The Monetary-Industrial Complex

THE MONETARY-INDUSTRIAL COMPLEX….Matt Yglesias just finished reading Larry Bartels’ Unequal Democracy: The Political Economy of the New Gilded Age, which argues (among other things) that Democrats are better for the economy than Republicans. But Matt says this is a mysterious claim:

What this book made me wish for was more economics: Bartels gives us a lot of empirical political science data that seems to indicate that partisan control of the White House is more economically important than you would think. Contrary to this, there’s substantial economic theory that seems to argue that this can’t possibly be the case.

This is true. The evidence suggesting that the economy performs better under Democratic presidents is surprisingly robust, but one of the reasons this evidence doesn’t get taken very seriously is that there doesn’t seem to be any plausible mechanism for it.

So let’s take a stab at it. In general, I suspect that the mechanism is related to the fact that Republicans tend to focus their policy prescriptions heavily on tax cuts and inflation fighting, while Democrats tend to focus on employment — and employment is more crucial to economic growth than taxes and inflation. However, as longtime readers may recall, one of the things Bartels shows is that although it’s true that Democrats generally outperform Republicans, in election years Republicans do better. By a lot. So this changes the question a bit. What happens in election years that makes the economy so strong under Republicans?

The answer, if you can believe a paper co-written by Jamie Galbraith last year, might be called the monetary-industrial complex. It’s not so much that Republican presidents goose the economy in election years, it’s that the Federal Reserve gooses the economy in election years. But only if the president is a Republican:

The hypothesis [] has two independent parts. On one side, it predicts that…monetary policy [is] more permissive in years when a Republican administration is seeking renewal, than when it is not. On the other side, the hypothesis predicts that…monetary policy [is] more restrictive, after controlling for the influences of inflation and unemployment, in years when a Democratic administration is seeking renewal.

….The results in Table 3 give striking confirmation to the most cynical historians of the 1970s. They show that, controlling for the impetus of inflation and unemployment, the Federal Reserve systematically intervened in election years [during the period 1969-1983]. Both variables are independently significant, of opposite sign, and together they suggest a habitual ceteris paribus differential in the term structure of between 200 and 300 basis points, favoring Republicans.

….Table 4 gives information on the modern period….Over the years 1984 to 2006, monetary policy moves strongly in favor of Republicans and (less strongly) against Democrats in election years.

So there you have it. When a Republican is president, the Fed eases interest rates in election years by much more than the objective economic circumstances dictate. Conversely, when a Democrat is president, the Fed tightens interest rates in election years by much more than the objective economic circumstances dictate. And for a while, anyway, the economy responds. And so do voters.

Nice little racket, eh?