ECONOMIC SHOCKS AND POPULISM

The Political Implications of Reference-Dependent Preferences

In this paper, we study a
model of political competition between a moderate and a populist candidate.
Voters have reference-dependent preferences, characterized by loss aversion and
diminishing sensitivity (i.e. risk loving attitudes over consumption below the
reference point). We assume that the populist candidate is riskier and less
efficient than the moderate. We show that, after an adverse shock, the populist
can prevail in the elections, because its riskiness becomes appealing for the
voters. This also implies that an external country/creditor may find it optimal
to unilaterally forgive part of the debt, in order to reduce voters’ appetite
for risk and prevent the election of a populist government that may impose
negative externalities on the creditor. Finally, if the reference point is
forward-looking, a permanent negative income shock induces a political majority
to favor a myopic policy, of borrowing and boosting current consumption at the
expenses of future consumption, to reduce current disappointment.