NEUTRALIZING FRACTIONALIZATION

Abstract

The more fractionalized a coalition government, the greater the likelihood of fiscal indiscipline. This indiscipline may appear in two forms: the deficit bias identified by Sachs and Roubini or the voracity effect theorized by Lane and Tornell. The deficit bias is the tendency for fractionalized nations to run larger deficits. The voracity effect is the propensity for fractionalized countries to have more expansionary fiscal policy in booms and contractionary policy in busts. Yet, fractionalized governments are held to disciplinary norms by forces outside the political process. This thesis asks if fiscal rules, legal constraints on the fiscal discretion of politicians, may neutralize fractionalization. The thesis argues that welldesigned rules force politicians to internalize the full cost of their actions. The study hypothesizes that fiscal rules neutralize both the deficit bias and the voracity effect. Using a dataset covering 67 countries from 1986-2012, this thesis conducts a pooled, time series, cross-sectional analysis in an attempt to answer this question. The analysis focuses on the interaction between fractionalization and rules. The results confirm the evidence for the deficit bias. The thesis advances the literature by finding that rules neutralize the deficit bias in the most fractionalized economies. The neutralizing effect is robust in European countries specifically and advanced economies in general. The analysis of voracity focuses on emerging markets where policy tends to be most cyclical. The thesis further contributes to the literature through identification of a voracity effect in emerging markets, which also can be neutralized by fiscal rules. However, this neutralization may be beneficial overall in only highly fractionalized countries. In less fractionalized governments, the rigid nature of fiscal rules may do more harm than good. Throughout this paper, the findings highlight the role of debt in spurring reform. When debt ratios increase, countries raise their primary surplus to meet obligations to creditors. This includes adopting stronger rules. These findings hold true across all subsets of the data. Unfortunately, more fractionalized nations with the most to benefit from strong rules have difficulties adopting them. Fiscal rules neutralize fractionalization and may lead to improved outcomes in the most fragmented coalition governments. These rules deserve careful consideration by policymakers.