Paths to a political business cycle

Business Standard, 14 April 2024

How does our thinking about macroeconomics change in an election year? Public choice theory is the idea that the state is made up of individuals that maximise their self interest. Elections are an important consideration for politicians. The idea of the `political business cycle' envisages certain kinds of policy actions prior to and after elections, which create impulses upon the macroeconomy. Our ability to understand these phenomena helps us better interpret economic conditions and developments.

Election considerations in fiscal and monetary policy

The biggest levers of macroeconomics, fiscal and monetary policy, are the first port of call in thinking about the political business cycle. In advanced economies, patterns of this nature have been discerned. In the old days, central banks would tend to cut rates prior to the election, as they believed voters could be fooled with a brief upsurge in economic activity, and there was a time lag before the inflation showed up. Similarly, there are incentives to spend more prior to an election.

The opportunities for such behaviour are restricted by markets and by institutional development. In advanced economies, the government fears the wrath of the bond market. Large deficits are immediately punished with higher interest rates, which hampers the entire economy. Through this, the temptation for such behaviour is controlled. On monetary policy, the political business cycle was one element of the rationale for putting an end to the old style monetary policy, where there was a `mystique' of central banking, where central bank staff had the discretionary power to do as they pleased. To the extent that there is inflation targeting, backed by a properly structured monetary policy committee, this concern is solved.

These issues play out differently in developing countries. Institutional quality is weaker, so there is a greater threat that economic policy decisions will be made with an eye on re-election. But there are a different set of constraints. Under conditions of financial repression, fiscal policy does not care about how the bond market thinks. But fiscal policy has little room to maneuver, in good times or bad. When faced with the pandemic, advanced economies were able to mount massive fiscal responses, because they had the commensurate fiscal flexibility. Given the difficulties of fiscal policy strategy, developing countries have limited fiscal policy flexibility, whether faced with a pandemic or with an election.

Most countries now have the formal apparatus of inflation targeting, but in many developing countries, this institutional apparatus is not yet well established and central bank staff has some power to think about election objectives. But they are torn between four methods to support the ruling party. Is it best to stabilise foreign investors by sticking to the inflation target? Is it better to impress voters (who may have a money illusion) by driving down inflation? Is it better to have soft interest rates and a depreciated exchange rate that will support export demand? Or is it best to have high interest rates, and an appreciated exchange rate, which will support machismo? There is no unambiguous answer.

Bunching of the completion of government infrastructure projects

Here is one pathway which could potentially become an election-related impulse upon the macroeconomy. In the world of infrastructure construction, when a project with 1000 workers starts up, this is expansionary, and when the project completes, these 1000 workers lose their jobs. Ordinarily, the start and end of project construction are random events. Every now and then, an old project completes (which is contractionary) and a new project starts up (which is expansionary). These events take place at random, and overall have a negligible net effect upon the macroeconomy.

But consider the possibility of a political business cycle in project completion. Suppose many projects complete in the one year prior to the elections. In this case, the flurry of project completions would go with the loss of livelihood for a large number of construction workers. This would be contractionary.

To assess the empirical significance of this conjecture, we turn to government projects as seen in the CMIE Capex database:

  1. In the quarterly data, from June 2019 (i.e. after the last election) to September 2022 (i.e. the end of the normal pre-election period), in each quarter, project completions of Rs.0.68 trillion took place. But in the quarters from December 2022 to March 2024 (i.e. the pre-election period), project completions took place at roughly twice the pace, at about Rs.1.36 trillion a quarter.
  2. The opposite pattern is visible in project announcements. In the non-election period (quarters from June 2019 to September 2022), on average, there were announcements of Rs.1.95 trillion per quarter. This dropped to Rs.1.37 trillion per quarter in the run up to the elections (December 2022 to March 2024).

This could be a pathway through which a political business cycle could arise. If this is the case, the year of the election and the one following it would be relatively weak on demand owing to this bunching of project completions.

Election related fluctuations of uncertainty

A second pathway to a political business cycle could lie in economic policy uncertainty. There are many industries where support from the Indian state is important to a business plan or an investment project. Changes in the ruling configuration, including changes of cabinet ministers and senior officials, could generate a shift in policy or a shift in behaviour towards private persons. If a certain proportion of firms feel their industry or firm is exposed to such risk, then there would be a go-slow approach to investment in the period before the elections. This could give a second pathway for a political business cycle. Bagow and Altaf, 2022, examine the Lok Sabha elections of 2009, 2014 and 2019, and support this idea.

Impulse and propagation

Nither of these two causal pathways (non-random placement of investment project completion, and firms/industries that face policy uncertainty) impact upon the entire economy. But even if these issues matter to only 10 or 20 per cent of the economy, they can add up to an economically significant business cycle impulse. These direct effects would play out into the economy through multiplier effects (e.g. the construction worker who loses her job buys less biscuits or clothes).

Political business cycle thinking, traditional and non-traditional

The mainstream economics literature on political business cycles emphasises the big tools of monetary and fiscal policy. These ideas do not readily port to Indian conditions. The existing literature has some interesting ideas in political business cycles such as loan waivers (Mahambare et. al., 2022). In this article, we wonder whether an old idea (political uncertainty) and a new one (non-random completion of infrastructure projects) could matter. Each of these ideas impacts upon macroeconomic conditions with a different set of dates relative to the election date. Understanding them, and taking a stand on each of these conjectures, will help us form a view about Indian macroeconomics in 2024.

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