With a permanently pro-cyclical fiscal policy, we could lose democracy and monetary policy

Abstract

This article shows that if, in a young democracy with weak institutions, one and the same party governs in virtually all upswings of the business cycle and promotes each time pro-cyclical fiscal policies, three serious negative effects emerge. The first is the loss of fiscal policy; fiscal policy remains pro-cyclical during the downturn as well, deepening the recession and extending the period in which output stays below potential. The second effect is the loss of democracy; unable to use fiscal policy to help exit the recession and speed up economic growth, the parties governing during downturns compounded by the pro-cyclicality of fiscal policies are perceived by the public as impotent and are penalized accordingly through a lower share of parliamentary seats, until the party that governs exclusively during business cycle upturns finds itself without a real opposition. The third effect is the loss of conventional monetary policy, manifesting if interest rates and inflation are low when recession sets in. Under these circumstances, lowering the monetary policy rate to zero might no longer suffice to stimulate the exit from recession and the quick return of output to its potential level, leaving central banks no option but to resort to unconventional monetary policies, such as quantitative easing.