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The True Cost of Polarization

February 27, 2017

“There’s No Such Thing as a Free Lunch” – Milton Friedman

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Source: Gary Markstein/Creators Syndicate

In their first lesson of economics, students are introduced to the concept of scarcity – an inherent condition in a world of limited resources – and, as a result, the existence of opportunity costs; Milton Friedman’s famous quote “There’s No Such Thing as a Free Lunch” echoes this idea that everything has a cost, even when it is not obvious. When it comes to government decisions, costs are often scrutinized: the cost of an investment, of giving (or not giving) a public service in concession or implementing a policy; however, the costs of political polarization are rarely analyzed.

What is the cost of political polarization?

Or, rather, which is the most valued asset lost for having political polarization? Certainty. In this essay, the author will provide arguments in favor of the hypothesis that the opportunity cost of the increasing gap between political attitudes of politicians towards major policy dimensions (trade, migration, gender, racial integration, public expenditure) is uncertainty and will discuss its negative effects on economic performance.

A first approach to studying the economic effects of uncertainty resulting from political activities is observing economic markets’ performance during electoral cycles. Brandon and Youngsuk (2012) estimated the effect of elections over corporate investment. Results indicate that, after setting control variables for investment opportunities and economic environment variables, corporate investment rates dropped, on average, by 4.8 percentage points the year prior to elections. In countries with polarization, the effect is expected to increase due to the risk of abrupt changes in policy. The changes may be moderate, for example: contract regulations, taxation, trade policy, or more drastic actions like expropriation of possessions and hostility towards non-supporters. Empirical evidence reveals that political polarization affects investment not only during electoral cycles, but also discourages long-term investments, with investors instead opting  to minimize their risk and making short-term opportunistic solutions such as  asset stripping, and intensive lobbying with state officials (Frye. 2002).

Other negative effects of polarization

Especially in countries with parties that exhibit diverging ideologies such as ex-communists and anticommunists, other negative effects of polarization are the imposed barriers to create consensus. There is a constant conflict over the economic reforms to be implemented, given the conflicting principles, and it does not allow politicians to reach agreements to effectively address economic crisis with coherent policies (Frye. 2002).

The struggle between opposing factions also has a detrimental effect on  the quality of institutions by increasing the state officials’ incentives to make opportunistic decisions, for example populism, clientelistic relationships, bribing and interference of power groups in government policies, just to name a few

According to a growing mass of literature on the subject, when a country lacks strong institutions and has a polarized government, it will be more likely to default on sovereign debt. It is important to bear in mind that sovereign debt crises   do not occur only when governments choose to default, as recent events have shown that crises can arise from investor’s uncertainty about a country’s ability or intentions to honor its responsibilities. Qian (2012) uses an economic model to show the dynamics between the quality of institutions, the level of government polarization and the sovereign default risk, for a sample of 90 countries. Her findings support the premise that the lack of strong institutions and a clear set of rules allows powerful groups to capture government and influence policies to their benefit, without considering their impact on other groups.

Additional evidence of the negative effects of polarization and weak institutions is found when combined with a globalized financial market. In particular, countries with low income and weak institutions are perceived as unreliable by investors and experience a threshold effect that will hinder their access to all the benefits of globalization, as presented by Alfaro, Kalemli-Ozcan and Volosovych (2008), as well as by Kose, Prasad and Taylor (2011).

Moreover, Broner and Ventura (2006) discuss the conditions under which globalization lead to higher financial market volatility. According to their model, the instability of domestic financial markets can be explained by: 1) uncertainty of governments’ behavior (incentives to default on foreign liabilities increased with globalization) and 2) the probability of a financial crisis (i.e., it depends largely on the nature of regulations and strength of judicial systems to enforce contracts). As a result of financial liberalization and the existence of the previously mentioned sources of uncertainty, the economy will alternate between two possible outcomes: an optimistic equilibrium (in which institutions are strong in enforcing contracts) or a pessimistic equilibrium (one with weak, opportunistic institutions). In a polarized government, the effect of the uncertainty sources would be amplified, potentially destroying the possibility of an optimistic equilibrium.

After analyzing polarized countries using these arguments, it is not a surprise to find that some countries have low levels of investment, slow economic growth, high volatility and recurring economic and institutional crises.

 “There’s No Such Thing as a Free Lunch”… especially when it comes from a politician.

References

Layman, G. C., Carsey, T. M., & Horowitz, J. M. (2006). Party polarization in American politics: Characteristics, causes, and consequences. Annu. Rev. Polit. Sci., 9, 83-110.

Baldassarri, D., & Bearman, P. (2007). Dynamics of political polarization. American sociological review, 72(5), 784-811.

 Qian, Rong. 2012. Why Do Some Countries Default More Often Than Others? The Role of Institutions. Policy Research working paper; no. WPS 5993. World Bank. © World Bank.

Frye, Timothy. 2002. The Perils of Polarization: Economic Performance in the Postcommunist World. World Politics, Volume 54, Number 3, April 2002, pp. 308-337

Brandon. J, Youngsuk, Y. 2012. Political Uncertainty and Corporate Investment Cycles. Journal of Finance, 67 (2012), 45-83.

Broner, F. and Ventura, J., 2006. Rethinking the effects of financial globalization. The Quarterly Journal of Economics, p.qjw010.

Corporación Latinbarómetro, Socio- demographic variables (2015). Retrieved from http://www.latinobarometro.org/latOnline.jsp

 

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