David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

14.7 Political economy: how governments decide
Now suppose Dick and Harry vote together. They vote for A, which Harry really wants, and for B, which
Dick really wants. Dick gains 4 since B passes, and loses only 3 when A passes. Harry gains 6 when
A passes and loses only 1 when B passes. By forming a coalition that allows them to express the intensity
of their preferences, they do better than under independent majority voting, when neither A nor B would
have passed.
Many decisions in the European Union reflect log-rolling. Individual countries get favourable decisions on
issues they really mind about, but are expected to repay the favour on other issues.
Commitment and credibility
Chapter 9 introduced credibility and commitment in the context of games
between firms. Similar ideas apply to the political economy of policy design.
Because expectations about the future affect current decisions, politicians are
tempted to make optimistic promises about the future in the hope of influencing
people today.
Our discussion of strategic entry deterrence in Chapter 9 gives you all the clues
you need to think about political credibility. Project your imagination into the
future and consider how politicians will then want to behave. Use this insight to
form smart guesses today about which promises are credible and which are not.
A credible promise about
future action is one that is
optimal to carry out when the
future arrives.
A commitment is a current
device to restrict future room
for manoeuvre to make
promises more credible today.
For example, most post-war Labour governments were big spenders, which required high taxation. When
out of office, Labour promises of low spending and low taxes when next in government were not very
credible. Gordon Brown's Code for Fiscal Stability was an attempt to enhance Labour's credibility by openly
and repeatedly committing to a tough policy that would then be politically costly to abandon. With so
much political capital invested in prudence and the Code for Fiscal Stability, the government would look
very stupid if it subsequently abandoned it.
Recently, many countries have adopted a commitment that has been very successful. They have made the
central bank operationally independent of government control, as Labour did with the Bank of England in
1997. The government chooses the aim of monetary policy - to keep inflation low - but the Bank alone
now decides what interest rates are needed to achieve this. By keeping the government's hands off interest
rates, central bank independence removes the temptation for the government to overheat the economy in
pursuit of a pre-election boom.
Policy co-ordination
Chapter 9 contained another useful insight for modern political economy. In
discussing games between oligopolists, we showed that collectively they make
Policy co-ordination is the
decision to set policies jointly
when two interdependent
areas have big cross-border
spillovers.
more profit acting as a joint monopolist than by acting without co-ordination. In
the language you later learned in Chapter 13, when actions are interdependent and externalities matter, the
efficient solution needs to take these spillovers fully into account. Internalizing externalities means stopping
free-riding.
The more interdependent different nation states become, the more it may be necessary to co-ordinate
national policies rather than formulate them in isolation. Global warming is one example, but many forms
of regulation and taxation fall under this heading.
French tax rates on alcohol are so much lower than UK rates that UK Chancellors can no longer set UK
alcohol taxes as high as they would like. The UK would like continental tax rates on alcohol to be higher.
Conversely, continental Europeans complain about low levels of worker protection in the UK and the
competitive edge this may give UK firms.
Pressure for closer policy co-ordination is likely to increase as globalization continues.
353