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KeywordsPolitical Economy Monetary Policy Market Failure Public Choice Theory Constitutional Political Economy
The term “political economy” (PE) is mainly used in two related contexts. First, it is used to denote a multidisciplinary research field in which political scientists, economists, legal scholars, and other social scientists investigate the relationship between the political sphere (most notably “the state”) and the economic system of different societies on Earth at different points in time. Second, social scientists, journalists, and other observers sometimes use the term PE to refer to the observable interaction of politics and business in real-world societies. Focusing on the first context, this entry gives an overview of the research field of political economy (PE) and discusses its relationship to law and economics as a research program.
Positive Political Economy: Analyzing What Is
Within the toolkit of PE, there are basically two different approaches which are currently used to analyze the relationship between politics and the economy: positive PE (explained in this section) and normative PE (see next section). Using a positive approach, researchers conduct empirical analyses in the form that they describe and explain the relationship between the political and economic sphere (i.e., what is) – but they usually do not make value judgments in the form of normative statements as to what public and private sector actors should do or not do: for instance, positive politico-economic analyses usually do not contain policy recommendations regarding the “right” way for the government to intervene in certain sectors or markets in the economy (i.e., what ought to be). In other words, scholars doing positive PE research first of all describe as precisely as possible the extent to which the state or other political actors intervene in the economic system of a society (or different societies, if a comparative perspective is taken) in a certain investigation period.
Political interventions in different sectors of the economy or particular markets may take various forms, such as government subsidies, taxation, state-owned enterprises, or regulations (Den Hertog 2000; Boettke and Leeson 2015), and may be done for various reasons, such as eliminating market failures/allocative inefficiencies, redistributing resources from the rich to the poor, or stimulating economic growth and employment (see below). As it is often the case that firms, business associations, trade unions, and other actors within the economic system try to influence the process of economic policymaking via lobbying and other forms of leverage, in many contexts we can observe a mutual interference of the political and the economic sphere. This may also include a possible correlation between (a) the economic situation in a society and (b) the popularity and election results of government, opposition parties, or individual politicians (Lewis-Beck and Stegmaier 2013).
Moreover, it has to be taken into account that external factors such as global issues (poverty, climate change, war refugees, etc.), international organizations (e.g., World Trade Organization, European Union, International Monetary Fund, World Bank), developments in international markets, or the activities of foreign governments (e.g., tariff policy, international tax competition, sovereign debt, sovereign defaults) may influence a (sub)national PE understood as the interaction of the political and economic system in a real-world society. The fact that nation states are these days embedded, in various respects, in an international system is analyzed in the literature on “international PE” and “global PE” (see, e.g., Ravenhill 2016). In this context it should also be mentioned that there is a strand of PE research which focuses explicitly on the differences between the national economic systems of the countries in the world including different “Varieties of Capitalism” (Hall and Soskice 2001) as well as the remaining more or less socialist “command economies” or “centrally planned economies” such as Cuba and North Korea (Fine and Saad-Filho 2012, chap. 7).
However, many politico-economic analyses within positive PE do not content themselves with describing the relationship between politics and the economy but, moreover, try to explain the observations made in the descriptive phase of research. Which factors can explain why the state intervenes in a particular way in a society’s economy? Which explanatory factors may have driven the transformation of the “interventionist state” over time? Why do some countries show a better macroeconomic performance (economic growth, employment, price stability, etc.) than other countries? In this spirit, for example, numerous politico-economic studies have empirically analyzed whether factors such as government ideology, powerful interest groups, fiscal pressure, socioeconomic problems (e.g., de-industrialization, unemployment, economic slump), path dependence, or globalization help explain the observable differences across the member states of the European Union (EU) or the Organization for Economic Co-operation and Development (OECD) with respect to the use of policy instruments such as public entrepreneurship, regulation, taxation, or subsidization in the decades after World War II (e.g., Leibfried et al. 2015; Obinger et al. 2016).
Similar studies exist for the less-developed world and/or for country groups including countries with “not-so-democratic” political systems. There is, for example, a politico-economic literature that describes and explains different aspects within the relationship between politics and the economy in autocratic regimes (e.g., Acemoglu and Robinson 2012; Leibfried et al. 2015, parts IV/V). Moreover, there are many studies entitled “The Political Economy of XY” which means that the particular study analyzes the interplay between political and economic factors in the specific context under investigation, for example, the political economy of migration, foreign aid, higher education, terrorism, and so on.
Normative Political Economy: Recommending What Ought to Be
PE research may be done not only in the form of empirical or “positive” analyses (as defined above) but also in the form of a normative analysis. This means that a specific area in the economic system is analyzed in order to come to conclusions as to what “the state” should (not) do in the area under investigation. Should the government intervene in a particular sector of the economy or a particular market by means of regulations or other policy tools? Should public bureaucrats be allowed to control certain activities of private sector firms and households? Should regulatory agencies be mandated to supervise competition in particular sectors and markets? Such questions are addressed in the fundamental and ongoing PE debate over the proper role of the state in the economy (see Boettke and Leeson 2015, for a survey). Contributions to this debate are based, more or less explicitly, on the following major schools of thought.
Varieties of Economic Liberalism
Political economists in the tradition of Adam Smith (1723–1790), whose seminal book on “the Wealth of Nations” (Smith 1776/1981) is the “bible” for those advocating “economic liberalism” and “market liberalism,” basically argue that the state should leave the economy alone. It is assumed that there is some kind of natural tendency to equilibria in markets. That is, if there is an excess demand or excess supply, then such disequilibrium will only persist for a short period of time. According to the economic laws of demand and supply, markets will find a “market-clearing price” at which demand equals supply. In other words, direct governmental interventions into markets are perceived to be unnecessary (or even harmful) as specific markets and the economy as a whole possess “self-healing powers” in the form of the “market forces”: that is, the interplay of demand and supply coordinated via the price mechanism.
However, it should be mentioned that Smith (1776/1981) and other advocates of economic/market liberalism such as Friedrich August von Hayek (1899–1992) and Milton Friedman (1912–2006) acknowledge that society may not be left to markets alone – but that the state has to perform at least some tasks to make markets and society work. For example, political economists in the tradition of Smith (1776/1981), Hayek (1960), and Friedman (1962) consider it to be a government task to ensure that there is a functioning legal system (rule of law, laws, courts, judges, etc.) that can be used, among other things, for enforcing (i) property rights and (ii) the contracts signed by market participants. By contrast, libertarian political economists, who consider the possibility of a stateless society, go a step further: they argue that private governance mechanisms (reputation, nongovernmental courts, etc.) are sufficient to enforce property rights and contractual agreements (see, e.g., Friedman 2014; Leeson 2014; Stringham 2015).
Furthermore, there are two specific variants of economic liberalism which were developed some decades ago but are still influential in the current politico-economic discourse: ordoliberalism and constitutional political economy. Ordoliberals in the tradition of the German economist Walter Eucken (1891–1950) criticize that Smith (1776/1981) and other advocates of classical economic liberalism and its laissez-faire approach have neglected that a market economy does not automatically increase the wealth of a nation. For example, individual markets or whole sectors of the economy may suffer from anticompetitive practices by private and/or public companies (market-entry barriers, cartelization, price collusion, competition-distorting state aid, government monopoly, and so on). Consequently, for ordoliberals it is essential that the state creates and enforces a legal order and institutions (e.g., a politically independent competition authority) that try to prevent private and governmental restraints of competition and market forces as far as possible (Eucken 1952/2004; Vanberg 2015).
In a similar vein, constitutional political economists in the tradition of James M. Buchanan (1919–2013) emphasize that markets, competition, and the economy as a whole need “rules of the game” – a “constitution” – which channel the individual self-interests of consumers, firms, and other actors (for more details, see Buchanan 1987; Vanberg 2005). Moreover, constitutional PE points out that creating and enforcing such “rules of the game” is far from trivial. Reading Eucken (1952/2004) one gets the impression that he takes it for granted that there is a benevolent government which realizes that the rules recommended by ordoliberals are beneficial for society and implements these rules. In contrast, constitutional PE assumes that not only firms and consumers but also politicians and public bureaucrats are self-interested actors. Under these conditions, not only powerful firms and interest groups but also politicians and public bureaucrats may impede the implementation of rules which could be beneficial for citizen-consumers and society as a whole (e.g., the abolition of government monopolies, the abolition of special privileges for state-owned enterprises, better regulations for public utilities, and so on). However, what ordoliberalism and constitutional PE have in common is that both prefer a rule-based economic policy over discretionary government interventions in the economy and market processes.
For the sake of completeness, it should be mentioned that constitutional PE is part of the broader research program entitled “economic theories of politics” or “public choice theory” established by Downs (1957) and others (see Mueller 2003, for a survey). Public choice theory breaks with the welfare-economic assumption of benevolent governments working in the public interest. Instead, it is assumed that politicians and public bureaucrats (i) are primarily interested in maximizing their individual utility and (ii) “act solely in order to attain the income, prestige, and power which come from being in office” (Downs 1957, p. 28). In other words, it is theoretically assumed that political decision-makers are self-interested not only when they make private choices (as consumers, investors, landlords, and so on) but also when they make public choices in government, parliamentary committees, and other political contexts. As “older” schools of PE (e.g., classical economic liberalism in the tradition of Smith) did not pay much attention to the motivations of public sector actors and implicitly assumed that the government is primarily interested in maximizing the wealth of a nation, in the politico-economic literature, public choice theory is often denoted as the “New Political Economy” (Frey 1999).
The next step in this area has been taken by scholars working in the field of “behavioral political economy.” Therein, it is taken into account that real-world actors often do not behave as rationally and with the self-interest that economists’ traditional homo-economicus model predicts; this may lead to other policy implications regarding the “optimal” design of the incentive structures under which certain types of consumers, investors, policymakers, and other individuals make their more or less informed and more or less selfish decisions (see Schnellenbach and Schubert 2015, for a survey).
Keynesianism and Other State-Interventionist Approaches
If the economy slips into recession, then hard-core economic liberals may argue that such an economic crisis may have painful consequences for firms and individuals (a drop in orders, bankruptcy, unemployment, poverty, and so on) but does not require government intervention – because thanks to its “self-healing powers” the economy will recover on its own after some time. By contrast, political economists in the tradition of John Maynard Keynes (1883–1946), whose seminal book “The General Theory of Employment, Interest and Money” (Keynes 1936) belongs to the most influential critiques of the laissez-faire approach of economic liberalism, consider it to be a government responsibility to stimulate the economy in times of economic slump (i.e., increasing government spending, reducing taxes, and so on). If the government lacks the necessary financial resources to implement an economic stimulus package, then Keynesians recommend (a) government borrowing (so-called deficit spending) and (b) repaying the debts after the crisis when government tax revenues increase due to economic growth and rising employment.
Critics of deficit-spending object that step (b) is often not conducted by government, which is one reason for the high levels of public debt observable in many countries these days. Keynesians usually respond to such criticism by arguing that costly state interventions to “stimulate,” “stabilize,” and “steer” the economy are necessary and legitimate as long as there is unemployment in a society (Krugman 2013). Complementary to fiscal stimulus packages, Keynesians propose measures of monetary policy to stimulate the economy (e.g., lower interest rates). If there is a politically independent central bank, then monetary policy is not a tool of government (i.e., politicians have no access to the tools of monetary policy).
While Keynesianism offers a macroeconomic justification for state intervention in the economy, the so-called market failure theory (for a survey, see Stiglitz and Rosengard 2015) has demonstrated that the laissez-faire approach of economic liberalism ignores the fact that different types of market failures offer a potential justification for government action. For example, the behavior of certain firms and consumers (e.g., environmental pollution by coal-fired power plants) may create negative externalities for other society members. The government may implement measures (law, regulations, etc.) that force polluters to reduce or even stop producing negative externalities. Moreover, it can be expected that many society members will not pay for certain goods and services if they can consume these goods and services free of charge. However, if free riding is possible, then private actors have a low or no incentive to supply such goods and services. To secure the provision of public goods in the sense that no one in society can be excluded from consuming such goods, the government may step in: for example, the public good argument offers an economic argument to justify the national defense being provided by the government and financed by taxes (i.e., society members, as potential free riders, are forced to pay for national defense).
Informational asymmetries constitute another type of potential market failure. If suppliers are better informed about certain characteristics of products and services (e.g., the quality of used cars) than potential buyers, then the markets for these products and services may not function well: because it can be expected that many consumers under these circumstances would hesitate to enter a market transaction as they would fear being exploited by the better-informed sellers (e.g., low-quality, high-price products). It is also possible that buyers are the better-informed market party. Imagine, for example, insurance companies that do not know the true health status of people seeking to buy a health insurance. In situations with informational asymmetries, the government may implement measures (governmental provision of quality information, disclosure laws, governmental regulation of product quality, etc.) to mitigate these informational problems and facilitate market transactions. Moreover, the market-failure framework considers natural monopolies to be a potential justification for government action. Such monopolies occur if for efficiency reasons in certain sectors or markets of the economy only one firm is doing business (e.g., the provider of a rail network, a power supply line or a water line). To avoid allowing this provider to exploit its monopoly power (high prices, bad quality, and so on), the government may regulate this natural monopoly (price regulation, quality regulation, etc.). And, as mentioned above in the context of ordoliberalism, the government may also intervene in some way to tackle the problem that markets and competition do not work properly due to “ordinary” monopolies and other anticompetitive practices.
It should be emphasized that the existence of a market failure does not automatically imply that the government has to solve the problem. For instance, there may be private third parties (e.g., private certification agencies) and market-based mechanisms (e.g., reputation, brand-name capital) that help market participants to overcome their informational problems, so that buyers and sellers are able to enter into mutually beneficial market transactions. In other words, in the politico-economic literature, it is not only discussed (a) whether a certain market or sector of the economy really suffers from “market failures” and “allocative inefficiencies” but also (b) which governmental or private governance mechanisms (or a mixture of both) seem to be the most suitable to solve the problem at hand (Ostrom 2010). Moreover, political economists stress that all of these mechanisms are imperfect solutions that work more or less well depending on the specific real-world context in which they are used (Wolf 1993). And it may be the case that government action to solve a market-failure problem may create new problems (for an overview of the politico-economic debate on “government failure,” see Keech and Munger 2015).
A normative yardstick that is often used by economic liberals to assess whether state activity is necessary to mitigate a certain type of market failure is the so-called subsidiarity principle. According to this principle, government action is only necessary if private market solutions and private governance mechanisms fail. A brief and oft-cited summary of this principle can be found in the book “Principles of Economic Policy” by Eucken (1952/2004, p. 348): “The structure of society should follow a bottom-up approach. What the individuals or the groups can autonomously accomplish should be done on their own initiative and to the best of their abilities. And the state should only intervene in those cases in which its assistance is indispensable” (own translation, K.M.). By contrast, political economists that have a less individualistic and more state-centered view of economy and society may start from the paternalistic, state-interventionist assumption that the state is automatically responsible for solving market-failure problems (for a survey of the politico-economic literature on paternalistic government, see Le Grand and New 2015). In democratic societies, the ultimate decision-maker in this context is the government in power – and this decision-maker is certainly free to ignore the normative (and often conflicting) policy recommendations made by political economists and other experts.
Marxism and the Social Question
Economic liberalism and its belief in markets and competition have always been the target of criticism. Karl Marx (1818–1883) and Friedrich Engels (1820–1895) have argued that it is a basic feature of capitalist market economies that the “working class” (the so-called proletariat) is exploited by business firms and their owners (the “capitalists”; see, e.g., Marx and Engels 1848/2002). The state is seen as an agent of the so-called bourgeoisie (including the capitalists) which constitutes the ruling class in society. Marx and Engels predicted that capitalism will be overthrown through a “proletarian revolution” that leads to socialism and, eventually, to communism (including a classless society). It is beyond the scope of this paper to critically review everything that has been written by Marx, Engels, and their followers under the label “Marxian Political Economy” about imagined and real existing types of capitalism, socialism, and communism (for a survey, see Fine and Saad-Filho 2012). Nor do we discuss the many problems of “command economies” or “centrally planned economies.” However, Marx and his followers have repeatedly pointed out a serious problem which many capitalist market economies still have to cope with: it may be the case that an economy consists of a system of well-functioning, efficient markets, but this system produces social problems.
For example, in many countries we observe income and wealth inequality among society members. While hard-core economic liberals may argue that such inequalities have to be accepted and simply reflect individual differences in performance and success on markets, other political economists argue that the state in the name of “social justice” has to tackle distributional problems via redistribution (see Piketty 2014, for an overview of this debate). And even economic liberals that are skeptical of state interventions, such as Hayek (1960) and Friedman (1962), take it for granted that those society members who, for whatever reason (e.g., disease, disability), are not able to earn money in the labor market should receive publicly financed welfare benefit payments ensuring a minimum income needed to exist. Whatever political economists from different schools may think about social problems and their solution – in the end, however, in democratic societies the scope and structure of the welfare state are determined in the political process.
Political Economy Meets Law and Economics
Last but not the least, we have to address the question of what law and economics (LE) as a research program has to do with PE as a multidisciplinary endeavor. First of all, we can observe that terms, concepts, and tools from the toolkit of PE (market failure, externalities, public goods, efficiency, utility, welfare, constitutional PE, behavioral PE, and so on) are used by LE scholars and in LE textbooks as well (see, e.g., Towfigh and Petersen 2015). In this context, it should also be mentioned that economists belonging to the LE movement have made important contributions to the research field of PE as sketched above. See, for example, the studies on externalities and public goods by Ronald H. Coase or the contributions by George J. Stigler, Richard A. Posner, and Samuel Peltzman to the economic theory of regulation (see the bibliographies in Den Hertog 2000; Boettke and Leeson 2015). In other words, many of the concepts presented above under the label PE, which is mainly used by political scientists, economists, and “political economists,” are presented in LE publications under the label LE, which is mainly used by legal scholars, economists, and supporters of the LE movement. And while some may classify Coase, Stigler, Posner, and Peltzman as economists or LE scholars, others may classify them as political economists.
Likewise, Persson and Tabellini (2003), La Porta et al. (2008), and similar studies investigating the interplay of legal institutions and the economy are oft-cited in the PE as well as in the LE literature. In any case, it should be clear now that political economists and LE scholars who are interested in analyzing different aspects of the interplay between the political and economic sphere of society share a common terminology. This offers opportunities for research cooperation and interdisciplinary research – but does not mean that the disciplines participating in the “joint ventures” labeled PE and LE would have lost their idiosyncrasies and specific strengths. For example, as noted above, in the politico-economic works of Hayek, Friedman, Eucken, and Buchanan it is argued that “the state” should provide a legal framework which ensures that markets and competition work well; however, these thinkers do not say much about the fundamental issue of how exactly the specific legal framework for a specific market or economic sector in a particular real-world society should be designed and enforced (contract law, competition law, capital market law, energy law, environmental law, and so on). That is, legal experts are necessary to bridge the gap between normative politico-economic theories of the proper role of the state and practical public policy.
Moreover, it can be observed that in the positive, empirical branch of PE and LE, there seems to be a methodological convergence in the sense that scholars doing empirical research in this area basically use the same toolkit, consisting of various quantitative and qualitative methods (statistical techniques, document analysis, field research, etc.; Towfigh and Petersen 2015). As we have seen above, however, such consensus cannot be observed in the normative branch of PE. Looking through the theoretical – some would say “ideological” – lenses of different schools of PE in many cases brings us to different conclusions regarding the question of what the state should do (or not do) in the particular area of the economy under investigation.
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