The Political Economy of Economic Policy

We should pay closer attention to the interactions between politics, economics, and other realms

The COVID-19 pandemic strikingly illustrates the intersection of politics,
economics, and other considerations. Public health experts have long warned
that the world was likely to face a major pandemic and called for greater
preparedness. Yet policymakers who have to focus on the next election find
it difficult to invest the time, money, and political capital to address
the abstract possibility of a future crisis. And so most of the world was
unprepared for a global public health threat of the magnitude posed by the
novel coronavirus.

As the pandemic has raced across the world, the policy response has
continued to be tempered by political realities. Some members of the
public, and some policymakers, have resisted the recommendations of public
health experts, hoping for relaxed restrictions and a return to normalcy
before the dangers have passed. At the same time, business interests have
pressed for exceptions to benefit themselves, and for substantial
subsidies—bailouts—to help them through difficult times.

At the international level, government responses to the pandemic illustrate
the difficult politics of worldwide cooperation. A global pandemic requires
a global response: microbes do not respect borders. A coordinated
international response is clearly the best way to confront an international
public health emergency. Yet policymakers under pressure from their
constituents have diverted resources away from other countries, banned the
export of food and drugs, and hoarded essential supplies. Each of these
measures—popular as they may be to national publics—imposes costs on other
countries. In the final analysis, the lack of cooperation makes everyone
worse off. Such international institutions as the World Health Organization
attempt to coordinate a cooperative global response to the global
crisis—but they can be powerless in the face of potent nationalist
political pressures (see, for example, Goodman and others 2010).

Every government faces tough decisions about the appropriate measures: what
restrictions to impose and when to loosen them, where money will be spent
and how it will be raised, and what national concerns can be limited to
favor international cooperation. These decisions have to take into account
public health recommendations, economic considerations, and political
constraints. Just as the policy response to the 2007–08 financial crisis
varied from country to country in line with local political economy
conditions, so national policy responses to the COVID-19 pandemic vary for
health, economic, and political reasons.

Politics at play

This hotly contested policy response to a universal threat is no surprise
to political economists. It happens all the time. For example, just about
every economist believes that small countries would be better off if they
removed all barriers to trade. Yet unilateral free trade is practically
unheard of, and no country in the world today pursues it. Why not? More
generally, why do governments have so much trouble getting economic
policies right? Why does the advice of independent observers, analysts, and
scholars go so often unheeded?

Politics
is the usual answer, and the answer is usually right. But that is too
vague—like saying that some countries are rich and others poor due to
economics. Exactly how does politics keep governments from making better
policy, even in the face of imminent crises? What does that tell us about
how economic policy can and should be made?

Political economy
is about how politics affects the economy and the economy affects politics
(see box). Governments try to pump up the economy before elections, so that
so-called political business cycles create ebbs and flows of economic
activity around elections. By the same token, economic conditions have a
powerful impact on elections. Political economists have uncovered the
simple (perhaps disturbing) fact that the rates of economic growth and
inflation are all the information we need to predict quite accurately the
results of the past 100 years of US presidential elections (see, for
example, Fair 2018). So why don’t elections work to push politicians to
choose the best policies?

Where you stand depends on where you sit

A basic economic principle is that any policy that is good for society as a
whole can be made to be good for everyone in society, even if the policy
creates winners and losers. It requires only that the winners be taxed just
a bit to compensate the losers—and everyone is better off. Economists use
powerful tools to clarify which economic policies are best for society. So
why should economic policy be controversial?

A basic political economy principle is that the winners don’t like
being taxed to compensate losers. And the battle is joined, not over what
is best for society but rather over who will be the winners and losers.
What is best for the country may not be best for my region, or group, or
industry, or class—and so I will fight it.

Even in democracies, plenty of citizens might agree that politics obeys the
golden rule: those with the gold make the rules. Special-interest groups do
seem to play an outsize role around the world, democratic or not. These
include wealthy individuals, powerful industries, big banks and
corporations, and formidable labor unions.

How else to explain why Americans pay two or three times the world price
for sugar? There are a handful of sugarcane plantations and a few thousand
sugar beet farmers in the United States—and 330 million sugar consumers.
You’d think that the 330 million would count for a lot more in politics
than the several thousand, but you’d be wrong. For decades, subsidies and
trade barriers have raised the price of sugar to the benefit of the sugar
planters and farmers and to the detriment of everyone else.

Why does a tiny group of sugar producers matter more than the rest of the
country? A commonplace of political economy is that concentrated
interests usually win over diffuse interests. The sugar producers
are well organized and work hard to influence politicians. If they didn’t
get favorable government treatment they’d go out of business, so it’s
important for them to organize to lobby and fund politicians. The cost to
consumers is estimated at $2 billion to $3 billion a year. That’s a lot of
money—but it comes to a couple of cents a day for the average American. No
consumer is going to talk to an elected representative or threaten to vote
for an opponent over a couple of cents a day.

The fact that producers are concentrated while consumers are diffuse helps
explain trade protection. A few automobile manufacturers can organize
themselves; tens of millions of car buyers can’t. That’s not all.
Management and labor in the auto industry may not agree on much, but
automakers and autoworkers agree that they want to be protected from
foreign competition. Politicians—especially politicians from areas where
automobile manufacturing is important—have a hard time denying a common
demand of workers and owners in a powerful industry.

Perhaps this is not such a bad thing. Sugar farmers and autoworkers depend
for their livelihood on supportive policies. Who is to say that their jobs
are less important than lower prices for consumers? There is no simple,
widely accepted way to balance the benefits against the costs—is cheaper
sugar important enough to bankrupt thousands of hardworking farmers?
Politics is, in fact, the way society adjudicates among conflicting
interests, and maybe those with more at stake should have a bigger say.

Political economists don’t usually take stands on complicated moral and
ethical issues of this sort. They try to understand why societies
choose to do what they do. The fact that sugar or car producers have much
more at stake and are much better organized than sugar or car consumers
helps explain why government policies favor sugar and car producers over
consumers.

Some consumers are concentrated, though. Sugar is sweet, and the
corporations of the Sweetener Users Association want it to be cheap as
well. Coca-Cola, Hershey, and the like have pushed hard to change American
sugar policy. The fact that there are powerful concentrated interests on
both sides of the issue helps explain why prices aren’t even higher than
they are. The same thing is true of industrial products. Steelmakers want
protection; steel users—like the auto manufacturers—don’t. Trade policy is not just a battle between big corporations and
disunited households; it’s also a battle among big corporations.
Otherwise we’d expect every industry to be protected and trade to be
tightly limited everywhere.

In fact, there are plenty of powerful interests in favor of
international trade and investment. The world’s multinational corporations
and international banks depend on an open flow of goods and capital. This
is especially the case today, when many of the world’s largest companies
depend on complex global supply chains. A typical international corporation
today produces parts and components in dozens of countries, assembles them
in dozens more, and sells the final products everywhere. Trade barriers
interfere with these supply chains, which is why most of the world’s
biggest companies are also some of the biggest supporters of freer trade.

In this 15-minute video, Prof. Jeffry Frieden responds to reader questions from around the world on political economy

A complex web

Special interests as well as voters on different sides of every issue fight
their battles in the political arena. But the rules of politics vary a lot
from country to country. The way a political economy is organized affects
who wins the battle over policy.

A logical starting point is elections, at least in democracies. Governments
that don’t satisfy their constituents don’t remain governments very long.
So we might expect democracies to choose policies that benefit the economy
as a whole. However, the economy as a whole doesn’t vote.

Politicians need votes from the people who decide elections. The decisive
or pivotal voters vary with a country’s electoral institutions and social
divisions. In most political systems, the best targets are swing voters,
who might change their vote in response to the policies of an incumbent or
the promises of a challenger. If the poor vote for the left and the rich
vote for the right, for example, the middle class could be decisive. In
recent American presidential elections, the most important swing voters
have been in distressed industrial regions of the Midwest. Many voters in
these areas believe that foreign competition contributed to manufacturing
decline. This helps explain why presidential candidates have become
increasingly protectionist, even though most Americans support openness to
trade.

In addition, policymakers in democratic societies must always pay attention
to the next election—otherwise they are likely to cease being policymakers.
This helps explain why it can be difficult for governments to pay money now
for policies whose benefits will be realized only in the long run—such as
pandemic prevention and preparedness.

The mass of special and general interests in society is overwhelming.Institutions help make sense of them. First are social institutions—the way people organize themselves. Some
businesses, farmers, and workers are well organized, giving them more
political clout. Farmers in rich countries are relatively few, are well
organized, and are almost universally subsidized and protected. Farmers in
poor countries are many, rarely organized, and almost universally taxed.
Where workers are grouped into centralized labor federations, as in some
northern European countries, they play a major role in national
policymaking. The ways in which societies organize themselves—by economic
sector, region, ethnicity—affect how they structure their politics.

Political institutions
mediate the pressures constituents bring to bear on leaders. Even in
authoritarian countries, rulers have to pay attention to at least some part
of public opinion. Political economists call this the “selectorate,” that
portion of the population that matters to policymakers. In an authoritarian
regime, this could be an economic elite or the armed forces. In an
electoral democracy it would be voters and interest groups. No matter who
matters, policymakers need their support to stay in office.

In democracies, the variety of electoral institutions affects how
policymakers feel constituent pressures. Organized political parties can
help extend the time horizons of politicians: while an individual
politician may worry only about the next election, a party has to be
concerned about its longer-term reputation. On another dimension, where
politicians are elected by the country as a whole, as in Israel or the
Netherlands, the focus is on national policy. Where politicians represent
narrower geographic locations, as in the US House of Representatives, the
general view is that “all politics is local” (usually attributed to
1970s–80s Democratic Speaker of the House Tip O’Neill). These different
electoral systems can drive politics toward more national or more local
concerns.

Electoral institutions affect the identity of the people politicians need
to attract to win an election. The US Electoral College makes
middle-of-the-road voters in the Midwestern industrial states pivotal in
presidential elections, driving the emphasis on protection for
manufacturing. In a multiparty parliamentary system, the pivotal voters may
be the supporters of a small party that can swing back and forth between
coalition partners, such as the fringe parties for the formation of Israeli
governments. Whichever voters the electoral system makes pivotal are likely
to have outsize influence over politics and policy.

The character of legislative institutions also matters. For
example, while a unitary parliamentary system can deliver big and fast
change, in the US separation of powers system change is more modest and
slower. Federal systems—in Australia, Brazil, Canada, Germany, the United
States—give provincial or state governments a lot of power, while
centralized systems allow the national government to rule unchallenged.
Some governments have handed off control of important policies to
independent bodies that are less subject to day-to-day political
pressures—such as central banks and public health agencies.

These institutions matter because they affect the weights that politicians
give to different groups in society. Some sociopolitical institutions give
labor unions a great deal of influence; others privilege farmers; still
others are dominated by business associations. Political economists analyze
the interests in play and how the institutions of society transmit and
transform them into government policy.

Second-best can be best

All this matters to policymakers or observers or even just people who care
about the economy because it can profoundly change the way we think about
policy and policy advice.

The policy that economic analysis indicates is best for the economy may not
be politically feasible. To go back to free trade, virtually all economists
would recommend that a small country’s best bet is to remove all trade
barriers unilaterally. Yet it is almost certain that a government that
attempted to move to unilateral free trade would face massive opposition
from special interests and from many in the public who would regard such a
move as dangerous. The result might well be the collapse of the government
and its replacement with one that could be relied on to maintain and even
expand trade barriers. In this case, pursuit of the first-best policy could
lead to a much worse outcome.

Politicians, analysts, observers, and just regular people who are
interested in economic policy are well advised to evaluate not only the
economic implications of policy initiatives but also their political
feasibility. If the pursuit of a first-best policy is bound to fail and
perhaps provoke a backlash, then truly the cure may be worse than the
disease. It makes more sense to consider the political realities the
government faces and to structure policy with those realities in mind. It
is better to settle for second-best than to insist on first-best and end up
worse—or, as folk wisdom has it, to let the perfect be the enemy of the
good.

Bottom line

Political economy is the integration of political and economic factors in
our analysis of modern society. Inasmuch as just about everyone would agree
that politics and economics are intricately and irretrievably
interwoven—politics affects the economy and the economy affects
politics—this approach seems natural. It has proved itself powerful in understanding governments and societies; it can also be a powerful
tool for those interested in changing governments and societies.
Policymakers should hold these important lessons in mind today as they
tackle the COVID-19 pandemic.