Coordinating Restraint:Deimocratization, Fiscal Policy and Money Creation in Latin America

Although previous studies have posited a link between new democracies and economic policy, theoretical justification for this hypothesis has been sketchy, while econometric tests have been lacking. This article explores the link between public finance and democratic age via the notion of "competitive externalities" and their effect upon monetary financing of expenditures (seignorage). The argument is that transitions to democratic rule heighten the challenge of coordinating fiscal decisionmaking in the short term by dispersing fiscal authority and reordering institutional relationships among policymakers. In the long term, asymmetries generated by elections and/or crises attenuate the external costs of democratization. This hypothesis is tested econometrically, using a timeseries cross-sectional analysis of monetary financing of deficits (seignorage) for ten Latin American countries, which shows that new democracies are indeed associated with a short-tenn bias toward seignorage. During the 1980s, governments throughout Latin America were forced to respond to a public finance crisis of enormous proportions. The combination of large transfers of resources to external creditors, pressures to reduce taxes on trade, and rising inflation entailed difficult decisions about how to allocate increasingly scarce public resources. In many cases, these decisions coincided with a return to democratic rule. The convergence of democratization and severe public finance constraints elicited a logical follow-up question: are governments in new democracies less capable of adjusting to revenue shocks than other governments and, if so, why? This article examines the relationship between democratization and the use of monetary financing of expenditures, or seignorage, as a response to the revenue constraints of the 1980s. While a growing body of literature has posited a link between democratization and economic policymaking, the theoretical basis of these arguments has been murky. Some argue that leaders in new democracies, eager to reinforce their legitimacy among civil society, are prone to pursue short-term macroeconomic expansion at the expense of long-term equilibrium (Haggard and Kaufman 1989: 59-60-1 Smith 1989: 156; Seligson and Muller 1987: 323). This "legitimating payoffs" hypothesis assumes that legitimacy-building is highly contingent upon material rewards to voters but leaves unexplained why such payoffs are relevant only within new democracies. Others argue that weak party systems and electoral volatility in new democracies leave policymakers little institutional "insulation" from social pressures (Kaufman and Stallings 1991: 26-27). Yet the focus on "policy insulation" rests upon an unspecified link between sustained electoral competition, governing majorities and policy outcomes. Meanwhile, Remmer (1990) offers some empirical evidence that suggests no connection between new democracies and macroeconomic outcomes. This study offers a theoretical framework and empirical evidence that link democratization and public finance via the notion of "competitive externalities" in the policymaking process. The argument is that democratization diminishes the short-term capacity to restrain public expenditures because new players are entering the policymaking arena at the same time as the norms and rules structuring their interactions are being reordered. Thus, democratization creates an externality in which policymakers are likely to disregard the collective impact of their respective expenditures. However, this effect is short-term because sustained competition and/or crises induce both hierarchical and cooperative coordination mechanisms. An econometric model of monetary financing of expenditures for ten Latin American countries shows that recent democratization is strongly associated With increased reliance upon this inflationary method of public finance. The theoretical framework and empirical results presented here expand upon notions of coordination problems within democratic systems by showing that decentralized decision-making is less important for policy outcomes than the context in which pluralistic policymaking occurs. …