Market and political power interactions in a SOE-RBC model: a DSGE model of southern European capitalism and the Great Recession

Guest Speaker

Vanghelis Vassilatos, Associate Professor of Macroeconomics, Athens University of Economics and Business

Seminar Topic

The Great Recession was deeper and lasted considerably more in Portugal, Spain, Italy and Greece, than in Germany, the United States, and other developed economies. Although Germany and the United States surpassed their pre Great Recession peaks, in about two and four years, respectively, Portugal, Spain, Italy and Greece had not returned to their corresponding pre Great Recession peaks, in almost a decade. It is the central thesis of this study that the politico-economic system of these South European countries is an important factor in understanding these disparities.

It is well documented that most Southern European countries feature not only a relatively large public sector, but also a large part of their GDP is produced by firms that, to various degrees, are controlled by government. Notable examples are power utilities, water and sewage utilities, phone networks, garbage disposal utilities, road networks, road, rail and sea transport companies, airports and seaports, oil refineries, natural gas networks, banks and insurance companies. The industries these firms operate are noncompetitive and moreover, they use labor organized in powerful unions. The latter bargain for “high” wages that lead to “high” prices for their services. As these services are important inputs for the rest of the economy, this affects total factor productivity and overall competitiveness. At the same time, the powerful unions and their strategic allies cooperate in the major political parties and government so as maintain and promote their interests. But, this arrangement results in relatively high government spending and financial needs. It is worth noting that such a strategic interdependence does not happen in Anglo-Saxon countries, because, there, unions and allied business interests have little market power. And, does not happen in the Scandinavian countries or some Central European countries where, although strong, unions and associated business interests work together, thereby taking account of possible negative effects of their decisions on the whole of society.

In terms of modelling, we introduce market and political power interactions that resemble the politico-economic structure of these South European countries, in a small open economy RBC model. The model incorporates the insiders-outsiders labor market structure and the concept of an elite government. Outsiders form a group of workers that supply labor to a competitive private sector. And, insiders form a group of workers that enjoy market power in supplying labor to the public sector and influence the policy decisions of government, including those that affect the development and maintenance of public sector infrastructures. This leads to labor misallocation and inefficient fiscal policies that are to the benefit of insiders. Thus, even though expanding public sector output has a positive effect on growth, eventually this is counterbalanced by the labor misallocation and inefficient tax policy outcomes. These frictions affect the economy’s shock propagation mechanism in a way that recessions last longer than in the canonical RBC and even leading to a growth reversal phenomenon.

The model proposed may be applicable to other countries that have a similar politico-economic structure, that is, a politico-economic system characterized by groups of selfish elites that enjoy market power but at the same time cooperate in influencing government in protecting and promoting their collective self-interests.

Speaker Bio

Vanghelis Vassilatos is Associate Professor at the Department of Economics of the Athens University of Economics and Business. His research focuses on growth, business cycles, and economic policy and political economy issues in dynamic, stochastic and/or deterministic general equilibrium models. The emphasis is on models with market and/or policy frictions as well as the introduction of political economy features in such models. His academic research has been published in peer-reviewed international academic journals such as Review of Economic Dynamics, European Economic Review, Journal of Economic Dynamics and Control, International Journal of Central Banking and European Journal of Political Economy.