Public debt and political incentives

This article was originally published in Spanish in the Economic and Financial Report #35 by EsadeEcpol.

At the end of 2023, in the presentation of the European Central Bank's (ECB) Financial Stability Report, Vice President Luis de Guindos identified Spain as one of the four most vulnerable countries to a potential sovereign debt crisis.  

Spanish debt has been above 100% of the country's Gross Domestic Product (GDP) for many years. This ratio is one of the highest in the EU, only surpassed by Greece and Italy, and similar to France. Twenty years ago, Spain's debt was below 50%. However, since the 2008 financial crisis, debt has been increasing significantly, and Spain has a high and recurring public deficit. That means public spending is higher than public income year after year. To worsen the situation, debt and deficit increased significantly during the pandemic crisis.  

The consequences of high debt are well known, such as increased financing costs, economic uncertainty, or the risk of a debt crisis. And what can the country's leaders do to fix it? Some options are to reduce debt and deficit are reducing public spending, increasing income, or implementing reforms to accelerate the country's economic growth.  

Since the financial crisis of 2008, Spanish debt has been increasing considerably

Why has this situation not been corrected yet if high debt and public deficit have been a recurring concern in Spain since the 2008 crisis? Many factors can contribute to answering this question. This article focuses on one and discusses the influence of politicians' electoral incentives on economic policy decisions.  

The ghosts of a bailout hovered over Spain in the years following 2008 (and not just the banking sector). In 2010, a €750 billion bailout package was granted to Spain to ensure financial stability in Europe. In these critical cases, a country with high debt may need financial assistance from international institutions such as the International Monetary Fund (IMF) or the European Union.  

Public debt and political incentives: A complex relationship according to evidence

Government actions are critical to correcting these types of situations and returning a country to the path of growth and stability. Academic studies such as Mahmalat & Curran (2017) analyze the importance of implementing political reforms in times of crisis and discuss how political incentives shape the implementation of these reforms. In this regard, there is much academic literature showing that politicians' incentives are not always aligned with what is optimal for citizens. For example, Alesina (2000) examines how political incentives affect the type of macroeconomic policies, the type of fiscal reforms, and the timing of their implementation. Persson & Tabellini (2002) and Alesina, Roubini & Cohen (1997) review the literature and discuss how electoral incentives can lead to policies that are not optimal for citizens. For instance, they show a tendency to implement expansive fiscal policies before elections, or to implement policies focused exclusively on the short term, which can affect long-term economic stability and growth.  

Political incentives are not always aligned with what would be best for citizens

In the study ‘Blaming Your Predecessor: Government Turnover and External Financial Assistance’ by Abad, Bermejo, Carozzi, and Gago (2023), we investigated how political incentives can affect a government's decision to request financial assistance in times of crisis. This request for financial assistance can be, for example, to the IMF or the EU if the country is undergoing a financial crisis or to a central government if the crisis affects a municipality or a region.  

Such requests are public, meaning they are visible to voters. Additionally, they often send a negative signal to the electorate about the government's management of public accounts. The study analyzes whether a government is more likely to request financial assistance when it is a new government in office and, therefore, has no responsibility for the inherited state of public finances. In that case, the new government can "blame" the previous government for the current state of public finances. The study includes an international analysis and a local analysis in Spain.  

In the international analysis, all IMF agreements during the period 1992-2021 are considered, which includes more than 2,300 interventions in 124 countries. The analyses show that new governments in office are significantly more likely to agree on a financing program with the IMF.  

To complement the international analysis and alleviate potential econometric biases, we also conduct a national analysis, allowing statistical techniques to optimize the estimation of results. A regression discontinuity design is implemented using close local elections. The study focuses on municipal decisions in the Spanish context of the Supplier Payment Plan (PPP) — also known as the supplier payment mechanism — announced in February 2012. In this context, municipalities had to choose whether to adopt an adjustment plan to pay accumulated debt to suppliers or to pay the debt over five years through the withholding of current transfers from the central government to local governments. The adjustment plan granted municipalities preferential payment conditions, but it meant making the state of public accounts more visible, with the resulting potential political cost.  

When a local government is new in office, it is more likely to request an adjustment plan

The analysis shows that municipalities that did not adopt the adjustment plan suffered a severe cut in monetary transfers from the central government after 2012, as foreseen in the PPP. The analysis shows this also impacted citizens through a significant increase in taxes in these municipalities (specifically the property tax, the main source of local income) and a notable decrease in municipal public spending. 

The analysis concludes that when the local government is new in office (and can, therefore, "blame" the previous government for the state of public accounts), the government's disposition to request an adjustment plan significantly increases. However, when the government has been re-elected and was, therefore, responsible for the management of public accounts in the previous political cycle, it is less likely to request an adjustment plan, despite the cost to citizens. 

The next thing analyzed in the study is whether making an adjustment plan is indeed visible to voters and whether new governments blame previous ones for the inherited financial situation. Using press databases, we show that making an adjustment plan is highly visible in the press, and consequently, this information reaches voters. Additionally, we used ChatGPT to analyze the content of press news covering the PPP. We found that it is common for new governments to blame the previous government for the state of public accounts.  

Developing an adjustment plan reduces the likelihood of future reelection, but only for governments that were already in office

The study also shows that developing an adjustment plan negatively affects the probability of future re-election, but only for governments that are not new in office. That is, making an adjustment plan only negatively affects governments that were already in office and, therefore, were responsible for past account management. In a survey of Spanish mayors, they acknowledged that rectifying past policies can have a political cost, as it highlights the mistakes that have been made.  

The study shows how politicians who govern for several terms (unlike new governments) have incentives to avoid requesting public bailout to protect their image. This is the case despite the cost to citizens.  

This result underscores the relevance of political alternation in democracies and how, under certain circumstances, electoral incentives can discourage the adoption of policies that might be more optimal for citizens in the long run.  

Implications for the current context

The abovementioned results are particularly concerning in the current context, where several factors have generated volatility and economic instability internationally. These include high inflation rates, interest rates that have recently reached the highest levels in the last 20 years, uncertainty generated by the Russia-Ukraine or Middle East conflicts, and the recovery from the pandemic.  

This context of high instability usually comes with high volatility in party systems (which includes, for example, the emergence of new formations or increased polarization) and off-cycle or unexpected elections (as has recently happened in Spain, Italy, or France). This further increases uncertainty for current rulers, which likely exacerbates political incentives to avoid implementing major adjustments, as described in the study by Abad, Bermejo, Carozzi, and Gago.  

In any case, it is crucial to continue researching to understand how our politicians' electoral incentives can influence their economic policy decisions and how they can affect long-term growth and economic stability.