Economic Volatility and Political Institutions

In this paper, we study how macroeconomic volatility affects social welfare through its impact on political institutions. In the presence of asymmetric information on the quality of politicians, volatility shapes political outcomes in two ways: (1) it alters the incentives of incumbents by changing their re-election probability and (2) it affects the ability of voters to select good politicians. Through the first channel, volatility distorts the trade-off between policies with a short-run benefit and costly reforms that pay out in the future. Depending on politicians' preferences and the abundance of high-ability candidates, an increase in the variance of macroeconomic shocks may reduce or increase the overall expected investment in welfare-improving long-run reforms. On the other hand, by adding noise to the economic variables that voters observe, volatility increases the probability of re-electing bad politicians or ousting good incumbents. We study the welfare consequences of these mechanisms and identify which forces improve or worsen efficiency. This analysis has a number of novel implications. First, it shows when and how macroeconomic shocks are costly for the society, even under risk-neutrality, through their impact on political actions. Second, it illustrates how volatility affects the efficiency of the electoral system by shifting the balance between its cost (political myopia) and benefit (selection). We show conditions under which efficiency may call for less frequent elections in highly turbulent economies. Third, our model suggests that macroeconomic volatility need not translate into political instability and that, contrary to conventional wisdom, political stability need not improve economic performance.