministry; thus, policy will be located at the multidimensional median.
The Laver-Shepsle model was a breakthrough in the study of parliamentary democracies as it offered a unified framework of analysis of government formation, duration, and policy implementation. Yet it has its limitations, both on the theoretical front (since it relies on the restrictive concept of the core, which can be found only in a three-party, two-dimensional space) and on the empirical front (since the model assumes that ministers and parties do not negotiate prior to or during the government’s life). Alternative models of government formation based on noncooperative game theory prove that when parties are policy and office seeking, different governments can form as a result of bargaining over policy and side payments. Yet they do not make any specific claims about the portfolio allocation process, like Laver and Shepsle do. As a result, most of our knowledge regarding portfolio allocation and its impact on policy comes from empirical studies conducted by scholars who study coalition governments.
The Electoral System: A Critical Intervening Factor Between Preferences and Policies
The electoral system is another intervening factor that significantly determines the distribution of political power and thus indirectly determines economic policies. The main direct effect of the electoral system on policy is via its effect on electoral competition at the district level. In single-member district plurality (SMDP) electoral systems, elections are won over marginal districts because parties do not have to worry about safe districts. This motivates parties to target voters and interest groups in these districts. In contrast, in proportional electoral systems where electoral districts are large and can be as few as one (e.g., in the Netherlands), political parties have incentives to target groups of voters instead of districts. As a result, in SMDP systems, there is less social spending but more public spending in the form of targeted goods, such as roads and hospitals.
The effects of electoral system on spending go beyond the district level. Since, as Maurice Duverger showed, the electoral system largely determines the number of parties in the political system, the electoral system has an indirect effect on policy preference aggregation via the number of parties elected in the parliament and in government. In more proportional electoral systems, more voices are represented in the government via multiparty governments as well as via strong parliamentary committees. G. Bingham Powell shows that the median voter is better represented in countries with proportional electoral systems, which have multiparty governments and give a voice to opposition parties in the parliament.
Another important empirical finding is that multiparty governments are larger governments (having higher public spending) simply because they represent more social groups than single-party governments. For this reason, some researchers have argued that multiparty governments are less economically efficient than single-party governments. In multiparty governments, every party has an incentive to spend on its own voters as much as it can since everyone draws from the same pool of money. Yet other researchers, such as Peter Katzenstein or Arend Lijphart, have argued that multiparty governments can more successfully undertake unpopular economic reforms because they can better achieve political and societal consensus.
The work briefly reviewed in the preceding paragraphs is certainly not exhaustive of the rich literature on the role of formal political and electoral institutions in the aggregation of interests and in policy outcomes. It is rather indicative of the complexity and interdependence of the processes that take place at the economic and political spheres. The following section of this article focuses on how economic conditions affect the choice of formal political institutions.
Types of Economy and the Origins of Formal Political Institutions
One of the growing areas of research investigates the source of electoral institutions. Currently, it is believed that political parties, primarily of the right, chose the electoral institutions that would best ensure their continued power, based on their knowledge of the effects of electoral institutions on electoral behavior and government formation. The best known argument, made by Stein Rokkan and, more recently, by Carles Boix, purports that when the ruling right-wing parties were united and/or confronted with a weak opposition, they chose to keep the existing plurality electoral systems. This favored single-party governments. On the contrary, right-wing parties that were afraid that they would be ousted out of power due to growing socialist dominance chose proportional representation (PR). Under PR systems, the Left would not be able to form strong majority single-party governments, and thus the Right would still have power in the political system. These arguments then suggest that the underlying social cleavages and political parties’ survival strategies determined the choice of electoral institutions.
More recently, alternative theories of the origins of electoral systems have been put forward. Here, we focus on a theoretical account that links the underlying production and labor relations with the origins of electoral systems. According to this account, advanced by Thomas Cusack, Torben Iversen, and David Soskice, the ruling right-wing parties acted as agents of the groups they represented, which were employers’ organizations. In economies where employers’ organizations had already established networks of cooperation and coordination with trade unions, the ruling right-wing parties chose PR electoral systems. The reason was that since PR systems encourage coalition governments and consensus building between the government and the opposition, both employers and trade unions would be guaranteed representation in the policy-making process. Only under a PR system could the existing cooperation between the holders of capital and workers be further fostered. Thus, in countries that had established coordinated forms of capitalism (corporatist systems), the ruling parties chose PR electoral systems. In contrast, where unions and employers did not cooperate, the ruling right-wing parties chose to retain the existing plurality electoral systems.
Future Research in Political Economy
The debate on the origins of formal political institutions is likely to continue in the future. In the meantime, other important questions still need to be addressed within the field of political economy. Questions of the democratic legitimacy of economic and political institutions that make up our contemporary expert democracies (such as central banks and various regulatory agencies) have not been addressed sufficiently. Does economic efficiency legitimize reducing democratic rights to vote on the economy? This question is becoming particularly relevant as economic globalization empowers transnational institutions such as the International Monetary Fund or the European Central Bank. Scholars of political economy will have to seriously study the role of such institutions in domestic politics as they are becoming relevant players and even “partners” in governments’ policy decisions in areas such as taxation and social welfare.
If the conduct of economic policy is changing thanks to economic globalization, do voters’ preferences and evaluations change as well, or do they remain strongly determined by their local and national realities? How do voters evaluate their leaders when they implement policies that have been “imposed” on them? Do we see a new cosmopolitan versus national cleavage in electoral politics? Such questions cannot be adequately answered until the role of international actors is integrated into the study of domestic economic decision making.
Scholars who work primarily within the field of international political economy have looked at how domestic politics affect foreign economic policy (e.g., Beth Simmons) or the international financial architecture (e.g., Barry Eichengreen). In addition, important work has been done by scholars who work in the intersection of international and comparative political economy, such as Bill Clark or Ronald Rogowski, who study how the global economy constrains national economic policy making. Unfortunately, there is no space here to present this important work. The challenge for political economy in the 21st century is to devise models that capture the tension between global economics and national politics and, particularly, the tension between global market forces and domestic political competition.
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