Fiscal Consolidation Under Electoral Risk

Abstract

The European debt crisis has uncovered a serious tension between democratic politics and market pressure in contemporary democracies. This tension arises when governments implement unpopular fiscal consolidation packages in order to raise their macroeconomic credibility among financial investors. Nonetheless, the dominant view in current research is that governments should not find it difficult to balance demands from voters and investors because the economic and political costs of fiscal consolidations are low. This would leave governments with sufficient room to promote fiscal consolidation according to their ideological agenda. We reexamine this proposition by studying how the risk of governments to be replaced in office affects the probability and timing of fiscal consolidation policies. The results show that governments associate significant electoral risk with consolidations because electorally vulnerable governments strategically avoid consolidations towards the end of the legislative term in order to minimize electoral punishment. Specifically, the predicted probability of consolidation decreases from 40% after an election to 13% towards the end of the term when the government's margin of victory is small. When the electoral margin is large, the probability of consolidation is roughly stable at around 35%. Electoral concerns are the most important political determinant of consolidations, leaving only a minor role to ideological concerns. Governments, hence, find it more difficult to reconcile political and economic pressures on fiscal policy than previous, influential research implies. The results suggest that existing studies underestimate the electoral risk associated with consolidations because they ignore the strategic behavior that our analysis establishes.