The Politics of the Political Business Cycle

Existing models of the political business cycle have performed poorly in empirical tests because they have misspecified the interests of their primary actors – the incumbent politicians. While these models assume that governments face similar incentives to manipulate the economy at each election, governments' incentives can in fact vary from election to election depending upon their political needs at the time. The more likely the government is to be re-elected, the less it can gain by inducing cycles that are costly because of their impact on both the government's reputation and future macroeconomic performance. The degree to which the government manipulates the economy should thus be negatively correlated with its political security going into the election.This prediction is tested by examining transfer payments in Great Britain, 1961–92. While a traditional model that is insensitive to the government's political needs finds no evidence of politically-motivated manipulations, a model which takes these factors into account reveals a robust, and at times sizeable, electoral-economic cycle.