Rules vs discretion

Will Wilkinson is “extremely suspicious of what strike me as intellectually contentious, ad hoc interventions into the economy aimed at expectation management.”

He should be suspicious because when policy makers have discretion, outcomes are worse. This is because people know the government can cheat by trying to exploit short-term trade-offs between outcomes and inflation. Because the government has discretion and they can cheat, people expect governments will cheat and increase inflation — by spending a bizzilion dollars for example — thus increasing their expectations of future inflation. This high expected inflation translates to actual inflation and thus a worse outcome.

On the other hand, if policy makers can commit themselves to a particular policy and that commitment is credible, expectations of inflation are lower, actual inflation is lower and outcomes are better.

How do policy makers credibly commit themselves to policy rules? Well, they don’t increase spending by almost 10% of GDP willy-nilly. Better is to have over 20 years of policies that lead to stable levels of inflation. Too bad we’re going to get the former and no-longer have the latter.

(Lectures 11-14 here are a pretty good and thorough introduction to these ideas. I just found it from googling so there may be something better out there.)

5 thoughts on “Rules vs discretion”

  1. Except, now we want inflation!!! What we need to do is convince agents we’re serious about creating inflation. That’s hard to do with such a small stimulus…

    The Fed has announced, of course, that it will keep interest rates low until we have inflation. I don’t think very many private agents know or care…

  2. The point is that even if this fiscal stimulus works this time, it goes a long way toward reducing policy makers’ credibility. BTW, what’s your theory that links size of a fiscal stimulus and the degree to which it affects inflation expectations? You might think agents believe the Fed will monetize all this spending, but then why wouldn’t straight monetary policy do the same job then?

    As for how information about policy commitments is transmitted to agents, I don’t know. You’re right people probably don’t pay much attention to Ben’s cryptic pronouncements on capitol hill, but this translation of policy to expectations happens some how (if you assume policy matters for setting expectations, that is).

    In any case, assuming the mechanism is invariant to policy, it doesn’t matter much how this translation occurs. People, however, are paying more attention to policy these days than usual… in my estimation its more likely for them to be reassessing policy makers’ credibility. Then again, people may feel like this is an emergency measure and so it wouldn’t change their expectations at all for policy in “normal” times. The issue with this is knowing (and knowing when agents know) when a period of time is “normal” or not.

  3. Don’t want to derail the topic, but is spending this wad of money on domestic economic hacks worse than spending a similar wad of money on invading a foreign country? The price tag for the stimulus is roughly equivalent to the cumulative price tag for Iraq (to date), but I haven’t seen complaints here about that invoice.

    Is it the amount being spent, or the direction of the spending that is bad?

  4. Not sure where to go with that… is your argument that because we wasted a bunch of money before (because of bad policy objectives) its ok to do so now (because of policy ineffectiveness)? I’m not seeing the connection.

    The economic argument against fiscal stimulus is what’s called a positive argument. It just says such policy is ineffective. Arguments against the war are normative (usually) on the other hand. In the case of war, its easy to see how different people would have different opinions about what the right thing to do is.

    In the case of recessions, though, there’s no disagreement about normative goals. We all want to decrease the severity of the recession and reduce suffering. That’s not what the debate is about. The debate is about whether or not certain policies are effective in reaching that common goal.

    Fiscal policy is ineffective. Also, it may be counterproductive in terms of other common goals… namely, it may in fact reduce future economic growth by slowing down sectoral adjustments and increasing the risk of sovereign default.

  5. Not quite – I’m arguing that the arguments against spending the massive wad of cash now should have also applied to the massive wad of cash spent then. There were rational, logical, well-balanced arguments against going to war based on the premise that it wouldn’t accomplish the stated goals. These arguments were quite separate from those with moral, religious, or political bases, and these arguments were shouted down.

    Don’t get me wrong – this package reminds me of the scene in Ghostbusters where they fail to convince the EPA official not to cut power to their ghost trap. I doubt this thing will put on a light show like that, though…

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