Monday, January 6, 2014

Political polarization and the business cycle

It is difficult for politicians to have much of an impact on economic outcomes when policy is set by consensus. Any fluctuation in power changes a policy a little, and the economy is in a rather flat portion around the optimum. In a polarized government where any power shift implies dramatic policy changes, not only are they never close to the optimum policy, they yank the economy around significantly. There are two losses here: first the average is substantially lower in the second case due to the concavity of outcomes, second there are significant fluctuations for the same reason.

This is essentially the explanation of Marina Azzimonti and Matthew Talbert why emergent economies have such wild business cycles, and I suspect this is even more so for developing economies. All they need to do to obtain such results is to take an off-the-shelf real-business-cycle model and add uncertainty to the returns of private investments. Let this be a lesson for more developed economies that are showing tendencies for political polarization.

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