Fiscal policy effectiveness in a background of political fragmentation

Several advanced economies have experienced a rise in political fragmentation over the last decades (see figure). Simultaneously, governments face major challenges, like the climate transition and geopolitical tensions, that increasingly require active fiscal policy.

While economists have long studied how economic conditions shape fiscal policy effectiveness, this paper provides the first empirical evidence that the political environment is important, too: political fragmentation substantially weakens the transmission of fiscal policy to economic activity.

Using data for 16 OECD countries over four decades, the paper measures fragmentation based on seat allocations in national parliaments. Average fragmentation has increased by more than 40% over our sample period. However, this trend masks substantial heterogeneity, which allows the authors to identify periods of high and low fragmentation that vary across countries and over time.  

The results are frame in terms of fiscal multipliers, which indicate the Dollar-change in GDP per Dollar-change in government spending. Multipliers above one indicate that government spending crowds-in additional private economy activity, while the opposite is true when multipliers are below one. The paper finds that the fiscal policy is far more powerful when political fragmentation is low. During such periods, the multiplier reaches about 1.4 and stays above one, whereas it is consistently below one when fragmentation is high. These results hold across different samples, identification strategies, and economic conditions.

A “confidence channel” drives this result: only in low-fragmentation periods do fiscal interventions boost household and business confidence, translating into stronger consumption and investment responses. High fragmentation, by contrast, is associated with higher uncertainty and lower trust, weakening the effect of fiscal policy on confidence.

Up to the end of the sample in 2019, Portugal exhibited relatively low political fragmentation, with a clear bipartisan structure dominated by PS and PSD. Since then, however, fragmentation has increased markedly, driven in large part by the rise of Chega over the last three elections. Based on these results, the authors suggest that, in the current political landscape, fiscal policy may face greater challenges in effectively stimulating economic activity.

Click here to go to the paper by Ricardo Duque Gabriel, Mathias Klein and Marvin Nöller.