The first edition of this book spoke of a “deep and fundamental faith in democratic institutions,” based largely on an analysis of political and economic practice in the United States. Recent experience has shaken that faith. I have learned more about democracy in the years since the first edition. It was not previously apparent to me how much the good economic performance of democracy in the United States was contingent on practices that are not part of the definition of democracy.

Since that first edition, the United States has experienced soaring government indebtedness, unintended adverse consequences of an effort to make housing more affordable, and massive moral hazard and time-consistency problems in the financial system. Each of these was permitted or encouraged by the incentives of electoral politics and by limitations on government, the two essential features of democratic institutions. To paraphrase Winston Churchill, American democracy may ultimately do the right things, but it is trying many alternatives before getting to them. And by the time it does them, it may have reduced its own standard of living and position of leadership in the world.

This section reviews contemporary political economy models of political behavior. The first two chapters address models of routine electoral politics. Chapter 3, Models of Accountability and Opportunism, deals with the timing of elections and how opportunistic politicians might try to manipulate the economy for their own benefit. Chapter 4, Models of Choice, deals with how different parties might structure the choices available to voters. Both are models of regular politics revolving around elections, the most visible of the defining characteristics of democracy.

Both the electoral cycle and the partisan models have advanced in the past decades. One major source of this progress is the recognition of the wider implications of the uncertainty introduced by elections. Elections as institutions of accountability and choice also inevitably introduce the possibility that the identity of governments will change, and this uncertainty can have economic consequences that may or may not be constructive. Almost all models of routine politics assume that incumbents or parties are motivated by policy goals, office goals, or a combination of the two.

Chapter 5 is a new chapter in this edition about irregular or non-routine politics in the United States. It identifies some of the ways that political choices have had unintended adverse consequences. This chapter also deals with irregular events such as financial crises and shows the importance of time-consistency and moral hazard. It raises questions about the benign message of the previous edition of this book. Chapter 5 also addresses the second essential feature of democracy – limitations on government. In the United States, this includes separation of powers and the freedom to petition the government for redress of grievances (i.e., to lobby).

This section treats the institutions and processes by which macroeconomic stabilization policy is made. Chapter 8 deals with political control of the money supply and interest rates, or monetary policy. Chapter 9 deals with the politics of taxing and spending, or fiscal policy. In both cases, the immediate pressures and demands of policy making take place in the context of an overall debate about rules versus discretion. Although policy makers are not always conscious of that overall debate, their actions may lean one way or the other. Until the recent financial crisis, I believe that monetary policy had moved in the direction of rule-based behavior since the 1980s, whereas fiscal policy had become increasingly discretionary and ad hoc.

In the period since World War II, there was a time when fiscal policy was seen as the main instrument of stabilization, but it has since been eclipsed by monetary policy. And for the period of the “Great Moderation” between about 1984 and 2007, it seemed that problems of stabilization policy had been resolved, that is, until the financial crisis of 2007 and after. Ad hoc fiscal policy has been used repeatedly in the twenty-first century, culminating in the massive stimulus bill passed in February 2009. Yet the standard view is and remains that “the central bank should and does have a dominant role in stabilization policy (Blinder 2006, p. 26, emphasis in original).

This is a second edition of Economic Politics: The Costs of Democracy (Cambridge University Press, 1995). That book used macroeconomic performance since World War II in the United States to make general statements about democracy. The main conclusions were that democracy had basically benign influences on economic policy and performance. Political economy and public choice models of opportunistic behavior by politicians did not identify systematically inferior policy, as had been suggested or intimated by Nordhaus (1973), Tufte (1978), and others.

I am no longer so optimistic. In the intervening years, the United States has taken a wrong turn economically, and I believe that the wrong turn has much to do with the incentives of democratic politics. But these developments are not inevitable features of democracy. They are often avoided by other democratic nations and have been avoided in the past by the United States.

I have changed the title of the book to Economic Politics in the United States: The Costs and Risks of Democracy. Such a title might have been a more honest title of the original book, given its predominant focus on the United States, but the revised title highlights the fact that democratic politics have gone astray in that country. This book will consider democratic politics in the United States as just one example of how democracy can work constructively or otherwise in the context of economic policy making and performance.

Voters are the ultimate authority in a democracy. Their preferences and behaviors are the fundamental sources of legitimacy for policy makers, who get their power through elections. Their preferences and behaviors also place constraints on what elected politicians can do. The electorate is the source for the authority of constitutional rules of procedure and for the authority of official statements of public goals. When there is ambiguity about what goals are appropriate for public policy, voter choices can resolve it at least provisionally. When there is ambiguity about which potential officeholders have correct or appropriate beliefs about the way the economic world works, voter choices can determine which ones will get to test their views against experience.

All this would be true in a world of ideal democratic citizens, but it is true in the real world as well. Yet the effort by candidates for office to maximize their share of the votes of even ideal citizens can lead to opportunism, according to some of the models of political economy we have reviewed. Whereas ideal citizens may be public spirited and fully informed, real-world voters may not have either of these qualities. This chapter will assess what we know about how voting behavior is affected by macroeconomic issues, as well as the implications for policy making. It will also raise some questions about how voter behavior may have contributed to the poor contemporary state of American political economy.

The United States faces an easily predictable fiscal crisis of unprecedented proportions, but democratic institutions and processes are standing in the way of confronting painful choices and making responsible fiscal policy. Fiscal policy is the biggest failure of democracy in the United States since the first edition of this book appeared. A single sentence goes a long way toward explaining the problem: “The country faces a fundamental disconnect between the services the people expect the government to provide, particularly in the form of benefits for older Americans, and the tax revenues that people are willing to send to the government to finance these services.”

It is surely not new for people to want more services than they are willing to pay for. Among what is new is the size of the present and future gap between revenues and expenditures. Also, both revenues and expenditures are largely on autopilot and would take painful action to correct. There was a time, before the 1960s, when belief in the balanced budget norm was strong enough and pervasive enough to make reconnecting revenues and expenditures politically feasible, but that time is long past. The formal institutions of fiscal policy have not changed much, but the informal, unwritten institutions have changed since the 1960s.

Monetary policy is the control of the money supply and of interest rates to stabilize the economy. For decades, it has been the main instrument of stabilization policy in the United States. Fiscal policy, the use of taxing and spending powers to guide the economy, receded into the background, though it has had a resurgence in the 2000s (Auerbach et al. 2010). Normally, the possible actions available to monetary authorities have to do with the levels of interest rates and the rate of growth of the money supply, which in turn may affect the level of economic activity and the rate of inflation.

Good and successful monetary policy can bring an appropriate balance between economic growth and stable prices, but, of course, the meaning of “appropriate” is contestable. Poor or unsuccessful monetary policy runs two main risks. If the money supply grows much faster than real economic activity, the result will be inflation or even hyperinflation. The opposite risk is that there will not be enough financial liquidity to support the real economic activity that would take place if credit were more readily available. The United States has never experienced hyperinflation, but monetary policy has been at least partly responsible for the sustained increases in price levels since World War II. The second risk was experienced in the banking panics and recessions of the nineteenth and early twentieth centuries, and the Great Depression itself has been attributed to poor monetary policy.

The world’s richest and freest countries are democracies. More than any other political system, democracies have the capacity to correct themselves. Democracy is basically about procedures, in contrast to political systems defined by eligible rulers, such as monarchs, military dictators, or other types of authoritarian rulers. The central procedural feature of modern democracy is elections, which provide the opportunity to replace the incumbents with alternatives. This is Riker’s (1982) minimalist liberal democracy, the opportunity to throw the rascals out, with no claims made about who or what will replace a rejected government.

Democracies can perform well or badly, The first edition of this book suggested that democracy in the United States was doing rather well when measured by its macroeconomic performance, even though the book was guided and informed by models and theories that emphasized that politicians might be motivated by careerist and opportunistic goals, rather than by a desire to deliver good policy and good performance for its own sake. The previous version found little evidence of policy or performance that was systematically inferior because of opportunistic behavior.

This version has emphasized different problems: unintended consequences, moral hazard, and time-consistency. It has emphasized suspicion and distrust between the major parties. The first edition interpreted voting behavior in the United States as not systematically demanding inferior or suboptimal policy. This may still be true, but the context has changed so that elections may no longer be as constructive or even as neutral as they were. Something in the options being offered to voters makes elections more risky than they were. And something in the implementation of checks and balances and of limitations on government is also not constructive.

The purpose of this chapter is to present to the reader the theories and the views of professional economists about how the macroeconomy works. Political choices regarding monetary and fiscal policy operate in an environment of real-world constraints; to understand the political choices and their consequences, we must understand the nature of these constraints.

As this chapter will show, macroeconomists have had divergent views about how the economy works, but there has been some convergence. For some, this convergence has survived the financial crisis of 2007–9. For others, macroeconomic training in recent decades has been “a costly waste of time” (“The Other-Worldly Philosophers,” Economist, July 18, 2009, p. 65). The recent crisis is seen both as a criticism and a vindication of the efficient markets hypothesis, which holds that prices of securities fully reflect all available information. And although there is some convergence as well as continued divergence in macroeconomic thinking, neither trend includes a prominent development in the discipline, behavioral economics, which has recently addressed macroeconomic issues.

Theoretical convergence or not, there is little agreement among macroeconomists on the causes of the recent financial crisis, what policies contributed to it, who is responsible, what to do to get out of the ensuing recession, and how to avoid future crises. Still, we must go to macroeconomic theory to understand the way the economic world works, to explain and predict, and to know what is possible and what is not. For better or worse, the message of this chapter is that no single, authoritative, uncontested theory explains the way the macroeconomic world works.

This book uses macroeconomic issues to address questions about how democracy works. It continues the kind of investigation I pursued in my first book, The Impact of Negro Voting: The Role of the Vote in the Quest for Equality (1968, 1981), which used racial issues to study the consequences of extending the franchise. It is a statement of applied democratic theory that uses economic issues to bring into focus questions about democratic institutions and practices. It brings together a body of research that has been written largely in the past fifteen years on the political dimensions of macroeconomic policy and performance. The book draws on work done by economists and by political scientists in roughly equal measure, and it is designed to present a variety of arguments fairly and neutrally.

I have taken aim at several audiences. First, the book is written to be accessible to a nontechnical audience of advanced undergraduates and thoughtful nonacademic citizens who might be interested in the relationship between politics and the macroeconomy, and in its implications for democratic theory. No special training in economics or political science is presumed. Although the book is meant to be readable by the nontechnical general public, it draws heavily on technical academic literature. As such, it makes the case that this literature is relevant to issues of broad public concern. Another audience is graduate students and faculty in political science and economics. For them, the book covers territory in the other discipline that may not be familiar, but more than this, it is an argument and an interpretation of known political and economic facts and ideas. In this way, it is also designed for the colleagues who have created the literature on which I draw.

The United States, which sometimes thinks of itself as the world’s leading democracy, is showing that democracy does not always work well. The American fiscal crisis is the clearest evidence of this. Federal deficits and federal debt are matters of political choice as well as of circumstance. Some good choices have been avoided and some poor choices have been made by the U.S. government. The links between democratic politics and the financial crisis of 2007–9 are more subtle and contestable, but this book will show how various decisions and practices leading up to the crisis and various responses to the crisis can be linked to democratic politics.

This is not to say that formal democratic institutions in the United States are flawed. It is to say that formal democracy works best when supplemented by informal institutions of prudence and caution. Such informal norms and practices have weakened in recent decades and the U.S. economy is showing the effects; it will probably continue to do so into the foreseeable future.

Nor is it to say that the message of democratic politics as benign in the first edition of this book was not correct for the time it was written. What has happened since to make for a more mixed message about the consequences of democratic politics has two sources. The first is the failure to act on problems that were foreseeable in 1995 or, worse yet, decisions that made the fiscal outlook worse. The second is that random events have made the economic world more dangerous, and American institutions were not prepared to deal with unforeseen random shocks to the financial system.

In Chapters 3 and 4, dealing with models of routine politics, we treated parties and voters as oriented to identifiable goals regarding inflation, unemployment, and income growth. We drew on the familiar misery index and showed how it could be modified to represent different preferences, and even to represent a conception of social welfare or the public interest. In doing so, we accepted goals and preferences as given, as predetermined, and as clearly defined. In this chapter and the next, we step back and ask where goals and preferences come from and how well defined and authoritative they are. In this chapter, we consider official public definitions of national economic goals, as well as what economists say about various targets of macroeconomic policy.

These chapters present the argument that there is no basis for an unambiguous or uncontestable definition of the public interest, and no basis for an authoritative welfare function. This argument undermines assertions that democracy has costs and pathologies. Without authoritative definitions of what public policy ought to be, we have no solid basis for comparing the outcomes of democratic politics to the best or most appropriate outcomes. It is difficult to argue that democratic political processes lead systematically to inferior outcomes when superior outcomes resist precise and authoritative definition. In fact, the goals of public policy are defined and redefined in a continuing and fluid political process.

Partisanship models have received considerably more attention and empirical support than electoral cycle models. Leading scholars, such as Alberto Alesina and Douglas Hibbs, have argued that partisanship is the most fundamental basis for political influence over macroeconomic policy and outcomes. There are, indeed, systematic partisan differences, but economic movements are so fluid that party differences are often overwhelmed by larger tides of change. A limitation in most of the existing studies of macroeconomic partisanship is that they have assumed that party differences regarding goals have remained fixed or constant. That assumption has rarely been documented or tested, and I will argue that partisan goals are, in fact, variable. Even fixed goals may be relaxed under certain circumstances that make them unusually costly, but I contend that partisan goals are themselves variable, subject to conditions that are still only poorly understood.

Also, the institutional framework in which American parties operate is not constant. Changes in the institutions in which fiscal and monetary policies are made are likely to affect the implementation of alternative partisan goals, even if those goals were to remain constant (see Chapters 8 and 9). Most of the empirical demonstrations of partisan differences have focused on presumably fixed differences between the Democratic and Republican Parties regarding control of the presidency. But a growing literature has argued that other patterns of variations in the control of office are also consequential. Most prominently, divided partisan control of the presidency and Congress can affect policy outcomes. Outside the United States, partisan competition is made more complicated in many democratic countries by the continuing presence of more than two parties. A two-party system that offers only dual alternatives is, by comparison, a radical simplification of the actual possibilities.

This chapter uses the recent financial crisis to identify and illustrate three risks of politics and government in general that are not captured by models of routine democratic politics: political business cycles (Chapter 3) and models of partisan competition (Chapter 4). The first is the simple and intuitive possibility that programs that reflect good intentions may have unintended and unanticipated consequences and that some of these consequences may be undesirable. The second is moral hazard, wherein insuring against risk may lead agents to behave less prudently than they would if they were to bear the full costs of the consequences of their behavior. The third is the time-consistency problem, in which there may be a conflict between the right thing to do for all times and the right thing to do at a particular time. These are problems to which all governments are subject, whether authoritarian or democratic, whereas the models of routine politics are unique to countries that choose their leaders through elections.

We focus on the financial crisis of 2007–9, with its aftermath of sluggish growth and high unemployment. The financial crisis exacerbated the deficit and debt problem that preceded it, which will be briefly introduced here and taken up further in Chapter 9. Each of these problems happened independently, but the financial crisis has made the fiscal situation even worse than it would have been without it.