Italian Public Debt: Role of Domestic Political Factors and External Pressure


Master's Thesis, 2012
57 Pages, Grade: 65 Merit

Excerpt

Table of Contents

Chapter 1: Introduction

Chapter 2: Domestic level and external constrain: theories.
2.1 Opportunistic Political Business Cycle
2.2 Partisan Political Business Cycle
2.3 Theory on Fragmentation, Government instability and Polarization
2.4 Alternative explanation: external pressure

Chapter 3: Italian Public debt variation: 1994-2008

Chapter 4: Explaining public debt variation
4.1 Opportunist and partisan models
4.2 Political Institutions models
4.3 External Constraint

Chapter 5: Qualitative research
5.1 Methodology
5.2 Findings
5.2.1 First period (1994-2001)
5.2.2 Second Period (2002-2007)

Chapter 6: Conclusion

Bibliography

Chapter 1: Introduction

The goal of this paper is to investigate whether the reduction of the Italian public debt between 1994 and 2004 and the increase after 2004 is due to internal or external factors. Given the current debt crisis in Europe, this is a fundamental question since it may demonstrate if Italy, and states in general, are able to handle their fiscal problem by themselves or they need external help.

In this paper, high public debt is considered to have mainly negative effects on the economic performance of the country (as suggested by Dornbusch et al., 1998, p.478; Moon 2010 p. 36; Spaventa, 1988, 16; Chowdhruy, 2010), although it may produce some benefits (Moon, 2010, 34). Thus, it must be reduced with different policies that governments can choose (Krugman 2012, Corsetti 2012). Italy, in particular, has a long history of extremely high public debt (Technical Commission for Public Finance, 2007, 1), however, from 1994 to 2008 there is an evident variation, in particular between 1994 and 2004 the debt decreased due to the reduction of primary expenditures.

The International Political Economy literature suggested three main possible theories to explain the variation of public debt regarding internal factors. First, the opportunistic political busyness cycle explains the variation by arguing that politicians manipulate the economy in order to be re-elected (Nordhaus, 1975; Tufte 1978; Alesina, 1988; Rogoff-Sibert 1988). Second, the partisan business political cycle explains variation due to difference goals among parties, with leftist parties tending to adopt more expansionary policies (Hibbs, 1977; Mulas-Granados, 2003; Fowler, 2006). Finally, the last and most viable theory looks at level of fragmentation, polarization and government instability to explain variation. Increasing levels of these variables tend to produce expansionary policies (Alt, Lassen, 2005; Grilli et al., 1991; Roubini et al, 1989; Alesina and Perotti, 1996; Person, Tabellini, 2004).

The alternative to these three internally focused theories is to consider external factors that may have influenced Italian decision makers in reducing the debt between 1994 and 2004 (Whitehead, 2006). The Maastricht Treaty and the European Union may have played this role since Italy has to reduce its debt in order to be able to join it (Efthyvoulou, 2011; Oatley, 1999).

The evidence, in the form of a detailed analysis of parliamentary debates and newspaper articles, will show that Italy was able to reduce the public debt only when pressured from outside and that the external constraints of the European Union, in the form of Maastricht Parameters, greatly impacted the level of Italian debt. Once Italy complied with them and became a member of the European Union, the effect disappeared and the Italian public debt started increasing again. Internal factors do not appear to have played a role. In particular, the qualitative study of parliamentary debates on the budget shows that the level of polarization and the role of veto players caused by it have remained constant and therefore can’t be used to explain the variation in public debt.

The essay is divided as follow. Chapter Two will outline in more detail the three theories relying on internal factors to explain debt variation and the external constraints explanation. Chapter Three will describe the variation of the public debt. Chapter Four will use macro data to verify whether fragmentation and government instability may provide an explanation. Chapter Five will describe the methodology and the qualitative analysis performed in order to verify whether polarization and the role of veto players or the external constraints played a role in the reduction and then increase of the Italian public debt.

Chapter 2: Domestic level and external constrain: theories.

There is a vast literature that tries to explain why countries have huge public debt while others are able to balance their budgets. Economic theories, however, are not sufficient to explain why some states run bigger deficit than others (Technical Commission for Public Finance, 2007, 18; Alesina, Perrotti, 1995).

Therefore, theories that consider both economic and political factors of why states run deficit are particularly useful. Three main theories are discussed and explained: opportunistic political business cycle, partisan political business cycle and that relying on variables such as fragmentation and polarization. It will be observed, however, that the first two theories do not apply to the case observed. Given the long period of reduction of the debt, the two theories can’t be applied since there is no reason why politicians did not adopt opportunistic behaviour during those years and both leftists and rightist governments were involved in the reduction of the debt. Therefore there will be only a short review of them.

Yet, to the list of possible theories that can help explain why countries may have bigger public debt, those ones that account for the role of external factors must also be taken into consideration. In particular, the European Union may have played a role in shaping Italy and other European countries’ policies.

2.1 Opportunistic Political Business Cycle

A possible explanation of why states run big deficits relies on the opportunistic behaviour of politicians. The model of opportunism political business cycle argues that a politician will increase expenditures before the election in order to gain support from voters (Nordhaus, 1975; Tufte, 1978).

This first wave of literature of opportunistic behaviour did not receive much support until later research. Scholars found mixed empirical support and were critical of the fact that voters were considered irrational (Alesina and Roubini, 1992, 3; Drazen, 2000, 96; Franzese, 2002, 380-381). As a consequence, a second wave of research elaborated on the opportunistic political business cycle (Alesina, 1988, 16). The aim of the scholars was to create a model where the voters are rational but can still fail to choose the best politicians due to other reasons such as, for example, lack of perfect information (see for example Rogoff-Sibert 1988, Cuckierman-Meltzer 1986).

Despite this new approach, these models still lack a unanimous empirical support in large cross-countries studies, although may perform well in one country case studies (Clarks et al., 2012, 88). Therefore, some scholars tried to introduce other variables (Schultz, 1995, 80-81; Clarks et al., 2012, 88) or applied the models to developing countries only where they are supported by the data (Block, Vaaler, 2004, 941; Shi, Svensson, 2006, 1368; Brender and Drazen, 2005, 1292).

2.2 Partisan Political Business Cycle

This theory argues that political parties have different goals and different priorities that they pursue while in office (Drazen, 2000, 88). Hibbs (1977, 1977) argues that left-wing parties have as priorities full employment and equalization of income distribution while right wing parties pursue price stability and, at a lower extent, balance of payments equilibrium. Therefore, leftist parties should produce larger debt than rightists. Similarly to the opportunist model, scholars have introduced rational expectations (Alesina, 1988).

Scholars have tested these models and have found that the partisan effects are not strong (Mink and de Haan, 2006; Alesina, Roubini, Cohen, 1999) or absent (Heckelman, 2006; Faust and Irons, 1999). In order to explain why sometimes there can be no partisan effects, scholars claimed that it may be because the party is sure to win (Fowler, 2006, 100), or because political parties may have changed policy preferences (Mulas-Granados, 2003, 36) or because there are other important factors that prevail such as the number of veto players (Perotti and Kontopoulos, 2002, 193-194).

2.3 Theory on Fragmentation, Government instability and Polarization

Another strand of the literature focuses on the attributes of the democratic political institutions and how they affect the level of public debt. These attributes can be fragmentation, government instability and polarization (Grilli et al., 1991, 349). These factors produce coordination problems and common pool dilemma problems within the government such as spending ministers (Hallerberg, unpublished, 3), political parties and other decisions makers such as decentralized units, and veto players (Alt, Lassen, 2005, 1405) that increase the chances that a government runs a bigger debt. Coordination problems refers to the increasing the number of actors involved in the decision making process which makes it, therefore, harder to get to an agreement. Common pool dilemma refers to the increasing number of actors with different goals and objectives. Thus, there are more chances for the approval of decisions that do not favour the whole community (ibid.).

In more detail, greater instability affects governments in terms of shortening the time horizon. Governments have, therefore, incentives to pursue the policy they want, disregarding future consequences (Grilli et al., 1991, 349). Polarization means the level of disagreement among policy makers. If it harder to get to a decision, there are more possibilities that a government is unable to adopt policies to reduce the debt (Eslava, 2011, 648). Fragmentation measures how many different actors are involved in the decision process. Different actors have different interests; they may try to adopt policies that favour their constituencies but share the costs on the whole country (Roubini et al, 1989, 126; Alesina and Perotti, 1996, 16). The first two conditions stress political instability as a key to explain variation of the public debt. Fragmentation, instead, regards government weakness (Grilli et al., 1991, 11).

Following these consideration, other scholars have suggested that politicians should have less decision power on economic issues in favour of independent institutions, such as central banks (Fatas, Mihov, 2002, 27). Among the three, fragmentation has been widely tested (Eslava, 2011, 657) and data seem to confirm that higher level of fragmentation produce higher level of deficit.

Electoral systems and types of regime directly affect instability, polarization and fragmentation (ibid.) Electoral systems determine the size of the support of the ruling party in the parliament, how many parties there are in the ruling government and how long the government is going to last. All these outcomes influence the ability of the government to keep the debt under control.

Electoral laws are classified in two broad categories: majoritarian and proportional (Person, Tabellini, 2004, 78-79). A majoritarian system is considered to be the best option in terms of reducing the chances that the elected politicians will increase the debt. Indeed, majoritarian system tends to produce strong and cohesive government, with only few or one party in the government (Fabrizio, Mody, 2006, 696). As a consequence, fragmentation and polarization are low. The best example is the electoral law of UK, where usually only two parties alternate. Proportional systems, instead, favour coalition governments and increase the number of players with diverging interests (Person, Tabellini, 2004, 78-79). These systems are associated with higher level of public debt since fragmentation is higher due to the fact that coalition governments composed of many parties. Polarization is also higher because the candidates are elected by different constituencies (ibid.).

Regime types are also important since they determine whether a government is parliamentary or presidential. The number of veto players in these two forms are different and, as a consequence, are also different in the size of expenditures (Grilli et al, 1991, 375; Person, Tabellini, 2004, 84-85). Different regimes may create incentives or favour policies that increase the public debt. The two main regime types are presidential and parliamentary (Person, Tabellini, 2004, 84-85). The presidential system is usually considered to favour austere policies by decision makers. The president represents the interests of the whole country and not special interests and he/she faces a limited number of veto players. Polarization and fragmentation are really low or absent. Also political instability tends to be really low, since the president is entitled to the executive power alone, and the end of his term usually follows the natural length of his presidency (ibid.).

On the other hand, parliamentary systems are often considered to favour higher deficit. The decision process is shared among the prime minister and the other ministers, and on top of that there is a direct link with the parliament. As a result, the number of veto players is higher and political instability is bigger since these veto players may be able to throw the government out of office (ibid.). Data shows that parliamentary and proportional systems are indeed characterized by higher level of public debt than countries with an elected president and majoritarian systems (Eslava, 2011, 657-658)

Scholars have tested these hypotheses in both developed and developing countries. In general, it has been confirmed that higher level of cohesion in the government reduces the chances of having a higher budget deficit. Cohesion is a general formula that encompasses both level of polarization and fragmentation. In more detail, fragmentation has been tested and there are clear results showing the negative impact on national budgets, while for polarization there are not as many studies (ibid.).

2.4 Alternative explanation: external pressure

Beside the three possible explanations considered, it is also worthwhile to look at factors outside the country. Countries are, in fact, players in the international system which is able to influence the domestic system. In the case of economic policies, it is possible to refer to a general external constraint that reduces the room to manoeuvre for policy-makers. In the context of this paper, an external constraint may be useful to explain why a particular government decided to adopt policies that reduce or at least tried to tackle high deficit (Tius, 2007; Efthyvoulou, 2011).

According to Tius (2007, 5), many scholars have relied on the theory of diffusion to explain how a subject or system can influence another one. The core idea is that an epicentre is the source of ideas that spreads policies to the other subjects of the system. However, in order to explain how the international system affects the domestic system, it is better to rely more on specific tools that can actually explain the link between the international system and the domestic system. For example, Whitehead (2006) identifies three ways the international system can influence domestic system: contagion, control and consent. According to Tius (2007, 5), the first two are particularly relevant because they almost only apply to the international system and how it influences the domestic level.

Another example it is provided by Wade (2006, 627-633) who studied developing countries and identified three ways in which the international system can influence the domestic realm: inspiration or when foreign ideas are internalized by the domestic system, subsidy which is when the domestic system is influenced though the provision of benefits and substitution which occurs when there is direct imposition of decisions and policy in the domestic realm.

In this paper, the European Union and in more detail the Maastricht Treaty, are the international factors that may help explain the policies adopted in the domestic level. Indeed, they may have played a role in influencing and changing the behaviour of domestic actors in Italy. Scholars have studied the role of the agreements among European countries in shaping domestic policies and some papers also analysed the impact of the EU among non-members (Brusis, 2002; Schimmelfennig, 2005).

Studies seemed to confirm that the European Union plays a role of constraining countries. For example, Efthyvoulou (2011, 640) found that in Cyprus, globalization and the European Monetary Union (EMU) have played a big role in reducing the difference among parties. Efthyvoulou argued that, although Cyprus has a political system that favours a strong political competition, with marked ideological differences among parties, being member of the European Union and before of the EMU have had a strong impact on the political life, greatly reducing the difference among parties. In other words, according to the scholar, the external constraint has made all politicians behave in the same way (Efthyvoulou, 2011, 639).

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Details

Title
Italian Public Debt: Role of Domestic Political Factors and External Pressure
College
London School of Economics
Course
MSc International Political Economy
Grade
65 Merit
Author
Year
2012
Pages
57
Catalog Number
V211454
ISBN (eBook)
9783656391746
ISBN (Book)
9783656392453
File size
718 KB
Language
English
Tags
master thesis, lse, ipe, economics, debt, italy, berlusconi, university, crisis, economic crisis, europe, eu, european union
Quote paper
Alberto Mittestainer (Author), 2012, Italian Public Debt: Role of Domestic Political Factors and External Pressure, Munich, GRIN Verlag, https://www.grin.com/document/211454

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