Political cycles: Beyond rational expectations

Motivation and method: Existing rational expectations models cannot satisfactorily explain why political budget manipulations systematically raise re-election chances and only occur in “specific contexts”. This paper offers a theoretical explanation by including unsophisticated voters into an opportunistic political cycle model; unsophisticated voters are unable to take the optimal behaviour of other agents (fully) into account, but may, nonetheless, vaguely suspect government deception. Results: First, rationally expected manipulations are, on average, fruitless in equilibrium. By including unsophisticated voters we can, however, corroborate empirically found electoral effects of political budget manipulations. Second, unsophisticated voters become anxious and suspicious in an intransparent or uncertain world, but the government tries to “outperform” their scepticism by increasing budget manipulations in order to appear more competent and, ultimately, increase re-election chances. It is, therefore, not surprising that political budget cycles are observed in countries suffering from intransparencies such as developing countries or new democracies. Third and in addition, the model presented here predicts that political opportunism produces, unintentionally, a countercyclical policy effect in election years, thereby, for instance, alleviating the typical problem of policy procyclicality in developing countries. Additional contribution: The paper also offers a theoretical explanation for political distortions found in forecasts by US states. Based on overly optimistic revenue forecasts the incumbent state government can conduct expansionary fiscal policies in order to appear more competent prior to an upcoming election. Since the resulting deficit can only be observed afterwards, the government can effectively circumvent a constitutional balanced budget constraint. As a result, there are political forecast and budget cycles in the state. More generally, however, these findings may also apply to European countries where balanced budget constraints are or will be in place (for instance the debt brakes in Switzerland and Germany); similarly, they apply to the supra-national European Fiscal Compact of the European Union.