January 30, 2013
Economics, Politics and Democracy in the Age of Credit-Rating Capitalism
Srinivas Raghavendra (email@example.com) is with the J E Cairnes School of Business & Economics at the National University of Ireland, Galway.
The author would like to thank Amit Bhaduri,
Torsten Niechoj, Frank Conaty and Thomas Boylan for their valuable
comments without implicating them in any of the remaining errors in the
Every crisis in society is also an opportunity for change. This is no less true for economic crises. Major economic crises in the past have
overthrown the incumbent orthodoxy in economic thinking and replaced
them with an alternative. The Great Depression in the 1930s stands out
as the most striking example both as the severest in living memory and
for the sharpest change in economic theorising and style of management
that it induced. Neoclassical thinking based on the belief that the
market mechanism of demand and supply has the inherent capacity to
recover automatically from a crisis was replaced by a new vision.
The chief architect of the new paradigm, John Maynard Keynes urged
his fellow economists to break away from the “habitual modes of thought” for solving one of the worst economic crisis capitalism ever faced. The change in economic thinking had a profound impact on many spheres
ranging from teaching economics1 to economic policymaking;
indeed, it is aptly called the Keynesian Revolution. The revolution
brought about a change in the political nature of the state. While both
fiscal and monetary policies were informed by scientific research based
on Keynesian economic theory, the politics of feasibility and
implementation of those policies was very much at the centre of policy
debates at that time.
The post-war political climate with systemic competition between
capitalism and Soviet socialism also contributed to the winds of change
in economic thinking, which in turn provided an economic rationale for
the welfare state. The post-war reconstruction aid from the US was
instrumental, not by design, in experimenting with the economic policies of the Keynesian revolution in Europe. Not only did Keynesian policies
demonstrate, based on the new theory of how even unproductive war
expenditure could result in full employment and turn around ailing
economies, it also provided the intellectual basis for the politics of
social democracy to bring about cooperation between the contending
economic classes of labour and capital. Furthermore, with the advent of
the welfare state, there followed one of the most prosperous periods in
European history, dubbed the “Golden Age of Capitalism” (Epstein and
Schor 1990; Bhaduri and Marglin 1990).
The uninterrupted growth in western economies created a kind of
positive feedback between the politics of the welfare state and
Keynesian style economic management. They reinforced one another over
time and became institutionalised, and, in Keynes’ own phrase, had
evolved into a habitual mode of thought. The state was seen as the
driver of the economy and its political nature was not questioned. More
importantly, state action was not seen as detrimental to the interest of capitalists as long as Keynesian style class cooperation created an
investment climateconducive to private investment driven by profit.
However, profit as the engine of growth slowed down with an ensuing
profit squeeze in the 1970s and the limit to such cooperation began to
emerge. The twin oil shocks (1973 and 1979) created inflationary
pressures on already stagnating economies and questions were raised
about the suitability of Keynesian policies, which by then had become
conventional wisdom. As economists led by Milton Friedman, in
particular, began to question the established doctrine of Keynesianism,
the foundational behavioural assumption of the money wage bargain on
which Keynes’ General Theory was built was challenged.
Friedman argued against expansionary fiscal policy on the ground that it could provide more employment only if real wages were lowered to
satisfy the profit maximising firms. But this requires money illusion on the part of the workers, which would at best be transitory and
ineffective in the long run simply because you cannot fool all the
people all the time. With the argument that fiscal policies of the
state-influenced inflationary expectations of the economic agents,
Friedman went on to prove that those policies would be ineffective in
the long run and the economy could end up having a “natural” level of
unemployment so long as it is consistent with the individual labourer’s
choice between work and leisure.
The argument in effect resurrected the notion of “voluntary
unemployment” (i e, unemployment was a matter of individual choice),
which is the core of the neoclassical orthodoxy argument that
counterposes individual freedom against state intervention. The fiscal
policies of the state were seen as distorting the “expectations” of the
agents in the economy while it had no real impact on the level of output and employment in the long run. The second phase in the development of
Friedman’s theory, often referred to as Monetarism Mark II, or the “New
Classical School” led by Robert Lucas, demonstrated the ineffectiveness
of monetary policy because workers endowed withrational expectationswould not be fooled by money illusion even in the short run. Crucial to the
argument is the idea that every agent determines his or her action by
adapting and forecasting the future on the basis of the same model so
that no space is left for surprise effects of economic policy of the
state. Paraphrasing the poet T S Eliot: “[I]ndeed after such awesome
rational knowledge (of individual agents), what forgiveness (for the
From the Keynesian revolution to monetarist counter-revolution, macroeconomics underwent a full circle2 comprising both fiscal and monetary policy ineffectiveness. The
counter-revolution had a profound impact on the style of economic
management. The new classical model claimed that monetary policy is
ineffective because economic agents are rational in a sense that they
would adjust their supply decisions even when the policy is simply
announcedby the monetary authority or the state. This allowed
them to take the argument further and claim that given its political
compulsions, the democratic state may not be in a position to stick to
its monetary policy commitments and this would cause inconsistencies in
individuals’ expectations about the future conduct of monetary policy.
Such inconsistencies would have a negative impact on the sentiment of
the investor about the future growth of the economy and thereby affect
their supply decisions. Hence, the proponents of the new classical
school argued for an “independent” monetary authority, viz, a central
bank that would conduct a rule-based monetary policy devoid of political interference from the state. The idea was set in motion of delinking
politics of the state from the conduct of the monetary policy by the
The idea of an independent, objective, non-partisan and apolitical
central bank targeting exclusively the inflation rate resonated well
within the financial community and was initiated in New Zealand. Many
developed and developing countries today claim to have an independent
central bank. Thus the monetarist counter-revolution, like the Keynesian Revolution, redefined the role of the state in the economic sphere. In
the pursuit of its ideal of a minimalist state as a counter to the
Keynesian Revolution, it took away from the state, as a first step, its
control over monetary policy. However, fiscal policy still remained
within the control of the state.
The counter-revolution provided a perfect economic rationale for the
conservative political ideology that advocated a minimalist state. The
economics of the counter-revolution and the politics of conservatism
centred on the minimalist state aligned perfectly at the turn of the
1980s. This is hailed as a period that ushered in the “second wave of
globalisation”. It was marked by the rise of “high finance” – the
financialisation phase of globalisation. With the counter-revolution
providing an intellectual justification for “freeing” monetary policy
from the politics of the state via an independent central bank, the
stage was set for the development of an unfettered financial sector
around the globe.
Fiscal policy was reined in to create a conducive tax climate and
boost private investors’ sentiment vis-à-vis the financial markets.3 Even though the financial market went through a few “shocks” in the
late 1980s and the 1990s, e g, the 1987 one-day crash and the dotcom
meltdown in 2000, the resilience of the modern financial sector was
hailed as robust4 and its contribution to the overall
prosperity of the economic expansion was applauded. Indeed, the
relatively uninterrupted growth in the second phase prompted Robert
Lucas, a leader of the second phase of monetarism or rational
expectation-based macroeconomics, to unequivocally declare,
[I]ts [macroeconomics] central problem of depression
prevention has been solved, for all practical purposes, and has in fact
been solved for many decades (Lucas Jr 2003).
New Consensus Macroeconomics
The enthusiastic declaration of depression prevention had to bite the dust with the onset of the “Great Recession” in 2007 in both the US and Europe. The weight of history was pointing unequivocally towards a new
revolution that would dismantle the incumbent monetarist orthodoxy.
However, it did not repeat itself; on the contrary it rhymed, as Mark
Twain would have insisted, better with the pre-Keynesian era of the
1920s. Monetarist orthodoxy has returned although under a different
guise called the New Consensus Macroeconomics and it would appear to
have consolidated its position during this recession.
The orthodoxy that dislodged the state from its monetary policy commitments by invoking marketsentiments got irrevocably locked into the process of circular reasoning in a
self-referential way. Monetary policy was conducted by independent
central banks, which supported the expansion of the financial sector
that was to be overseen by an objective and scientific risk-rating
mechanism. Credit rating agencies provided such a service and gradually
they became the underwriters of risk for the entire financial system,
including central banks, for their financial market operations conducted within the ambit of monetary policy. The apparently objective and
scientific process of underwriting risk provided a perfect barometer
that gauged market sentiments. In this process, the logic of
market sentiments became institutionalised via the risk-rating mechanism of the credit rating agencies. A pliable theory was restored from
pre-Keynesian history to put in place a perfect self-referential setting by which an independent central bank was assumed to deliver consistent
and credible monetary policies that supported the expansion of the
financial sector, which was certified in turn as sound by a presumably
objective process of risk-rating by the credit rating agencies. The
result was massive financialisation driven by financial innovations
justified by this self-referential logic, which circumvented the state
during the so-called second wave of globalisation.
As the rating agencies began playing a more central role, the process of financialisation in the 1990s was characterised by the expanding
capacity of the credit rating agencies to underwrite complex debt
instruments. The developing system of an extremely complex network of
claims and counterclaims was justified in terms of the same
self-referential logic and was believed to have efficiently allocated
the available liquidity to optimally distribute risk across the
financial sector. In hindsight, it is clear nobody understood this
enormously complex and opaque system but it went largely uncontested
because almost all the players were willing or unwilling victims of that self-referential system of rationalisation.
Rise of Rating Agencies
During the expansion, it was understood that financial innovation,
which improved the efficiency of the resource allocation function,
combined with the objective of a scientific underwriting process would
improve the resilience of the overall financial system by sharing and
distributing risk. A “competitive” market for the underwriting process5 developed and the efficiency of that market was considered vital for
the resilience of the financial system and the overall economy. As the
process of financialisation deepened, the business and influence of
rating agencies grew in proportion and began to shape market sentiments
and their activities became integral to the functioning of the modern
The catastrophic collapse of the financial markets in 2008 and the
ensuing economic crisis in the western economies did not affect the
influence of the rating agencies. On the contrary, the agencies that
endorsed as optimal the rising level of systemic risk before the crisis
have strengthened their position, which now seems politically
unassailable despite the deepening of the crisis. In fact, using the
current crisis the agencies have moved beyond rating the risk of private financial institutions to decisively underwrite the capacity of the
nation state in conducting its economic affairs.
Such a position of power of the rating agencies and their influence
during a crisis, comparable in proportion to that of the Great
Depression, should be seen in the broader context of the dominance of
the monetarist paradigm that still governs policymaking in many central
banks and in the International Monetary Fund (IMF). This dominant
monetarist paradigm, which is endorsed by the respectability of the
award of several Nobel prizes in economic sciences to their theorists,
reinforces its unwavering commitment to the primacy of the role of
market sentiments for the growth of the capitalist system and in turn
provides the intellectual source from which the rating agencies draw
their economic justification for the underwriting process. Moreover, in
the current crisis the rating agencies began to perform the role of
“enforcer of discipline”, i e, disciplining the state from its
extravagances via the rating of sovereign debt using an “objective and
scientific underwriting process”, reinforcing the dominance of the
monetarist orthodoxy and, in fact, providing it a great opportunity to
implement its vision of a minimalist state.
The self-proclaimed disciplining role played by the rating agencies
is not legally prosecutable for the reason that they merely give
“opinions” on the riskiness of assets, including sovereign debt. For
instance, in the US the rating agencies claim protection under the First Amendment as a matter of free speech and freedom of the press.6 This advantage without accountability, ironically protected by the US
constitution, makes the self-referential system dangerously powerful as
the rating agencies assume a pivotal role in the economy and polity in
capitalist democracies. As a result, they shape market sentiments and
through their opinions control almost every domain of economic
policymaking, laying the foundation for “Credit Rating Capitalism”.
Their power does not merely stop at inhibiting the state and its
agencies from borrowing from the market, it goes beyond the bond markets into the realm where it is beginning to reshape the politics of
representative democracy in the conduct of the fiscal affairs of the
The economic rationale for delinking politics from fiscal affairs is
to eliminate uncertainties concerning the conduct of economic policy in
general and fiscal policy in particular. The discretionary nature of
fiscal policy is questioned because it adversely affects investors’
expectations and market sentiments, and it is desirable to minimise
uncertainties in the conduct of fiscal policy. This argument echoes the
1980s debate when monetary policy was delinked from the politics of the
state on the ground that discretionary monetary policies induced
inconsistencies in individual investors’ minds regarding their
expectations about future policy change, which, in turn, adversely
affected market sentiments. Similarly, it is now argued that
discretionary fiscal policy should be replaced by “fiscal policy rules”, which enhance transparency and consistency to sustain the stability of
Such a move to impose fiscal policy rules without discretion and
separating it from “political pressures” is clearly articulated in the
economic policy framework of the European Central Bank (ECB). The
framework is succinctly described by the ECB as follows:
The (Maastricht) Treaty foresees three different modes of policy-making in the various fields of EMU: (i) full transfer of
competence to the Community level for monetary policy; (ii) rules-based
coordination of fiscal policy; (iii) ‘soft’ coordination for other
economic policies (ECB 2008: 22).
Having reached the limit of manoeuvrability in terms of monetary
policies, the ECB has broadened its remit by using its “technical”
capacity to advise and influence both the formulation and conduct of
fiscal and other structural policies in the member countries of the
eurozone. Drawing from the intellectual wisdom of the New Consensus
Macroeconomics, the ECB has been pushing the so-called expansionary
fiscal austerity or fiscal consolidation view7 in the conduct of fiscal policy to boost market sentiments in favour of the troubled
countries, viz, Ireland, Italy, Greece, Portugal and Spain. Moreover,
the ECB has also been using the soft coordination approach using both
“peer pressure and support” and, more importantly, the logic of market
sentimentsto influence the structural policies in reforming the labour markets in the troubled countries.
Thus, the ECB has engineered its way to control fiscal policy
indirectly through various means, including the way it pressed the
Government of Ireland to seek a bailout using the argument of contagion
risk to other European countries.8 Again, using the bailout
terms and conditions, the ECB has insisted on the establishment of
fiscal councils in bailout countries like Ireland, Portugal and Greece
to advise the government in fiscal matters. These independent technical
experts will assess and advise the government on various aspects of
fiscal policy. For example, the role of the Irish Fiscal Advisory
[T]o provide an assessment of, and comment publicly on,
whether the Government is meeting its own stated budgetary targets and
objectives. It will also be charged with assessing the appropriateness
and soundness of the government’s fiscal stance and macroeconomic
projections as well as an assessment of the extent of compliance with
the government’s fiscal rules. The latter are also to be brought forward in the proposed Fiscal Responsibility Bill.9
The argument of a rule-based fiscal policy devoid of any political
interference echoes both in ideology and in substance the argument in
the late 1980s for rule-based monetary policy and for an independent
central bank that could conduct monetary policies without any political
Final Act of Drama
However, in contrast to the rule versus discretion debate of the
1980s over monetary policy, the monetarist counter-revolution is no
longer replacing the incumbent Keynesian orthodoxy. Instead, in the
current crisis the incumbent monetarist orthodoxy is getting further
entrenched in the same economic rationale that pushed the western
economies to the brink of collapse. The final act of this drama has just begun to unfold. The central banks themselves, once the bastion of the
monetarist counter-revolution against Keynesianism, are now being
coerced and dictated to by the rating agencies based on their power to
shape market sentiments. Has Aladdin’s genie gone out of control?
The emerging politics of the present crisis is driven by the coercive power of the rating agencies over the institutions of the state through the delinking of the politics of deliberative democracy from the
conduct of economic policy in general and fiscal policy in particular.
Ironically, the rationale and justification for delinking politics from
economic policy is derived from overlooking diverse political
representations that characterise western democracies in Europe.
In Europe, three-quarters of the governments formed after the second
world war were comprised of multiple political parties. With increased
political diversity and wider representation in government, it is
recognised that policymaking has become even more challenging than in
single-party governments. The challenges of consensus building by
democratic means in policymaking arise not only from the inevitable
tension between the parties on compromising their ideals, but also
reflect the reality that coalition partners must compete separately at
election time. Hence, unlike authoritarian regimes or single-party
democracies, compromise is at the heart of politics, particularly when
it comes to diverse multi-party coalition governments (Martin and
Two major problems have emerged in recent academic debates: the
“principal-agent problem” and the “common-pool problem”. Research on the principal-agent problem has documented how politicians can extract
rents from being in office, but voters might wish to limit these rents
by subjecting politicians to stricter rules (see von Hagen 2005 for a
detailed analysis). However, the uncertainty and complexity of economic
and political developments induced by multiparty coalition governments,
it is argued, prohibit the writing of complete contracts. Therefore, the principal-agent relation resembles an “incomplete contract”, leaving
politicians with some undesirable discretionary powers (Kassim and Menon 2002).
Research on the so-called common pool problem has documented how
problems arise when politicians can spend money from a general tax fund
on targeted public policies (Hallerberg et al 2009). The fact that the
group that pays for specific targeted policies (the general taxpayer) is larger than the group that benefits from them creates a divergence
between the net benefits accruing to the targeted groups and the net
benefits to society as a whole. This divergence, it is argued, induces
the targeted groups and politicians representing them to demand excess
spending which is sub-optimal for society as a whole. Thus, the common
pool problem leads to excessive levels of public spending (Bawn and
Rosenbluth 2006; Roubini and Sachs 1989). This excessive spending is the source of increased deficits and debt. Moreover, it is documented that
ethnic divisions and/or ethno-linguistic and religious fractionalisation of society increase the asymmetry of the tax burden, making the common
pool problem even more severe (Alesina et al 1997).
Unsurprisingly, academic research under the influence of monetarist
orthodoxy analyses the shortcomings of the diversity and wider political representation in government. Its recommendations articulate a case for reshaping institutions that govern decisions over public finances.10 Three types of fiscal institutions are prescribed: (1) Ex ante rules,
such as constitutional limits on deficits, spending or taxes, (2)
electoral rules fostering political accountability and competition, and
(3) procedural rules for the budget process. Research on these types of
fiscal institutions has produced voluminous literature, which in turn
has provided an intellectual basis for the argument of conducting
rule-based fiscal policy for minimising the distortionary effects of
discretionary policymaking by coalition governments in the west and
developing countries alike (Haan et al 1999; von Hagen 2005; Fabrizio
and Mody 2006).
While academic research under the influence of the monetarist
orthodoxy has further intensified the orthodoxy’s intellectual
dominance, the credit-rating agencies, drawing their rationale from the
dominant intellectual paradigm, have become the “enforcers of
discipline” against discretionary excesses by the multiparty democratic
state. During the current crisis, the credit rating agencies have
further consolidated their role as enforcers of discipline by severely
restricting the state from implementing its duty of democratic
accountability. The capacity of the state is undermined by the
credit-rating agencies, through both overt and covert actions. The
credit-rating agencies directly inhibit the state and its agencies from
borrowing from the market by downgrading the state using the
credit-rating mechanism. Covertly, the rating agencies have moved beyond the bond market and have entered the political realm by rating
“democracies” and forcing the state to delink the politics of
deliberative democracy from the conduct of its economic affairs. Such a
covert coercion is visible in the eurozone, where the peripheral member
states’ credit ratings also depend on the reform of their fiscal and
It is quite extraordinary that the logic of market sentiments that
drove the western economies to the brink of disaster has become the
economic rationale for the basis of economic recovery and for reforming
the state. Furthermore, insulating policymaking of the state and its
institutions from the so-called political pressures seems to be the
emerging politics of this crisis and is being aggressively enforced
through the veil of market sentiments by the apparently objective
risk-rating mechanism of the credit rating agencies. Thus, it could
result in delinking and disengaging the politics of deliberative
democracy from the conduct of economic policies of the state and is
tantamount to undermining the very foundations of democracy in that it
seems that the state is more accountable to the invisible sentiments of
the market and not to its own people.
1 Although Hick’s (1937) paper is hailed for its pedagogic impact for it helped in bringing Keynes’ General Theory to the classroom, it should be borne in mind that the paper in a subtle way restated Keynes’ theory, particularly in deriving the “Investment
Savings” curve, using the theoretical foundations of the neoclassical
2 For example, if one looks at the theory from the point of view of
explaining unemployment in the real economy, starting from the
pre-Keynesian era of explaining unemployment in terms of a voluntary
decision of labourers to the Keynesian phase where unemployment was seen as involuntary due to the inability of markets for products to clear
due to insufficiency of demand. In the monetarist counter-revolution
phase, the pre-Keynesian notion of choice was resurrected in a different guise. It was indeed old wine in a new bottle, and perhaps not as good
as vintage wine!
3 The effective marginal tax rate (economy-wide weighted by sector)
on capital income during 1953-59 was 47.3%. It was gradually reduced to
35.3% in the 1980s and further reduced to 28.3% during 2000-03,
amounting to an almost 40% reduction during the period 1953-2003 (cf
4 “The use of a growing array of derivatives and the related
application of more sophisticated approaches to measuring and managing
risk are key factors underpinning the greater resilience of our largest
financial institutions … Derivatives have permitted the unbundling of
financial risks” – Alan Greenspan (May 2003).
5 Three major players are Moody’s, Standard & Poor’s (S&P)
and Fitch; however, Moody’s and S&P dominate the rating market. An
interesting question arises as to who owns these rating agencies.
Moody’s was sold as a separate corporation by Dun and Bradstreet in 1998 and is now quoted on NYSE; S&P is owned by publishers McGraw-Hill.
There has been a massive growth in the number of rating firms in OECD
countries (including Japan after 1985 and Germany during the late 1990s) and in the developing countries. See T J Sinclair (2010) for further
analysis on the competitive nature of the rating market.
6 See Nagy (2009) for a detailed legal analysis of how the
credit-rating agencies in the United States successfully defended
lawsuits using the First Amendment shield in the case of Residential
7 “Fiscal discipline is required for the smooth functioning of
Monetary Union, as unsound ﬁscal policies may create expectations or
lead to political pressures upon the central bank to accommodate
higher inﬂation in order to alleviate the debt of the government sector
or to keep interest rates low” (ECB 2008: 25) (Italics added).
8 While writing this article it has emerged that there was a letter
from Jean Claude Trichet, the former chairman of ECB to the late Brian
Lenihan, the former minister of finance of Ireland, dated 12 November
2010. The letter itself was not released to the public but it is
believed to have threatened the withdrawal of Exceptional Liquidity
Assistance (ELA) to Ireland if the then government refused to accept the bailout that included a ban on burning the bondholders (Cf: Irish Times, 1 September 2012. weblink: http://www.irishtimes.com/newspaper/ ireland/2012/0901/1224323462435.html).
9 Ministry of Finance, Ireland, http://www.finance.gov.ie/viewdoc.asp?DocID=6927
10 See Besley (2004) for an overview of the “New Political Economy”
literature that analyses the issue of how the institutional structures
affect policy outcomes.
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