A political economy theory of the soft budget constraint

Why do soft budget constraints exist and persist? In this paper we argue that the prevalence of soft budget constraints can be best explained by the political desirability of softness. We develop an infinite horizon political economy model where neither democratic nor autocratic politicians can commit to policies that are not ex post optimal. We show that because of the dynamic commitment problem inherent in the soft budget constraint, politicians can in essence commit to make transfers to entrepreneurs which otherwise they would not be able to do. This encourages such entrepreneurs to support them politically. Though the soft budget constraint may induce economic inefficiency, it may be politically rational because it influences the probability of political survival. In consequence, even when information is complete, politicians may fund bad projects which they anticipate they will have to bail out in the future. We show that, maybe somewhat surprisingly, dictators who are less likely to lose power, are more likely to use the soft budget constraint as a strategy to gain political support.     

Attracting Fdi in a Politically Risky World*

Conventional wisdom holds that lack of government commitment deters foreign investment in developing countries. Yet this explanation is not convincing because some econometric studies have found little support for the role of political risk and host governments can offer upfront subsidies that compensate foreign investors for their sunk cost. This paper shows that a second commitment problem upsets the argument. A multinational firm cannot credibly commit to invest in only one country. Since countries differ in production costs and government credibility, this article explains the pattern of investment in a politically risky world.     

An experimental study of democracy breakdown,income and inequality

Many empirical studies investigate the relationships between economic development, inequality, and democracy survival; however, establishing causal links with naturally occurring cross-country data is problematic. We address this question in a laboratory experiment, where in democracy citizens can invest in profitable projects and vote on income taxation. In the alternative regime—autocracy—efficient investment levels and equitable redistribution are implemented exogenously, but there is a risk of resources being partially expropriated. Citizens can voluntarily switch from democracy to autocracy by a majority vote, which mimics recent historical examples, where voters voluntarily delegate political powers to an autocrat in exchange for a promise of high taxation and redistribution. We find that the likelihood of democracy breakdown increases with the degree of inequality but does not vary with productivity. The link between productivity and democracy survival depends critically on the degree of sophistication of the median voter.     

Why a clean politician supports dirty politics: A game-theoretical explanation for the persistence of political corruption

Using a theoretical model of repeated political competition among two career politicians, I study the incentives of both the corrupt and clean politicians not to adopt a fully effective reform targeting political corruption. In the setup I study, each politician can credibly adopt the reform as part of his policy platform in the elections. Yet, when the level of political corruption is high, neither politician does so in a Nash Equilibrium. Intuitively, political corruption changes the zero-sum nature of political competition: the reform eliminates the illegal rents of the corrupt candidate and the competitive advantage of the clean candidate.     

Democracy, collective action and intra-elite conflict

We analyze a model where there is uncertainty about the future power of two ex-ante symmetric elites to appropriate surplus, and ex-ante surplus sharing agreements are not binding. We show that in an oligarchy, the stronger elite appropriates the entire available surplus, whereas a democracy results in a more balanced surplus allocation between the two elites. In a democracy, the newly enfranchised non-elite organize to act collectively, so that the weaker elite can credibly threaten to form a coalition with the organized non-elite against the stronger elite. Such a threat ensures that the more balanced surplus sharing proposal chosen by majority voting is renegotiation-proof. Therefore, sufficiently risk-averse elites unanimously choose democracy as a form of insurance against future imbalances in relative power. We emphasize that franchise extension to, and low cost of organizing collective political activity for, the non-elite are both necessary features of a democracy. Our formal analysis can account for the stylized facts that emerge from a comparative analysis of Indian and Western European democracies.     

The Political Economy of Clientelism*

In this paper, we argue that the political‐commitment problem provides an explanation for why much income redistribution takes an inefficient form, particularly employment in the public sector. A job is a credible way of redistributing when it provides rents (such as in situations with moral hazard), and employment is optimal ex post. Moreover, a job is selective and reversible, and thus ties the continuation utility of a voter to the political success of a particular politician. We show that the need to make offers of employment incentive‐compatible leads to inefficiencies in the supply of public goods. We also show that such inefficient redistribution becomes relatively attractive in situations with high inequality and low productivity. Inefficiency is increased when the stakes from politics are high, when inequality is high, and when money matters less than ideology in politics.     

Foreign direct investment and bilateral investment treaties: An international political perspective

This paper investigates the effect of the implementation of bilateral investment treaties (BITs) on the bilateral stocks of foreign direct investment (FDI). We argue that the understanding of how BITs affect FDI requires recognizing that multinational enterprises (MNEs) are not Stateless and that their investment return may well depend on the quality of political relations between the home and host countries. Using bilateral FDI data and event data to measure political interactions between countries, we show that the effect of the entry into force of a BIT crucially depends on the quality of political relations between the signatory countries; it increases FDI more between countries with tense relationships than between friendly countries. We also find evidence that BITs and good domestic institutions are complementary. BITs should therefore be understood as a mechanism for host governments to credibly commit not to expropriate investors in the future.     

Democracy and capitalism: Are they compatible in the long-run?

Starting from a discussion of Schumpeter's analysis of the relationships of capitalism, socialism and democracy, it is shown that, in a complex society, democracy is only compatible with a decentralized market economy with safe property rights. But in time democracy shows a tendency to weaken the capitalist system by more and more regulations and an ever-increasing share of government (including the social security system) in GDP. This tendency is a consequence of political competition because of the development of interest groups and the presence of rationally uninformed voters. It leads to a weakening of efficiency, investment, innovation and thus to lower growth rates of GDP. But in time forces opposing this development arise. First, because of the negative consequences of growing government the welfare and regulatory state is bound to move into a crisis in the long run. Thus innovative politicians have a chance to win the support of a majority of voters for reform projects, who perceive finally the ever-increasing burden of higher taxes and regulations and realize that these burdens are not worth the benefits bestowed on them. In doing so, they may face, however, the competition of ideologies. Second, there are other states with lower taxes and less unnecessary regulations which show higher growth rates of GDP, and gain thus relative advantages in international political and military competition since they can command greater resources with the passage of time. To maintain their relative international power position, reforms are thus considered as necessary by rulers. This may be helped by pressure resulting from comparisons of the standards of living done by their citizens.     

Private Investment and Political Institutions

Recent research has demonstrated a negative link between macroeconomic and political uncertainty and levels of private investment across countries. This raises the question whether certain types of government institutions might help reduce this uncertainty. North and Weingast (1989) propose that political institutions characterized by checks and balances can have beneficial effects on investment by allowing governments to credibly commit not to engage in ex post opportunism with respect to investors. In this paper I develop and test a modified version of their hypothesis, suggesting that checks and balances, on average, improve possibilities for commitment, but that they are not a necessary condition for doing so. Results of heteroskedastic regression and quantile regression estimates strongly support this proposition.     

Electoral competition with environmental policy as a second best transfer

This paper explains why some governments fail to adopt policies that are sufficiently strong, while others adopt policies that are too stringent. Constructing a political economy model in which voters face uncertainty due to the types of politicians and the risk of environmental damage, we show that there is an equilibrium in which a politician uses a weaker environmental policy rather than efficient direct transfers for redistribution. We also show that there is an equilibrium in which a stricter environmental policy can be implemented by a politician who has no incentive to make transfers. Then, we discuss which equilibrium should be more plausible. We conclude that the latter equilibrium in which a too stringent environmental policy emerges can dominate the former unless the citizen’s estimate of environmental risk is sufficiently low.     

THE POLITICS OF FDI EXPROPRIATION

I examine the role of political instability and fractionalization as potential explanations for the lack of capital flows from rich countries to poor countries (i.e., the Lucas Paradox). Using panel data from 1984 to 2014, I document that (i) developed countries exhibit larger inflows of foreign direct investment (FDI), (ii) countries subject to high investment risk (IR) receive low FDI inflows, and (iii) IR is higher in fractionalized and politically unstable economies. These findings suggest a negative relationship between political instability and FDI through the IR channel. I inspect the theoretical mechanism using a dynamic political economy model of redistribution, wherein policymakers can expropriate resources from foreign investors. The proceeds are used to finance group‐specific transfers to domestic workers but hinder economic growth by discouraging FDI. I show that the political equilibrium exhibits overexpropriation and underinvestment.     

Strategic Political Participation and Redistribution

The purpose of this paper is to study formation of support and opposition to redistribution. We analyze a society with two groups of citizens and a government. The government distributes income from one group to the other in response to political pressure. The interaction between the groups is modeled as a two-stage game. In stage 1, the groups decide if they want to be politically active. In stage 2, the active group or groups seek influence on the direction and size of the transfer. We demonstrate that supporters of redistribution are always politically active but that opposition is often absent. Moreover, when opposition is absent there is a strong tendency for underdissipation of the transfer, while political competition typically leads to overdissipation.     

Comparative cheap talk

When are comparative statements credible? We show that simple complementarity conditions ensure that an expert with private information about multiple issues can credibly rank the issues for a decision maker. By restricting the expert's ability to exaggerate, multidimensional cheap talk of this form permits communication when it would not be credible in a single dimension. The communication gains can be substantial with even a couple of dimensions, and the complete ranking is asymptotically equivalent to full revelation as the number of issues becomes large. Nevertheless, partial rankings are sometimes more credible and/or more profitable for the expert than the complete ranking. Comparative cheap talk is robust to asymmetries that are not too large. Consequently, for sufficiently many independent issues, there are always some issues sufficiently symmetric to permit comparative cheap talk.     

IS EQUALITY OF OPPORTUNITY POLITICALLY FEASIBLE?

We develop a political-economy model where the amount of education subsidies is determined in a majority vote and spending is financed by revenues from taxation. Our analysis demonstrates that limiting the extent of subsidization and thus excluding the poor from gaining enough education can be a political equilibrium. Despite being the main beneficiaries of subsidies, the politically decisive middle class hesitates to extend monetary benefits, since improved access to higher education diminishes the return to education. Moreover, a non-monotone relation between inequality and the extent of redistribution through tax-financed educational subsidies obtains.     

The size and scope of government:: Comparative politics with rational politicians

We try to demonstrate how economists may engage in research on comparative politics, relating the size and composition of government spending to the political system. A Downsian model of electoral competition and forward-looking voting indicates that majoritarian – as opposed to proportional – elections increase competition between parties by focusing it into some key marginal districts. This leads to less public goods, less rents for politicians, more redistribution and larger government. A model of legislative bargaining and backward-looking voting indicates that presidential – as opposed to parliamentary – regimes increase competition between both politicians and voters. This leads to less public goods, less rents for politicians, less redistribution, and smaller government. We confront these predictions with cross-country data from around 1990, controlling for economic and social determinants of government spending. We find strong and robust support for the prediction that the size of government is smaller under presidential regimes, and weaker support for the prediction that majoritarian elections are associated with less public goods.     

Effect of credible quality investment with Bertrand and Cournot competition

We show how credible revelation and ability to commit to quality choice effect equilibrium qualities and welfare when product market is either Bertrand or Cournot competition. We show that results depend on the type of competition but not generally on the cost of quality function. We show that with Bertrand competition, the equilibrium qualities are lower with credible commitment. Competition is moderated and producer surplus is higher and consumer surplus lower. With Cournot competition, higher quality will be better but lower quality will be worse with credible commitment. Consumer surplus is always greater with credible commitment and if cost does not increase too quickly with quality, producer surplus will also increase. Thus credible commitment is a collusive device with Bertrand competition but it can improve social welfare with Cournot competition. Received: February 8, 2000; revised version: February 14, 2002 RID="*" ID="*" The idea of this paper originated in the weekly workshops of Mordecai Kurz at Stanford. I am forever in debted to Mordecai and fellow students – Luis Cabral, Peter DeMarzo, John Hillas, Michihiro Kandori, Steve Langois, Patrick McAllister, Steve Sharpe, Peter Streufert, Steve Turnbull and Gyu-Ho Wang – for their criticism and encouragement. I also benefited from comments from Yi-Heng Chen, Jin-Li Hu, Kala Krishna, Jinji Naoto, Thomas J. Prusa, and Shyh-Fang Ueng at various later stages of this work. Last but not least, I am grateful for the detailed comments of the referee.     

Resolving the Credibility Problem of an Honest Government: A Case for Foreign Investment Subsidy

We develop a simple model of direct foreign investment where the host country government cannot credibly signal its honest intention such as to stick to the contracted tax rate. The foreign firm has some prior belief regarding the ex post discretionary policies of the local government. Since the investment is completely irreversible, such a belief pattern might not induce the firm to invest in a country which badly needs it. It is shown that the host government can design a subsidy scheme which might attract foreign investment by removing the credibility problem.     

Sudden Stop and Sudden Flood of Foreign Direct Investment: Inverse Bank Run,Output, and Welfare Distribution

In this paper, I focus on a phenomenon that has not received much attention in the literature, namely that the mere expectation of foreign direct investment (FDI) incentivizes long‐maturity investment projects by domestic residents, and a Sudden Stop when expectations are frustrated. Long‐maturity investment projects enhance productivity but increase the economy's vulnerability to Sudden Stop. The discussion is framed in a context in which a Sudden Stop follows a surge of capital inflows (Sudden Flood), and FDI is concentrated on ongoing projects. A Sudden Stop episode can trigger a fire sale of long‐term assets, output collapse, and welfare redistribution, which is another ignored phenomenon.     

Strategic sourcing for entry deterrence and tacit collusion

By sourcing key intermediate goods to a potential entrant, an incumbent firm can credibly and observably commit to an intense post-entry competition, thereby deterring the entry. At the same time, a collusive effect exists, whereby the entrant’s loss from staying out of the final-good market is compensated through their sourcing transaction. We find that entry-deterring sourcing in general has ambiguous effect on social welfare. However, there exist scenarios where it enhances not only social welfare, but also consumers’ surplus.     

SUNK COSTS OF CAPITAL AND THE FORM OF ENTERPRISE: INVESTOR‐OWNED FIRMS AND WORKER‐OWNED FIRMS*

ABSTRACT ** : This paper examines implications of sunk costs of capital for efficient forms of enterprise. It is assumed that firm owners and outside traders are asymmetrically informed of venture risks, and that there are sunk costs associated with investment in physical and human capital. We then make an efficiency comparison between investor‐owned and worker‐owned firms. We find that the firm is efficient when it is owned by the input supplier (the investor or worker) who incurs large sunk costs. This is because such an input supplier can credibly signal to the other input supplier that he in fact has a safe project. An empirical study based on the Japanese manufacturing industry seems to support the theoretical result.