The Loan Shark Welfare State? Electoral Institutions and Political Responses to Economic Polarization

Abstract: Standard models of democratic political economy assume that politicians respond to widening income gaps with fiscal redistribution. Yet prominent accounts of the global financial crisis have argued the politicians in the United States responded to increasing inequality and decreased economic mobility not with the fiscal redistribution but with policies extending credit further down the income distribution, enabling consumption. How this works is underspecified. We formalize one way in which this process might play out; a key implication is that politicians' responses to widening gaps in pre-tax income will be conditional on the electoral system: PR systems will exhibit greater fiscal redistribution while SMD systems will resort to credit and consumption stimulus. We examine these expectations using OECD data from 1980-2010 and find that SMD systems are indeed significantly more likely to expand credit as pre-fisc inequality grows while no such relationship is visible in PR systems. Our findings have implications for the financial system risk: SMD democracies are marginally more prone to credit booms and financial crises than countries functioning under PR systems.