The relationship between economics and politics is complex and interrelated. For anyone working in the field of economics, an understanding of this relationship, known as the political economy, is essential.
The political economy is a social science that studies how economic theories affect different socio-economic systems and the implementation of public policy. It analyses how political forces affect the economy and vice versa, as well as using economic tools to study politics. For example, voters and interest groups can have a powerful effect on economic policy, whilst macroeconomic trends can impact political direction.
Political ideology
The financial and political landscape between one country and another can vary vastly depending on each country's political ideology.
Operating within a socialist or capitalist society for example, determines the basis of the economic system within that country. In capitalist countries such as the UK, US, Hong Kong and Canada, the economy is characterised by the private ownership of assets and the free market, which determines the price, income, wealth and distribution of goods.
On the other hand, a socialist society has greater intervention from the government, who aim to allocate wealth and resources more equally.
Interestingly, it is thought that no country is 100% socialist and that most countries, such as China and Vietnam, operate a mixed economy which incorporates socialism with capitalism and/or communism - where society is controlled by an authoritarian state.
No matter where a country falls on the political spectrum, its economy will be heavily influenced by its political position.
In a capitalist society, governments have less intervention in the economy, but that doesn’t mean they don’t influence it.
Government influence
In fact, one of the governments’ primary objectives is to manage the economy. There is a correlation between effective management of the economy, and political popularity and power. For this reason, it is in a governments’ best interest to adjust its spending - through monetary and fiscal policy - to keep their economy buoyant.
For example, if there is a rise in inflation, the government will use tax payments, savings, interest rates and imports to decrease demand and lower inflation. On the other hand, if there is a recession, the government will use injections such as investments, lowering tax and interest rates, Public Sector Borrowing Requirement (PSBR) and exports to increase demand and reduce unemployment.
Political stability is also good for economic growth, as disruption and uncertainty can affect confidence in the market.
“Any sudden change at government level is bound to cause shift in economic policies, something every investor or businessperson fears. Business on its own is a risky venture, no one wants the added burden of uncertain policies”, writes Maham Babar Khan in a report for Modern Diplomacy. “[In times of political uncertainty] investors are not sure whether the new policies would benefit their business, [if they will] be forced to pay more taxes, or [if] uncertainty will lead to a spike in property costs. This drives away the foreign investment desperately needed in this globalised world [and] for developing economies in particular”.
Impact of crisis
Times of crisis keenly highlight the link between the economy and politics.
Financial crashes have been shown to give rise to right-wing populism, with links between the financial crisis in Germany in 1931 and the rise of the Nazi Party thereafter. More recently, following the financial crash in 2008, the West has seen a growth in far-right political forces, stemming from the cost of bank bailouts, lost economic growth, public debt, austerity, and the increased inequality that was caused by the crisis. We’re also seeing another rise in far-right politics in response to the COVID-19 pandemic.
“It seems that when social groups fear decline and a loss of wealth, they turn to right-wing parties that promise stability and law and order”, writes Foreign Affairs Magazine, whose research has shown that after a financial crisis, the share of the vote going to right-wing parties increases by more than 30%.
COVID-19 has also had a significant impact on the global economy. The FTSE dropped 14.3% in 2020; its worst performance since 2008. In response to the impact on the global stock market, central banks in many countries, including the UK, cut their interest rates.
According to experts, this should encourage spending that will boost the economy.
It is reported that the British government are planning to spend 280 billion pounds of public money in 2021 to support jobs and businesses in a bid to repair the economic damage the pandemic has caused.
China has invested in increasing their industrial production to boost their post-pandemic economic output. This approach resulted in an expansion in their GDP of 6.5% in the final quarter of 2020 – making them one of the only countries in the world to register growth last year.
Impact of pandemic
The pandemic has also had a devastating impact on developing countries, plunging an estimated 150 million more people into extreme poverty.
“If a poorer country can't sell its resources, then a huge percentage of its national businesses and workforces are going to feel the pinch. Therein lies the problem when a global pandemic hits and their richer trading partners shut their borders” reports Emmy Hawker for Business Because.
As a result, according to the United Nations Development Program (UNDP), developing countries could see income losses in excess of $220 billion.
Increased poverty at this level is likely to have a significant political impact, with experts linking poverty to rises in extremism and political conflict.
Political economy
Due to its powerful influence, the exploration of the relationship between politics and the economy is a key part of economic theory and practice. The political economy impacts upon many areas of economics, banking and finance, including the trading decisions in financial markets and the behavioural biases of investors, managers and other economic agents.
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