decentralization and inflation in … · based on different theoretical premises, ... at a basic...

DECENTRALIZATION AND INFLATION IN DEVELOPED

AND DEVELOPING COUNTRIES

Do political and fiscal decentralization make it easier or harder tocontrol inflation? If high inflation reflects the time inconsistencyproblem, devolving power might restrict the center’s ability torenege on promises of monetary stability, thus reducing inflation. Ifinflation results from failure to coordinate on a stabilization plan,devolving power to numerous regional governments should makematters worse. Other factors thought to affect inflation—opennessto imports, political instability, etc.—may also correlate withdecentralization. This paper examines average annual inflationrates in a panel of 87 countries in the 1970s and 80s. It finds asharp divergence between developed countries—wheredecentralization correlates with lower inflation—and developingcountries—where it correlates with higher inflation. Empiricalanalysis suggests that decentralization helps preserve central bankindependence in OECD countries, while in non-OECD countries itincreases pressures on the government to overspend and get thecentral bank to monetize the deficit. In developing countries,decentralization of tax authority also seems to reduce imports, thusreducing the political cost to central government of inflation-induced currency depreciation.

Daniel TreismanAssistant Professor

Department of Political ScienceUniversity of California, Los Angeles

4289 Bunche HallLos Angeles, CA [email protected]

June 1998

Draft. Comments Welcome.

I. INTRODUCTION

Do political and fiscal decentralization make it easier or more difficult to control

inflation? A policymaker faced with this question might be excused for feeling some confusion.

While the pros and cons of decentralization are vigorously debated in countries around the world,

little is known conclusively about its relationship to stable prices. Opposite arguments exist,

based on different theoretical premises, supported by different empirical examples, and implying

opposite predictions.1

Some view inflation as essentially the result of a commitment problem. Policymakers

have an incentive to renege on promises of stable monetary growth because unanticipated

inflation has a positive real effect. Only if the political authorities are able to restrict their future

ability to renege will their promises be credible and a low inflation equilibrium achievable

(Kydland and Prescott 1977; Barro and Gordon 1983). Devolution of control over spending or

monetary policy to lower levels of government is one way to restrict the center’s ability to

renege. Under this logic, then, decentralization should reduce inflation.

1 Decentralization is defined by different scholars in somewhat different ways. By “fiscal decentralization”, I meanthe allocation of greater revenue-raising authority and/or expenditure responsibilities to subnational levels ofgovernment. I use “political decentralization” broadly to mean increases in the scope of political decision-making onwhich subnational governments or legislatures have autonomous authority.

DECENTRALIZATION AND INFLATION\2

Another argument attributes inflation to difficulties of coordination. When many actors

must agree on a plan for macroeconomic stabilization, collective action problems or asymmetric

information can lead to delays (Alesina and Drazen 1991). Stable prices are a public good, which

will tend to be underprovided when the number of potential beneficiaries who must agree to

contribute is large. Under this logic, dividing up authority between different levels of government

is likely to increase coordination costs and thus complicate the task of reducing inflation. The

more governments there are involved in negotiating how to apportion the costs of stabilization,

the higher—or longer lasting—the inflation is likely to be.

Examples that support the commitment view are easy to think of. In Germany and

Switzerland, some scholars have argued, federal institutions and strong subnational governments

have helped to discipline central economic policymakers and preserve central bank independence

(Lohmann 1998). But examples that make the opposite case are also numerous. In various Latin

American countries, political decentralization seems to have increased pressures for higher

public spending, fostered excessive public sector borrowing, and weakened the one actor with an

encompassing interest in price stability (Campbell et al. 1991). The hyperinflationary last years

of Yugoslavia serve as a particularly trenchant manifestation of the “dangers of decentralization”

(Prud’homme 1995). As control over the central bank and monetary policy slipped progressively

from a weakening federal government to the more assertive republics, this exacerbated strains

upon the country’s territorial cohesion (Treisman 1996).

Whatever its impact on inflation, decentralization has many other persuasive arguments

to recommend it. Politically, strong local governments are thought to encourage participation,

foster civic spirit, and provide a check against central tyranny (Tocqueville 1988, Madison 1961,

Weingast 1997). Economically, competition between subnational jurisdictions may lead to more


efficient public good provision while decentralized decisionmaking can satisfy regionally diverse

demands more precisely (Tiebout 1956, Oates 1972). Motivated by such considerations, regimes

from post-apartheid South Africa and post-authoritarian Latin America to post-communist

Eastern Europe have placed decentralization high on their political agenda. Decentralization

projects are “in the air” everywhere (Bird 1993)—and have been adopted in about 85 percent of

developing countries with populations over 5 million, by one scholar’s count (Dillinger 1994). In

the developed world, European countries are preparing to replace national control over monetary

policy with a loose confederal arrangement under an independent central bank.

So it is important to understand if decentralization, besides the better understood benefits,

can also have economic or political costs. If the consequences of decentralization for inflation are

different in different settings, we need to know why and whether the negative ones can be

avoided. This article examines this question empirically. It analyses the relationship between

political and fiscal decentralization and average inflation rates in a broad sample of countries in

the 1970s and 1980s. It finds that among developed countries decentralized political institutions

did enhance the credibility of central commitments to monetary stability. Among developing

countries the logic was quite different: coordination and other problems associated with

decentralization eroded any commitment advantage, weakening the independence of monetary

authorities, and prompting inflationary deficit spending. The result was higher inflation than in

more centralized developing states.

The next section examines theoretical arguments about the relationship between

decentralization and inflation. Section III presents a statistical analysis of these questions. Section

IV elaborates on the results’ implications and concludes.

II. COMMITMENT, COORDINATION AND THE COSTS OF INFLATION


At a basic level, most economists and political scientists assume a common model of the

causes of inflation. Inflation is a monetary phenomenon that results from disproportionate

increases in the money supply. Such increases occur when monetary authorities yield to pressures

to finance levels of public spending beyond the budget’s means. Given this, a country’s inflation

rate will be higher when either (a) the capacity of monetary authorities to resist political pressures

is lower, or (b) the pressures themselves are stronger. The pressures on monetary authorities to

inflate will, in turn, be stronger if either (c) the cost to politically influential actors of

coordinating their spending demands is high, or (d) the marginal cost of inflation to government

and politically influential groups is lower.

The first possibility motivates the literature on time inconsistency and credible

commitment. All governments will press for a suboptimally high level of monetary growth,

regardless of the cost of inflation, for the simple reason that to do so is the government’s

dominant strategy (Kydland and Prescott 1977; Barro and Gordon 1983). Only some institutional

mechanism that shields the monetary authorities from government pressure can achieve price

stability. The most frequently discussed institutional solution is independence of the central bank;

and central bank independence has been found empirically to correlate with lower inflation

rates.2

But given the degree of central bank independence, the pressures to inflate that the central

bank must withstand may vary considerably. A second view of inflation focuses on factors that

might cause these pressures to be stronger. The demand for inflationary monetary policy will be

2 See Alesina and Summers (1993), Cukierman (1992), Cukierman, Webb and Neyapti (1991). Cukierman finds thatin developed countries legal independence of the central bank is associated with lower inflation. In developingcountries, legal independence appears to differ from actual independence, as proxied by a low frequency of turnoverof the bank’s governor. It is the latter that significantly correlates with inflation.


greater, it is argued, if political power is divided up between a number of actors. Inflation results

in this view, not from a lack of commitment but from failures of coordination. Stable prices are a

public good, while the high levels of public spending that cause inflation provide concentrated

benefits to particular constituencies. Public goods tend to be underprovided if the number of

consumers is large and no single actor has an “encompassing interest” in providing them (Olson

1965). A suboptimally high rate of inflation may result from a failure of the concentrated

beneficiaries of public spending to agree on how to divide up the costs of austerity. In this

perspective, difficulties of coordination lead to delays in enacting stabilization programs (Alesina

and Drazen 1991), to stagflation (Olson 1982), and to universalistic spending patterns (Weingast,

Shepsle, and Johnsen 1981).

The coordination view of inflation informs a variety of recent work on the political

economy of fiscal and monetary policy. Among OECD countries, those with more fragmented

party systems and those with coalition governments tend empirically to have higher public sector

budget deficits (Roubini and Sachs 1989; Grilli, Masciandaro, and Tabellini 1991). By the same

logic, presidential systems, in which power is more sharply divided between executive and

legislature, might be expected to have greater problems of economic management than

parliamentary systems, where the two branches of power are fused at the top.3 The more “veto-

players” simultaneously control government policy, the harder will it be for the government to

move away from a path of high debt or inflationary finance (Tsebelis 1995, Franzese 1998).4 By

3 Various scholars have debated the relative efficiency and stability of parliamentary and presidential rule. For a briefreview with attention to the economic implications, see Haggard and Kaufmann (1995, pp.345-50).

4 However, countries already on a path of macroeconomic stability may be less likely to depart from it.


the Alesina and Drazen logic, ethnic divisions might also complicate coordination on an austerity

plan, and some have suggested that ethnic divisions inhibit financial system development and

have other undesirable economic consequences (Easterly and Levine 1997).

Coordination problems are not the only reason political actors might end up pressing for

inflationary rates of monetary growth. Even governments with highly coordinated institutions

and homogeneous societies may do so if the potential gains to them from inflation outweigh the

potential costs. What might determine the relative costs and benefits of inflation to governments?

First, in a repeated game setting governments may be able to partially overcome the time

inconsistency problem by investing in reputation (Barro and Gordon 1983). Thus, acts of

government that clearly link its reputation to pledges of monetary stability may increase the cost

of reneging. A common mechanism for tying the government’s repuation to its monetary policy

is for it to adopt a pegged exchange rate: if the monetary authorities inflate too far, the

government will be forced to devalue the currency in a very public reversal of course (see, for

instance, Giavazzi and Pagano 1988). Ghosh et al. have found empirical evidence that countries

with pegged exchange rates tend to have lower inflation than those with floating rates (Ghosh et

al. 1995). Second, assuming that inflation eventually leads to depreciation regardless of the

exchange rate system officially declared, the costs of inflation will be higher in countries that are

more dependent on imports, since depreciation will increase import prices (Romer 1993). Third,

the inflation tax—though distortionary—is relatively more attractive to governments that are

unable to collect sufficient revenues from conventional taxes. In countries with less developed

tax systems (in general, those with less developed economies), the marginal benefit to the

government of seignorage will be greater.5


Various political factors also affect the relative costs to government of inflation. Political

instability reduces the incentive for incumbent governments to sacrifice the short-run gains from

inflationary spending in order to invest in a reputation for monetary austerity. A number of

studies have found an empirical relationship between inflation and various measures of political

instability (Edwards and Tabellini 1991, Cukierman and Webb 1995, Cukierman, Edwards and

Tabellini 1992). Some scholars have argued that authoritarian regimes may find it less costly

than democratic governments to repress group pressures for public spending and implement

unpopular stabilization programs, or that the process of democratization is associated with

macroeconomic instability, though the empirical evidence for this is unclear (Haggard and

Kaufmann 1992, Dornbusch 1992, p.15, Geddes 1995). Posen argues that the actual

independence of central banks—and the tight monetary policy such independence tends to

support—depend on the relative political influence of the financial sector, usually the most

adamant opponent of inflation (Posen 1995).

Given these various arguments about the causes of inflation, what difference might

political or fiscal decentralization be expected to make? This depends on whether cross-national

variation in inflation rates results from differences in the credibility of monetary authorities’

commitments, in the difficulties of coordination on a stabilization plan, or in other costs and

benefits of inflation to the relevant governments. If inflation is caused by insufficient

independence of the central bank, then the subdivision of power that decentralization entails may

help. The autonomy of organizations can sometimes be enhanced by dividing authority over them

between competing actors with conflicting interests. The ability of any one of them to dictate

policy may then be checked by the others (Persson et al 1997; Moser 1997). Dividing power over

5 See, for instance Campillo and Miron (1997, p.336), and Barro and Gordon (1983).


the central bank between central and subnational governments might, by this logic, strengthen the

bank’s ability to resist political pressures and increase the credibility of its monetary policy.

Lohmann argues that exactly such a decentralization of power helps to explain Germany’s

success in avoiding high inflation in the post-war period (Lohmann 1998). The independence of

the Bundesbank was enhanced by the way it was embedded into the country’s federal institutions.

A majority of members of the bank’s council were appointed by the Land governments. Central

and Land elections were staggered, and the parties dominating governments at the two levels

often differed. The Lander were also represented in the Bundesrat, the upper house of parliament,

which could veto changes to central banking legislation. These factors served to check attempts

by central governments to inflate the economy in order to buy popularity during electoral

campaigns. Germany’s inflation in this period was among the lowest in Europe. Wildasin also

argues, along these lines, that in South Africa “strengthening provincial and local institutions

may create a credible institutional constraint on the exercise of the redistributive powers of the

public sector...” (Wildasin 1996, p.324).

If, however, inflation results from the difficulty of coordinating on an austerity plan, the

subdivision of power that decentralization entails should make this worse. The central

government—the loser from decentralization—is the only actor with an encompassing interest in

price stability. Subnational governments have far less reason for restraint, since the costs of

inflationary spending are spread across all regions, while the benefits can be targeted to their

constituents. Forcing the central government to share power with partly autonomous subnational

governments means, thus, giving actors with inflationary preferences a stronger say.6


Decentralization may also affect the relative costs and benefits to the central government

of inflation via some of the pathways discussed already. As noted, countries that are more

dependent on imports will suffer greater losses from inflation, since this will sooner or later lead

to costly depreciation. For two reasons, more decentralized countries are likely to have lower

levels of imports. The first reason is coincidental—decentralized countries tend to be larger (the

demand for decentralization in Russia is obviously far greater than in Singapore), and larger

countries tend to have lower levels of import penetration. The second reason is causal—when the

power to tax is divided up between more than one level of government, competition between the

levels to extract resources before the other level gets to them is likely to lead to “overgrazing”,

and in particular excessive taxation of goods such as imports whose producers do not have

domestic political rights. Tax rates on such defenseless targets may be ratcheted up beyond the

optimal level, even if this drives wouldbe importers away.7 In this way, fiscal decentralization

may actually cause imports to be lower.

Two other coincidental correlations are possible. If, as appears to be the case, more

decentralized states tend also to be more economically developed, then their more effective tax

systems would reduce governments’ temptation to resort to the inflation tax. On the other hand,

if more decentralized states tend to be democracies (authoritarian states may be less willing to

tolerate local or regional sources of autonomous power), this might render them coincidentally

more vulnerable to popular pressures to overspend.8

6 In the words of the World Bank’s 1997 World Development Report: “Because decentralization increases thenumber of actors and of budgetary accounts, countries facing serious budgetary and inflationary pressures will beconfronted with additional challenges and risks...” (World Bank 1997, p.124.)

7 See Shleifer and Vishny (1993) for a similar argument about the inefficiencies of competition between levels indecentralized bureaucracies.

8 If one accepts the argument that democracies are less effective at imposing austerity.


Political decentralization might be associated with greater political instability if the

division of power vertically creates incentives for conflict between levels. At the same time,

political decentralization may correlate with ethnic division, since devolution of power or

spending rights is often suggested as a means of containing and alleviating ethnic or regional

conflicts. Greater ethnic division or political instability within more decentralized states might,

for the reasons already discussed, lead to higher inflation. Third, political decentralization might

encourage the growth of regionally concentrated parties, leading to greater fragmentation of the

party system, which in turn is thought to reduce fiscal and monetary discipline. By contrast, there

do not seem to be compelling reasons why decentralized states would be more or less likely to

have pegged exchange rates, strong financial sectors9, or parliamentary rather than presidential

systems. (The indicators I use for these three variables in the analysis that follows were not

strongly correlated with any measure I had of political or fiscal decentralization.)

The commitment, coordination, and relative costs of inflation arguments all appear to be

based on valid logic. Their implications, however, conflict. The more political power is divided

up between levels of government, the weaker will be governments’ aggregate capacity to force

the monetary authorities to inflate (the enhanced commitment argument). Yet, the more divided

is political power, the greater will be governments’ motivation to press for inflationary transfers

(the coordination problem). Decentralization—if associated with economic development and

more effective tax bureaucracies—should correlate with lower inflation. If associated with lower

9 Posen (1995, p.260) does argue that federalism will be associated with more politically powerful financial sectors,but the reasons he gives—that in a decentralized system “private interest groups have more avenues of influenceupon policy” and that “federalism denies access to national issues expcept to those groups—such as the financialsector—that can offer a unified front across regions”—do not seem to me convincing. Other private interest groupsmay offset the financial sector’s lobbying both at subnational and national levels. Organized labor is unified acrossregions even in some federal countries.


imports, greater ethnic division, political instability, party fragmentation, or democracy,

decentralization might be expected to coincide with higher inflation.

When theories conflict, the most useful way forward is often empirical. Should

policymakers in inflation-prone countries decentralize political powers and fiscal responsibilities

in the hope of insulating monetary policy? Or should they centralize power in order to avoid

difficulties coordinating on stabilization plans? To answer these questions, we need to know

more about which logic predominates in given settings. I turn now to an investigation of the

actual patterns of inflation in a broad selection of countries in the 1970s and 80s.

III. DECENTRALIZATION AND INFLATION: EMPIRICAL ANALYSIS

A. Decentralization and Inflation

Which of the various possible relationships between decentralization and inflation holds

in practice? I analysed average inflation rates of the CPI in a panel of 87 countries

for four five-year periods in the 1970s and 1980s.10 The sample includes all countries for

10 The dependent variable is the log of average inflation over the five-year period, taken from the IMF’sInternational Financial Statistics Yearbooks. The log is used, as in numerous other studies, to avoid giving excessiveweight to observations of extremely high inflation. Hyperinflation is widely thought to be generated by a non-linearprocess.


which data were available for the main independent variables. The estimation strategy is Least

Squares with Dummy Variables, using White heteroskedasticity-corrected standard errors.11 In

each regression, I include three dummy variables for the time period (1975-79, 1980-84, 1985-

89; the excluded category is 1970-74) and five dummy variables for region (Asia, Latin America

and the Caribbean, Subsaharan Africa, the Middle East and North Africa, Eastern Europe and the

former Soviet Union; the excluded category is Western Europe and North America). I also

experimented using different regional groupings to check that this did not affect the main results.

For political and fiscal decentralization, I used three admittedly imperfect indicators.

First, I used whether or not the state was officially classified as federal.12 Second, I used the share

of subnational governments in total government spending (compiled mostly from the IMF’s

International Financial Statistics Yearbooks, data taken as close to the midpoint of the five-year

period as possible.) Third, I used the share of subnational governments in total tax revenues.

These three variables are quite highly correlated in the country-years for which data were

available (the two fiscal variables with each other at .90, and both with federal status at .59).

Table 1 shows the results when log inflation is regressed in turn on federal status,

subnational spending share, and subnational tax share, for the full sample of country/periods, all

regressions including the already-mentioned regional and period dummy variables (the results for

which are not reported). None of the decentralization variables are even slightly significant.

Based on just this, it might seem that political or fiscal decentralization do not have much to do

with inflation.

11 For a discussion of this technique, see Stimson (1985). The fixed effects for which I control are not for individualcountries but for regions and time periods.

12 I used the classification of Elazar (1995), though since the data end in 1989 I do not count as federal eitherBelgium or Spain. They came to be considered by some scholars to be federal only in the 1990s.


Table 1: Decentralization and Inflation, All Countries(Dependent Variable is Log Average Annual Change in CPI for Five-Year Period)

(1) (2) (3)

Federal Status .08(.07)

Subnational .00Spending Share (.00)

Subnational .00Tax Share (.00)

Constant .80*** .67*** .73***(.05) (.11) (.09)

R2 .176 .208 .248

N 334 183 175Note: Estimation by Least Squares Dummy Variables; White-corrected standard errors inparentheses; all regressions also include dummy variables for Asia, Eastern Europe or formerUSSR, Middle East or North Africa, Subsaharan Africa, and Latin America or Caribbean (WesternEurope or North America is the excluded category), and dummy variables for 1975-79, 1980-84and 1985-89. * p < .10; ** p < .05; *** p < .01. For data sources, see appendix.

However, consider Table 2. Here I show results for the same regressions when run

separately on the OECD and the non-OECD countries. It turns out that all three measures of

decentralization are significantly related to the average inflation rate, but in opposite ways in the

developed and developing countries. The apparent lack of a relationship in Table 1 occurs

because the opposite effects among OECD and non-OECD countries roughly cancel each other

out. Among developed countries, federal status and fiscal decentralization are significantly

associated with lower inflation. But among developing countries, federal status and fiscal

decentralization are significantly associated with higher inflation.

Since the rest of the paper tries to make sense of this result, it is worth repeating that it

holds regardless of which of these three measures of political or fiscal decentralization is used.

Each is imperfect it its own way. Coverage for the fiscal variables is much poorer, and the data


may contain considerable measurement error. At the same time, states that call themselves

“federal” are not by any means equally politically decentralized. The fact that the same result

appears whichever of these indicators is used helps somewhat to enhance confidence in the

finding. In most of the analysis below, I use federal status as the primary decentralization

indicator, since it is available for a far larger number of cases than either of the fiscal variables.

But where relevant I also use the other indicators.

Table 2: Decentralization and Inflation, OECD and Non-OECD Countries(Dependent Variable is Log Average Annual Change in CPI for Five-Year Period)

-------------OECD----------- ---------Non-OECD--------(1) (2) (3) (4) (5) (6)

Federal Status -.26*** .27***(.05) (.10)

Subnational -.005*** .011***Spending Share (.002) (.004)

Subnational -.004** .012***Tax Share (.002) (.004)

Constant .99*** 1.08*** .99*** .42* 1.13*** .44*(.03) (.06) (.04) (.21) (.15) (.26)

R2 .317 .384 .355 .207 .260 .322

N 96 82 82 238 101 93Note: Estimation by Least Squares Dummy Variables; White-corrected standard errors in parentheses; all regressionsalso include dummy variables for Asia, Eastern Europe or former USSR, Middle East or North Africa, SubsaharanAfrica, and Latin America or Caribbean (Western Europe or North America is the excluded category), and dummyvariables for 1975-79, 1980-84 and 1985-89. * p < .10; ** p < .05; *** p < .01.

Running a regression for the full sample and including an interaction term for federal

status and GNP per capita, it is possible to estimate the level of development at which federal

status goes from being associated with higher inflation to being associated with lower inflation.

Since the different effects may be caused not by income per se but by some other correlated


factor, this should be interpreted with care; still, for purposes of illustration it is useful. It turns

out that the per capita GNP level at which federal status starts to be associated with lower rather

than higher inflation is around $7,000—about the level of Japan in 1978 or Greece in 1992 .13

Why are decentralized states more prone to inflation in the developing world but less

prone to inflation among richer countries? To try to answer this question, I proceed as follows. I

consider each of the possible mechanisms by which inflation might be related to decentralization

discussed in Section II. I consider first whether the variable in question is, as hypothesized,

correlated with decentralization in OECD and non-OECD countries. Then, I test whether the

variable is related to inflation in the way expected in the two sets of countries, in the process

replicating in this dataset the results of a number of previous empirical studies of the causes of

inflation. To explain why decentralization is associated with higher inflation in developing

countries but lower inflation in developed countries, I would need to find evidence that some

mechanisms are significant and work differently in the two subsets of cases. I examine for such

differences.

B. Correlates of Decentralization

Section II suggested that more decentralized states might have lower inflation if: (a)

decentralized states have more independent central banks, or (b) decentralized states tend to be

more economically developed, and more developed states are less tempted by inflationary

finance. It suggested, by contrast, that decentralized states might have higher inflation if the

pressures on central government to overspend are relatively greater in decentralized states. One

13 GNP per capita figures are converted to dollars by the World Bank’s Atlas method (World Development Report1997).


indirect measure of the strength of such pressures is whether central governments yield to them.

If the argument is valid, one might expect that more decentralized states would have

proportionally larger central government budget deficits.

Greater pressures for inflationary spending might occur if: (a) decentralized states tend to

have lower imports, which reduces the political cost of currency depreciation, (b)

decentralization occurs more often within democracies, and democratic governments are more

vulnerable to popular demands to overspend, (c) decentralization occurs more often in ethnically

divided states, and ethnic divisions increase spending pressures, (d) decentralization increases the

fragmentation of party systems, and more fragmented parties coordinate less succesfully on non-

inflationary aggregate spending levels, or (e) decentralization causes political instability, which

reduces the incentive for government restraint.

Taking each of these arguments separately, I examined whether the variable in question

was related to decentralization in the expected way in this dataset. In each case, I regressed an

indicator of the relevant concept on federal status along with the regional and period dummies. I

ran separate regressions for OECD and non-OECD cases. The estimated coefficients on the

federal status variable in these regressions are shown in the second column of Table 3, along with

the White heteroskedasticity-corrected standard errors.

To measure central bank independence, I used (1) Cukierman et al.’s index of central

bank legal independence and (2) their measure of the frequency of turnover of central bank

governors, in negative form, to measure practical independence.14 I tried both log and non-log

14 Cukierman, Webb, and Neyapti (1992). They found that central bank legal independence was related to (lower)inflation in the developed countries, but turnover of central bank governors was related (positively) to inflation in thedeveloping ones. Since the indices of central bank independence are calculated only by decade, I use the same valuesfor the two halves of each decade.


forms for the GNP per capita indicator of economic development. For democracy, I created a

variable measuring the total years out of five in the period that the country was rated a

“democracy” by Alvarez et al. (1996).15 For ethnic division, I tried three alternative indicators:

the proportion of the population not speaking the official language, the proportion not speaking

the most widely used language, and a measure of ethnolinguistic fractionalization used in various

previous studies.16 For party fragmentation, I used a measure developed by Tatu Vanhanen of the

proportion of the vote going to parties other than the one winning the largest vote in presidental

and/or parliamentary elections during the decade.17 Finally, I tried three alternative specifications

for political instability: civil war during the decade, war with an external power during the

decade, and the number of revolutions and coups during the decade (as in Barro 1991).18

Which of the hypothesized correlates of decentralization are actually correlated to it in

this dataset? Among the OECD countries, there is strong confirmation for the Lohmann

hypothesis: federal countries did tend to have far more independent central banks. Among

developing countries, however, the relationship was the opposite: federal states tended to have

central banks with less practical independence, at least as judged by how frequently their chief

15 Alvarez et al. define democracy as “a regime in which some governmental offices are filled as a consequence ofcontested elections”. They code regimes as democratic if the chief executive and legislature are both elected, there ismore than one party (both at the beginning and end of the current term of office), and the incumbents do notunconstitutionally close the legislature and rewrite the rules in their favor. Their rating is more comprehensive thanmost others available and correlates highly (at .85 or higher) with others compiled by Coppedge and Reinecke,Bollen, Gurr, and Gastil.

16 The first two are from Gunnemark (1991), and were used in Easterly and Levine (1997). The third is the AtlasNarodov Mira rating, previously used by Mauro (1995), Easterly and Levine (1997), and others.

17 I use Vanhanen’s measure of party competition, “COMP,” for 1970-79 for the first two five-year periods, and hismeasure for 1980 for the second two. See Vanhanen (1997).

18 All variables were taken from the dataset for Easterly and Levine (1997). Those for war and civil war werecompiled by Sivard (1993); I have subtracted the civil wars from the war variable to create a variable recording justwars with external powers. The coups and revolutions variables were compiled by Banks (1994).


executive position changed hands.19 Second, among both OECD and non-OECD countries, it

was true that greater decentralization tended to occur in the most developed economies, though

among non-OECD countries the relationship showed up only when per capita GNP was in log

form.20 More decentralized countries tended to yield more readily to pressures to spend and ran

proportionally larger central budget deficits in the developing world—though not in the

developed world. There was no clear difference between rich and poor countries when it came to

imports: federal states among both income groups tended to import less.

It was slightly harder to judge whether democracies were more likely to have

decentralized structures than authoritarian regimes. Since the indicator of democracy was not

continuous, least squares regression was inappropriate. I calculated the mean number of years out

of five that federal and non-federal states were rated “democratic” in the OECD and non-OECD

subsamples (not controlling in any way for period or region). In both sub-samples, federal

structures tended to occur in more democratic countries. The difference was moderately

significant for the OECD and marginally significant among non-OECD countries.

19 Lohmann, in fact, anticipates exactly this divergence of results in developed and developing countries (Lohmann1998, pp.445-6) She suggests that in developing countries where pressures on governments to spend and redistributeare greater, stronger regional governments may actually be associated with lower central bank independence.

20 There is also a highly significant relationship in the OECD sub-sample if either indicator of fiscal decentralizationis used.


Table 3: Possible Links Between Decentralization and InflationVariable Thought Likely

to Affect InflationIs the Variable Related to Decentralization?(Estimated coefficient from regression of var. on federal

status along with region and period dummies)

OECD non-OECDCentral Bank Independence Legal Independence (Cukierman et al. 1992)

Infrequency of Change of Governor (Cukierman et al. 1992)

+.22*** (.02) -11** (.04)

Economic Development GNP per capita

Log GNP per capita

+4,269*** +139 (979) (193)

+.60*** +.26** (.12) (.13)

Pressures on Central Govt. to Spend Central government budget surplus (% expenditures)

+1.33 -6.20** (1.96) (2.50)

Exposure to Imports Imports/GNP

-7.53*** -13.95*** (2.60) (3.63)

Democracy Years (out of 5) rated “democratic” by Alvarez et al. (Note: variable not continuous, so LS estimation not appropriate; means for federal and non-federal states provided instead. Indep. sample t- tests (variance unequal for OECD, equal for non- OECD) found difference significant at p < .05 for OECD and at p < .10 for non-OECD.)

Fed: 5.0 1.8

Non-Fed: 4.8 1.2

Ethnic Division Proportion not speaking official language

Proportion not speaking most common lang.

Ethnolinguistic fractionalization index

-.18 +11.74*** (1.10) (3.31) +5.96* +10.72*** (3.11) (2.85) +20.40*** +9.77*** (5.58) (3.44)

Party Fragmentation Percent of vote not won by most successful party in recent elections

+1.70 +9.46** (2.60) (3.93)

Political Instability A civil war during the decade

War with external power during decade

Revolutions and coups during decade

Only cases: Turkey +.38in 70s and 80s; it (.42)a

was not a federation.No cases +1.39* (.75)a

Only cases: Turkey ? b

during 80s Notes: for data sources, see appendix. a estimated by logistic regression, since variable dichotomous. b attempted to estimate with ordered logit, since variable polychotomous; convergence not achieved. OLS regression highly insignificant. * p < .10; ** p < .05; *** p < .01.


Federal states clearly tended to be more ethnically divided than their non-federal

counterparts in the developing world, and were probably so among developed countries too,

though this result was only significant with two of the three alternative indicators. Developing

countries with federal structure tended also to have greater party fragmentation—but this was not

true for developed countries. Finally, the relationship between decentralization and political

instability was difficult to judge with the data available. OECD countries very rarely underwent

major domestic upheavals in the 1970s and 80s (in fact, the only cases of civil war or revolutions

or coups recorded in the Easterly and Levine dataset, taken from Banks (1994), were in Turkey).

While major disturbances were more frequent in the developing world, the only significant result

I could find using logit and ordered logit regressions was a marginally significant relationship

between federal structure and war with an external power. On this link, it seems necessary to

remain agnostic.

C. Determinants of Inflation

To test which of the potentially relevant correlates of decentralization might explain the

relationship with inflation, I ran several multiple regressions for the OECD and non-OECD

subsets separately. These are shown in Table 4. The first regressions (columns (1) and (4))

attempted to judge whether the cross-country variation in inflation rates could be linked to either

the independence of the central bank, the fiscal profligacy of the central government, or both.21

Log inflation is regressed on Cukierman et al.’s measure of central bank independence—legal

independence for the OECD countries, and “practical” independence for the non-OECD

21 This is at best an imperfect way of proceeding since the government’s fiscal profligacy would be influenced by itsexpectations of how the central bank would react; as a first step, however, the test is useful.


sample—along with the size of the central government budget deficit as a percentage of

expenditures half-way through the five-year period.

As Table 4 shows, I was able to replicate Cukierman and colleagues’ results on central

bank independence in this dataset (Cukierman, Webb and Neyapti 1992). Central bank

independence was significantly linked to lower inflation in both OECD and non-OECD

countries. Just as Cukierman found, in OECD countries it was the legal independence of the

monetary authorities that correlated most strongly with lower inflation, while among non-OECD

countries, it was the practical independence (as measured by the infrequency of turnover of the

bank’s chief executive officer.) The regressions also suggest the intuitive conclusion that among

both developed and developing countries larger central budget deficits were associated with

higher inflation.22

But what determines how large a budget deficit the central government will decide to run

(given its expectations about the degree to which the central bank will accommodate it with

money creation)? In the subsequent regressions, I replace the government deficit variable with its

hypothesized determinants. As in Section II, I divide possible influences into two groups: first,

factors that affect the costs and benefits to the government of inflationary spending, and second,

factors that explain the relative strength of societal and political pressures on the government to

22 The accuracy and comparability of published figures on the size of central budget deficits are at the very leastsubject to question, especially in developing countries (see, for instance, Dornbusch 1992, p.18). Thus, it issomewhat surprising and encouraging to find the expected relationship between deficits and inflation clearlysupported.


Table 4: Determinants of Inflation------------OECD---------- ---------non-OECD------(1) (2) (3) (4) (5) (6)

Central Bank Independence Legal Independence -.51*** -.44** -.66***

(.17) (.17) (.22) Infrequency of -.88*** -.58** -.52** Change of Governor (.27) (.28) (.24)

Government Profligacy Net Central Government -.011*** -.010*** Budget Surplus (% Exp.) (.003) (.003)

Costs and Benefitsto Govt of Inflation Developed Tax -.31*** -.38*** -.06 .04 System (log GNP p.cap.) (.05) (.07) (.06) (.08)

Pegged Exchange .00 .07 -.14** -.17** Rate System as of yr. one (.03) (.05) (.07) (.07)

Political Instability Revolutions and .10 .06 .20** .17* Coups in Decade (.09) (.15) (.09) (.10)

Recession or Boom GDP Growth -.00 -.03* -.02** -.02*

(.01) (.02) (.01) (.01)Pressures on Government Democracy -.03 .04

(.05) (.03) Parliamentary -.01 -.02 System (.01) (.04)

Ethnolinguistic Fractionalization .002 -.00(.002) (.00)

Party Fragmentation -.001 -.002(.004) (.003)

Strong Financial .004 -.002 Sector (Services/GDP) (.007) (.006)

Imports/GNP -.007** -.006***(.003) (.002)

Constant 1.09*** 3.49*** 4.18*** .14 1.42*** 1.67***(.08) (.42) (.59) (.24) (.47) (.53)

R2 .3372 .6727 .7635 .3313 .3923 .5085

N 79 63 58 143 127 110Note: Estimation by Least Squares Dummy Variables; White-corrected standard errors in parentheses; all regressionsalso include dummy variables for Asia, Eastern Europe or former USSR, Middle East or North Africa, SubsaharanAfrica, and Latin America or Caribbean (Western Europe or North America is the excluded category), and dummyvariables for 1975-79, 1980-84 and 1985-89. * p < .10; ** p < .05; *** p < .01. Sources: see appendix.


engage in inflationary spending.23 The relative costs of inflationary spending to the government

are increased if it has commited its credibility to maintaining a pegged exchange rate; they are

decreased by political instability (which makes large, fast gains more attractive relative to

investment in reputation) and by low economic development (which reduces alternatives to

raising revenue by the inflation tax.) In addition, I control for the rate of GDP growth in the year

in question, since a tax-smoothing government would prefer to run deficits during a recession

and surpluses during a boom (Barro 1979). I introduce these factors into the regressions in

columns (2) and (5). The strength of pressures on government for inflationary spending might be

increased by democratic institutions, ethnic divisions, a fragmented party system, or a

presidential rather than parliamentary system (in which the executive is less likely to be able to

count on support from the dominant party in the legislature). They might be expected to be

decreased by a strong financial sector or a high dependence of the population on imports (the

prices of which would be forced up by any currency depreciation.) I include indicators of these

factors as well in the regressions in columns (3) and (6).

The regressions in columns 2-3 and 5-6 replicate the findings of several other studies of

the causes of inflation. Ghosh et al. found that countries with pegged exchange rates tended to

have lower inflation than those with floating rates.24 I found evidence for this among the

developing countries, though such commitment appeared less important among their developed

23 These categories are obviously porous. I use them to organize presentation of the results, rather than to establishany particular theoretical point.

24 Ghosh et al. (1995). The variable I construct from their annual ratings takes the value of 3 for a pegged exchangerate system, 2 for an “intermediate” system, and 1 for a floating system. I use the rating in the first year of the five-year period to reduce as far as possible the problem of endogeneity: inflation may influence the choice of exchangerate system as well as vice versa.


counterparts (where apparently even countries with floating rates could make their commitment

to monetary stability credible to investors). More politically unstable developing countries—as

judged by the frequency of coups or revolutions—did have higher inflation, as various other

scholars have found. Among the OECD countries, however, the only one to experience either

revolution, coup or civil war during these years was Turkey. Though it had unenviably high

inflation in most periods, it was not clear that this owed more to political instability than to low

income or other factors. Both for OECD and non-OECD sub-samples, I tried all three alternative

indicators for political instability; the number of revolutions or coups was more significant than

civil war or external war for both groups. In both rich and poor countries, there was some weak

evidence of attempts at tax-smoothing: where growth was low, inflation tended to be higher.

Finally, the regressions replicate Romer’s finding that greater exposure to imports correlates with

lower inflation for both the OECD and non-OECD subsets.

I was not able to find clear evidence in these controlled regressions that inflation rates

differed in democratic and authoritarian regimes, parliamentary and presidential systems,

ethnically divided or homogeneous countries, or those with more or less fragmented party

systems.25 As always, the lack of positive results may indicate flawed indicators, inadequate data,

high correlations between the independent variables, or an insufficient number of cases, and so

the negative findings should be interpreted cautiously.26 In an attempt to control for Posen’s

argument that countries where the financial sector is politically strong will have lower inflation, I

included a measure of the service sector’s share in GDP—an admittedly imprecise indicator. This

was not significant; but the result clearly should not be taken as a valid test of the Posen

25I tried the three alternative measures of ethnic division already mentioned—Gunnemark’s measures of theproportion not speaking the official language and not speaking the most common language, and the index of


hypothesis given how far removed the indicator (service sector share) is from the concept in

question (financial sector political power).27

Putting together the results of Tables 3 and 4, what can one infer about the different

inflation dynamics in developed and developing decentralized states? Inferences can only be

tentative for various reasons, not least because of the possible endogeneity of several variables in

the regressions. But they provide an interesting set of conjectures for further testing.

The relationships discovered in Tables 3 and 4 cast doubt on some of the potential

explanations advanced in Section II. Political instability does correlate with higher inflation

among developing countries, but there was no clear evidence in this dataset that more

decentralized countries tended to have greater political instability. (The only indicator of

ethnolinguistic fractionalization. None of these was significant in the multiple regressions, though some weresignificant in uncontrolled regressions. I present results here for ethnolinguistic fractionalization, which was the mosthighly correlated with federal structure. The variable classifying regimes as parliamentary systems is taken fromAlvarez et al. (1996). They code as parliamentary those regimes in which “governments must enjoy the confidence ofthe legislature”. The alternative classifications are “presidential” and “mixed”.

26 Among the OECD countries, several of the independent variables were correlated at higher than .4: log GNP percapita with GDP growth at -.45, with party fragmentation at .49, and with service sector share at .57; ethnolinguisticfractionalization correlated with pegged exchange rate system at -.47 and with service sector share at .44; partyfragmentation correlated with revolutions and coups at -.76 and with service sector share at .42. Among non-OECDcountries, log GNP per capita correlated with ethnolinguistic fractionalization at -.61 and with service sector share at.66; democracy correlated with parliamentary system at .50 and with party system fragmentation at .63;parliamentary system correlated with party system fragmentation at .48; and ethnolinguistic fractionalizationcorrelated with service sector share at -.50. The latter results suggest two syndromes of effects: among non-OECDcountries (a) those with greater ethnic divisions tend to have lower GNP per capita, and a high share of services inGDP is an attribute of more advanced economic development; (b) the measures of democracy, parliamentary system,and party competition are measuring overlapping phenomena. I tried running regressions as in column (6), butincluding only one of the three variables in (a) at a time (ie, log GNP per capita, service sector share orethnolinguistic fractionalization. Even with the other correlated variables excluded none of these was even slightlysignificant. I also tried running regressions as in column (6) including only one of the three variables in (b) at a time(ie, democracy, parliamentary system, or party fragmentation). Again none of these was even slightly significant.

27 Posen (1995) constucts an indicator of the strength of “financial opposition to inflation” based on: the extent ofuniversal banking, the independence of the banking sector from central bank regulation, whether the country isfederal, and the degree of party fractionalization in parliament. I did not use this because it was available for only 32countries and because the arguments linking the elements of the index to financial sector opposition to inflationseemed somewhat tenuous; in any case, some of them might affect inflation in many ways other than via their effecton the financial sector’s opposition to price rises. The choice to include service sector share as an alternativeindicator of financial sector strength is also very weak. Further work gathering data is clearly needed here.


instability that did seem to be weakly related to decentralization—external war—was highly

insignificant in regressions of log inflation.) Though decentralization may tend to occur

somewhat more often among democratic states, no clear relationship between democracy and

inflation emerged. Among developing countries, federal states had both more ethnically divided

populations and more fragmented party systems; but neither of these traits was significantly

related to inflation.

Four arguments, however, were supported. First, central bank independence—legal for

the developed countries, practical for the developing ones—did appear to reduce inflation. But

central bank independence bore a different relation to decentralization in the developed and

developing worlds. Among OECD countries, political decentralization enhanced central bank

independence, helping to explain the low inflation there enjoyed by federal states. But in non-

OECD countries, decentralization was actually associated with less practical independence for

central bankers, apparently helping to boost inflation. Whereas in Germany or Switzerland the

balanced competition of regional interests may help to insulate central monetary authorities, in

countries like Brazil or Russia the unbalanced competition of regions to extract central aid seems

more likely to undermine whatever autonomy central bankers were supposed to have.

The greater impact of such spending pressures in federal developing countries is the

second key finding of the regressions. In the developing world—though not in the OECD—

federal states tended to run significantly larger central government budget deficits.28 Such

deficits

28 Among OECD countries, if a system of regional dummies is used that distinguishes between North America andWestern Europe federal status actually correlates significantly with smaller budget deficits.


were inflationary in both rich and poor countries. Governments apparently ended up pressuring

the central banks to monetize their deficits, in the process eroding central bank independence.

Whereas in developed countries, federal structure enhanced central bank independence and left

central government deficits unchanged, in the developing world decentralized political

institutions led to higher central deficits and central bankers who, whatever the laws said, were

less politically independent in practice.

A third finding relates primarily to the OECD countries. Federal states tended to be

among the most economically advanced, both within OECD and non-OECD subsets. At the same

time, among the OECD but not the non-OECD countries, more developed countries tended to

have lower inflation. Thus, among OECD countries, the federal ones may have had lower

inflation in part because they happened to be more economically developed—and therefore had

more effective tax agencies or some other revenue-raising advantage of modernity. Among

developing countries, higher levels of economic development did not help to reduce inflation—

and so did not confer an anti-inflationary advantage upon federal states.

Finally, federal states in both rich and poor parts of the world tend to import less. And

lower exposure to imports correlates with higher inflation. This helps to explain why federal

states in the developing world might have higher inflation. But it makes the low inflation of

decentralized states in the OECD more surprising. The relatively low share of goods and services

imported by the US or Germany reduces the discipline on public spending that fear of

depreciation usually provides. It is thanks, therefore, to a particularly strong effect of greater

central bank independence and more advanced economic development that these countries

manage nevertheless to achieve such low inflation rates. (Both the coefficients on log GNP per

capita and central bank independence increase in size in the OECD regressions in Table 4 when


imports are added, suggesting that the former effects are even stronger than could be inferred

from regressions not controlling for imports.)

In short, federal states in the developed world have lower inflation, despite lower

discipline from imports, because they tend to have more independent central banks and to be

more economically developed. Federal states in the developing world, by contrast, have higher

inflation because: (a) they import less and therefore fear depreciation less, (b) their central

governments tend to yield more than those of centralized states to demands for inflationary

deficit spending, and—probably because of this, (c) they tend in practice to have less

independent central banks. Adding the central bank independence and economic development

variables to a regression for OECD countries of log inflation on federal status along with the

usual dummies reduces the coefficient on federal status from -.26 to -.02, and deprives it of all

significance. This enhances confidence that it is in fact these two correlates of decentralization

that account for its anti-inflationary results. Similarly, adding the import share, central bank

independence, and central government deficit variables to the same regression for non-OECD

countries reduces the coefficient on federal status from .27 to -.01. It does appear to be these

factors that explain why federal developing states suffer from higher inflation.

To know what policy implications to draw from the imports result, we need to know why

federal states tend to import less. Two possibilities were suggested in Section II: decentralized

states may import less because they tend to be larger, or because decentralization of tax authority

leads to “overgrazing” by different levels of government on the relatively vulnerable target of

foreign importers. Space here does not permit an elaborate analysis. However, I tried regressing

the share of imports in GNP on indicators of both hypotheses along with the usual regional and

period dummies. For the size of the country, I tried three specifications to test for different


functional forms of a relationship: the country’s area, area in log form, and area along with area

squared. For the degree of tax decentralization, I used the share of subnational governments in

total taxes collected. Both of these factors turned out to be significant when included together.

Larger countries imported less. But controlling for the country’s size (in any of the three

functional forms), countries where subnational governments received a larger share of total tax

revenue had significantly lower imports.29 The coefficients on the tax share ranged from about -

.13 to -.31, implying that devolving 10 percent of total tax revenue to subnational governments

was associated with a fall in imports of somewhere between 1.3 and 3.1 percent of GNP. Thus,

some of the higher inflation in decentralized developing countries probably results from the

devolution of tax authority rather than just from the larger size of countries that choose to

decentralize.

IV. CONCLUSIONS AND DISCUSSION

A powerful tradition of work from Tiebout and Buchanan to Oates and Weingast has

described the economic benefits to be expected from political and fiscal decentralization. This

work informs current attempts to reform political and economic orders in the post-authoritarian

and post-communist world. Some, however, have questioned whether the logic that leads to

greater efficiency, more economically liberal governments, and higher growth applies fully in the

context of some developing countries, and whether as well as benefits there may at times be

“dangers of decentralization” (Prud’homme 1995, Davoodi and Zhou 1997).

An intriguing unanswered question has been whether political and fiscal decentralization

tend to increase inflation, reduce it, or leave it unaffected. To those who attribute high inflation

29 Significant at p < .05. The tax share also remained significant controlling for percapita GNP.


to the time inconsistency of optimal policies, decentralized institutions have seemed a way to

restrict central authorities from manipulating monetary policy, thus enhancing the credibility of

commitments to stable prices. To others, who trace inflation to the failure by the interested

parties to coordinate on a stabilization plan, devolving power to numerous subnational leaders

would seem to make the coordination problem even worse. The scope of damage that either the

commitment or coordination problem is likely to cause will itself depend on certain other

factors—the exchange rate system, dependence on imports, political instability, among others—

that determine just how painful to the government a bout of inflation is. Many of these factors are

also likely to be related to decentralization.

This paper sought empirical leverage on the question. It found a clear divergence in the

relationship between decentralization and inflation among developed and developing countries.

Among OECD countries, those with decentralized political and fiscal structures had significantly

lower average inflation rates in the 1970s and 1980s. But among non-OECD countries, more

politically and fiscally decentralized states suffered from higher average inflation rates. The

difference was apparent and significant whether an indicator of political decentralization (federal

structure), or indicators of fiscal decentralization (the subnational expenditure or tax shares) were

used.

Further empirical analysis suggested several reasons for this divergence. Some depended

on coincidence. Among OECD countries, the more economically developed ones tended both to

be more decentralized and to have lower inflation, presumably because development reduced

their need to rely on the inflation tax to raise revenue. Among the non-OECD countries, by

contrast, there was no link between development and lower inflation. This probably helps to

explain the divergence. Larger countries tend both to be decentralized and to have lower imports,


which reduces the political cost of inflation-induced currency depreciation. This explains in part

why decentralized developing countries might seem less averse to inflation—though it makes the

low inflation of the developed decentralized countries even more surprising.

However, some of the divergence in the relationship between decentralization and

inflation in richer and poorer countries appears anything but coincidental. Central bank

independence reduces inflation in countries at all levels of development, though in developing

countries one has to look beyond the legal statutes to judge actual independence. In OECD

countries, political decentralization seems to shield the central bank from political pressures to

inflate. This is not the case in developing countries. There, the main effect of decentralization

appears to be to increase the pressures on central government to interfere with central bank

independence and boost the money supply. Central governments in federal developing states ran

larger budget deficits. And larger area is apparently not the only reason why more decentralized

states in the developing world have lower imports. Even controlling for the country’s area, lower

imports are associated with greater tax decentralization. When different levels of government

have significant taxation authority, imports apparently represent an easy target for overgrazing.

By scaring off importers, such systems of decentralized taxation also reduce the domestic costs

of inflation.

Many questions remain unanswered, and will have to await future work. I was not able to

pinpoint the manner in which greater spending pressures on the central authorities emerge in

decentralized developing countries. It did not appear to be the greater ethnic division or party

fragmentation of federal developing states that led to the higher spending and larger central

budget deficits. While political instability does increase inflation, it was not clear that

decentralized states were any more unstable than their centralized counterparts. I interpret the


more frequent turnover of central bank governors in decentralized developing countries as

reflecting the impact of greater spending pressures on the government, which then invades the

central bank’s domain. But the pathways by which this happens merit further study. Another

question that deserves examination is why exactly the richer OECD countries have lower

inflation. Besides their more effective tax agencies, such countries may also tend to benefit from

more developed state securities markets, greater foreign investor confidence, or a larger monetary

base, which could reduce the inflation necessary to finance a given deficit. Finally, the kinds of

decentralization I am able to study with this data conflate decentralization to regions or states

with decentralization to localities. There is reason to believe that the dangers created by

strengthening intermediate units may be reduced or non-existent if authority is decentralized to

the municipal level. This, and many other questions, are susceptible to empirical analysis.

Decentralization has many advantages. But the findings of this paper do suggest at least

reason for caution in recommending it to developing countries that face major macreoconomic

stresses. In such cases, political decentralization may strengthen pressures on the central

government to spend more than it can finance and to pressure the central bank to monetize the

deficit. Decentralization of taxation authority may lead to onerous taxation of imports, reducing

the discipline on monetary policymakers. Where decentralization does occur, the analysis

suggested that the introduction of a pegged exchange rate system may limit the inflationary

effect. As Poland embarks on a plan to create stronger regional governments and South Africa

struggles to impose financial discipline on its new provinces, these issues are likely to become

increasingly important.


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DATA APPENDIX

Inflation data: average of annual inflation rates of CPI 1970-74, 1975-79, 1980-84, 1985-89.Unless otherwise indicated, from IMF, International Financial Statistics Yearbook, 1994,pp.106-9 (line 64). Notes: Poland 1971-4; Czechoslovakia 1971-4; Hungary 1973-4; China 1971-4; Kuwait 1973-4; Nicaragua 1973-4; Romania 1971, 73, 74; Uganda 1981-4; Jordan 1985, 87-9.

Subnational Expenditure Shares: unless otherwise noted, (state + local government totalexpenditures)/(consolidated central government total expenditures + state + local governmenttotal expenditures) 1972, 1977, 1982, 1987, from IMF, Government Finance Statistics Yearbooks1977, 78, 79. Subnational Tax Shares: unless otherwise noted, (state + local government totaltax revenues)/(consolidated central government total tax revenues + state + local governmenttotal tax revenues) 1972, 1977, 1982, 1987, from IMF, Government Finance Statistics Yearbooks1977, 78, 79, 86, 88, 90.NOTES ON EXPENDITURE AND TAX VARIABLES:For 1972 variables: Canada 1973, 1974 for expenditures. Netherlands 1973, 1974 forexpenditures. USA 1973. Austria 1973. France 1974. Korea 1974. Jordan 1974 (budgetarycentral govt). Chile 1974. Spain 1973, 1972 for expenditures. Italy 1973. Ecuador 1974 (taxvariables 1975). Mexico 1974 for tax.Brazil expenditure 1974, from Garman, Haggard and Willis (1996). Tax 1972 from Anwar Shah,The New Fiscal Federalism in Brazil, World Bank Discussion Paper 124, 1991, p.16.Colombia 1974. India 1974. Kenya budgetary central govt. Zaire 1973. Pakistan 1975.Cameroon 1975 and local revenue is all revenue, not just tax. Iran 1973. Indonesia 1975.Bangladesh 1974 for expenditures, for others 1975 central is “budgetary central government”;local is total revenue. Taiwan (ROC) 1973. Uruguay 1973 (total revenue instead of tax, bothlevels). Zimbabwe: from World Development Report 1997, for 1974.Japan 1975, from Tokue Shibata, ed., Japan’s Public Sector, University of Tokyo Press, 1993,p.145.

For 1977 variables: Belgium 1978; Malaysia local revenue is total revenue, not tax revenue;Note Greece unit change from 1972; Italy 1975; Uganda, 1980 and “budgetary centralgovernment”. Bangladesh central is “b.c.g.”; local is “total revenue”. Trinidad and Tobago1979. Uruguay local is total revenue. Honduras 1976. Zambia=budgetary central government.Bolivia 1980. Philippines 1978. Japan 1974. Taiwan 1977. Uruguay: both levels=total revenue.Japan 1975, from Tokue Shibata, ed., Japan’s Public Sector, University of Tokyo Press, 1993,p.145. Indonesia: 1975-6, from Anwar Shah et al., Intergovernmental Fiscal Relations inIndonesia, World Bank Discussion Paper 239, 1994, p.196. Brazil tax: 1977 from Anwar Shah,The New Fiscal Federalism in Brazil, World Bank Discussion Paper 124, 1991, p.16.

For 1982 variables: New Zealand 1981, budgetary central govt. Poland 1984. Bolivia 1985.Uruguay local is total revenue. Ethiopia 1981. Italy 1985. Ecuador 1980. Italy tax=1985.Japan 1980, from Tokue Shibata, ed., Japan’s Public Sector, University of Tokyo Press, 1993,p.145. Ecuador: central govt for consolidated. No local data. Mexico: from Garman, Haggardand Willis (1996). Argentina, 1983, from Garman, Haggard and Willis (1996) Brazil:expenditure from FIEL book on Argentina. Tax 1982 from Anwar Shah, The New Fiscal


Federalism in Brazil, World Bank Discussion Paper 124, 1991, p.16. Venezuela: 1980, fromGarman, Haggard and Willis (1996). Taiwan, from Statistical Yearbook of the ROC 1995.Honduras, from Nickson, Local Government in Latin America, figures for 1984.Indonesia: 1980-81, from Anwar Shah et al., Intergovernmental Fiscal Relations in Indonesia,World Bank Discussion Paper 239, 1994, p.196.

For 1987 variables: Japan 1985, from Tokue Shibata, ed., Japan’s Public Sector, University ofTokyo Press, 1993, p.145. Indonesia: 1985-6, from Anwar Shah et al., Intergovernmental FiscalRelations in Indonesia, World Bank Discussion Paper 239, 1994, p.196. Venezuela: 1989, fromGarman, Haggard and Willis (1996). Pakistan and Nigeria, from Anwar Shah et al.,Intergovernmental Fiscal Relations in Indonesia, World Bank Discussion Paper 239, 1994, p.52.Kenya 1986. Taiwan, from Statistical Yearbook of the ROC 1995. Dominican Republic: fromNickson (1995), for 1986. Nicaragua: from Nickson (1995) for 1989. Panama: from Nickson(1995) for 1991.Costa Rica from Nickson (1995) for 1984. Brazil: tax 1987 from Anwar Shah, The New FiscalFederalism in Brazil, World Bank Discussion Paper 124, 1991, p.16; expenditure=1988, fromShah p.18.

GNP per capita: From World Bank, World Tables 1992, for 1972 data; World Bank, WorldDevelopment Reports, 1980 (1978 data), 1984 (1982 data), and 1990 (1988 data).China (PRC) 1978: GNP per capita is based on partial official information. Iran, 1978: per capitaGNP from 1977 is used.

Central Government Budget Deficit(-)Surplus(+): as percentage of total expenditure andlending minus repayments, from various annual issues of IMF, Government Finance StatisticsYearbook.

Imports as Percent of GNP: imports as % of GNP 1973, 78, 82, 88 (GDP used in 1973). Importdata from World Bank, World Development Reports, various years; World Bank, World Tables1992; and IMF, International Financial Statistics Yearbooks, various years. 1973 GDP is fromWorld Bank, World Tables 1972. GNP in 1978, 82 and 88 calculated from GNP per capita andpopulation figures given in World Bank, World Development Reports.

Growth: percent change in GDP over previous year in constant prices, IMF, InternationalFinancial Statistics Yearbooks, various years.

Service Sector Output as Percent of GDP: from Taylor and Jodice (1983, pp.223-225); all datafor mid-late 1970s.

Country Area: World Bank, World Development Reports, and CIA, World Factbook, variousyears.

Sources of other data explained in the text.

decentralization and inflation in … · based on different theoretical premises, ... at a basic...

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