Christian Bjørnskov and Martin Rode

Discussions on the optimal level of government intervention in the economy have become very intense in recent years, especially following the 2008 financial and economic crisis. The hardships produced by this temporal economic downturn have led to some very heated debates among the economics profession on how much government should intervene in the economy to offset the negative effects for income and unemployment. Recently, this debate has again been revitalized in the context of the populist surge that many developed countries are currently experiencing.

Certain prominent voices in the international debate, such as Paul Krugman and Thomas Piketty, have recently argued for much more active government. Their claim is that current size of public sectors and their regulatory activity are insufficient to overcome the long-term effects of substantial crises, such as the Great Recession. Yet, almost all rich countries affected by the 2008 crisis substantially increased government spending, although some of them, in attempts to offset the expansionary increase in government spending, shortly afterwards were forced to design deficit reduction policies that had exactly the opposite objective. 

Apart from specific case studies, it remains unknown if such crisis-driven increases in government size and regulation become permanent, whether they are purely temporary, or whether perhaps the overall effect is even negative. But, if deficit reduction programs are more substantial than the initial countercyclical crisis policies, a claim that has often been made by the virulent anti-austerity calls in the media, it could very well be possible that public sector size and regulation are actually reduced as a long-term consequence of an economic crisis.

A main problem is that theoretical considerations do not help inform these questions. A number of previous studies argue that economic crises may lead to more interventionist policies and bigger governments. However, other studies argue that crises cause “neoliberal” deregulation and reductions of public sector size. Interestingly, the empirical evidence from cross-country studies on crisis and government size is equally mixed as the theoretical literature, with some authors finding that crises cause governments to tighten the interventionist grip on the economy, and others concluding that they are used as moments in which deregulation and less interventionist policy can be implemented. 

Given these mixed findings, we recently introduced what we see as an important but overlooked empirical complication that has not been tested in the existing literature. First, we argue that while economic crises do represent politically critical junctures, they are also moments where more substantial change is possible. As such, we argue governments’ core ideology is particularly important for the decision to implement more or less interventionist policies in such moments. 

Theoretically, the scope and structure of stabilization policies should thus depend substantially on the political ideology of the incumbent government, as ideal views of government intervention and the market economy differ greatly across the ideological policy spectrum. In other words, we ask whether the very mixed findings in existing studies are caused by ideological differences across governments deciding and implementing crisis policy.

Second, we argue that a transitional gains trap, as well as the democratic political dynamics of rent-seeking and lobbyism by interest groups, may prevent crisis policies from being rolled back when the crisis is over. If such effects are prevalent in most middle- and high-income societies, temporary crisis policies may become permanent, as quipped by Milton Friedman.

We test these propositions in a panel of 69 countries with Western political institutions observed between 1975 and 2015 for which we have our three main variables: 1) measures of the size of the government and the degree of market regulations; 2) measures of economic crises; and 3) a measure of the ideological position of the government on economic issues. 

Comparing the development of government size and regulatory activity since 1975, we find that both indicators have actually declined over the total time period under observation. Still, anti-crisis policies are substantially more interventionist in countries where the incumbent government is politically on the left. Interestingly, we also find evidence of policy ratchets, meaning that certain crisis policies tend to become permanent, regardless of the ideology of successive governments in power. This means that, for example, a following right-wing government typically does not reverse the crisis-driven interventions.

Finally, when separating multi-year crises from single-year recessions, we find that the more severe economic crises create stronger incentives for policymakers of all political ideologies to relax constraints on government spending and augment the regulatory activities of government, but these tendencies remain much stronger for left-leaning governments.

As such, we argue that the confusingly mixed evidence in previous studies is a consequence of the ideological heterogeneity in crisis policies, but also that the combination of ideological crisis policy and policy ratchets holds a final implication. While rolling back the public sector in size and scope is evidently possible, our results show that, on average, it does not clearly occur as an ideologically driven reaction to anti-crisis policies. In other words, policies implemented in and immediately after economic crises often come to permanently characterize countries’ economic policies.

 

 

You can read the full article in Political Studies here

Christian Bjørnskov is Professor of Economics at the Department of Economics, Aarhus University, in Aarhus, Denmark, and Affiliated Researcher at the Research Institute of Industrial Economics (IFN) in Stockholm, Sweden. Most of his research focuses on the political economy of institutions. Martin Rode is Assistant Professor of Economics at the Department of Economics, Universidad de Navarra, in Pamplona, Spain. His research focuses on political economy and public policy.