General Equilibrium Effects and Voting into a Crisis

We show that in democracies insufficient recognition of general equilibrium effects can lead to a crisis. We consider a two-sector economy in which a majoritarian political process determines governmental regulation in one sector: a minimum nominal wage. If voters recognize general equilibrium feedbacks, workers across sectors form a majority and will favour market-clearing wages. If voters only take into account direct effects in the regulated sector, workers in the other sector are willing to vote for wage rises in each period since they also reckon with higher real wages for themselves. The political process leads to constantly rising unemployment and tax rates. The resulting crisis may trigger new insights into economic relationships on the part of the voters and may reverse bad times.