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CHAPTER 24. SHOULD POLICYMAKERS
BE RESTRAINED?
I.
MOTIVATING QUESTION
Should External Limits be Imposed on Policymakers?
Perhaps, but not because the effects of policy are uncertain. Policymakers understand that uncertainty
provides an argument for moderation in setting policy. Assuming they are benevolent, they will impose
their own restraint. On the other hand, the strategic interactions between the private sector and the
government, as well as the exchanges among political parties suggest that economic performance may
improve when constraints are placed on discretionary policy. However, the need for discretionary policy
in times of economic distress calls for care in the design of institutional limits on policymakers.
II.
WHY THE ANSWER MATTERS
Modern macroeconomics was founded on the premise that governments could take action to improve
economic performance. Toward this end, the previous 23 chapters have discussed policies available to
governments and the likely effects of such policies. Although caveats have been offered along the way,
the basic message is that governments can take action to reduce economic fluctuations and increase the
long-run level of the capital stock, but have little ability to influence growth, beyond establishing
institutions that reward innovation and protect property rights. This chapter examines the limits on
discretionary policy. It asks whether governments can be expected to exercise their discretion wisely and
whether institutions can be designed to encourage good policymaking.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
i.
In economics, a game is strategic interactions among a set of players.
ii.
A government faces a time inconsistency problem when it has an incentive to deviate from a
promised policy once private agents have made decisions based on the policy.
iii. A political business cycle occurs when policymakers try to generate expansions before elections in
hopes of securing reelection.
IV. SUMMARY OF THE MATERIAL
Despite the apparent beneficial role that macroeconomic policy can play, arguments for restraints on
policymakers are common. These arguments fall into two classes. One view is that policymakers, in
trying to do well, do more harm than good. The other view is that policymakers do what is best for them,
rather than for society as a whole.
1.
Uncertainty and Policy
One reason that policymakers may do harm is that the effects of policy are uncertain. In the mid-1980s,
an exercise conducted at the Brookings Institution used twelve prominent macroeconomic models to
predict the effects of a specified monetary expansion. There was substantial variation in the quantitative
results. Since such models (and their descendents) capture existing quantitative knowledge about the
effects of policy on the economy, the implication is that policymakers face substantial uncertainty about
such effects (Of course no forecaster or policymaker relies exclusively on the output produced by these
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models. Each and every one of them take exogenous factors not captured by the models into account
when producing their forecast).
If extreme macroeconomic outcomes are very harmful, uncertainty provides an argument for moderation
in policymaking. After all, the smaller the change in policy, the more narrow the range of possible
outcomes and the lower the probability of a bad outcome. This argument is less relevant when the
economy is suffering a severe recession or hyperinflation. In these cases the effects of relevant
compensating policies—no matter how extreme—are likely to improve economic performance. There is
every reason to believe policymakers understand that uncertainty calls for restraint. Thus, the existence
of uncertainty does not provide justification for imposing external constraints on policymakers.
2.
Expectations and Policy
The relationship between the government and private sector can be described as a game, i.e., strategic
interactions among a set of players. Private firms and households make decisions based on expectations
of future policy. The government forms policy based on the expected response of the private sector.
Viewing the economy in this perspective can provide a rationale for external constraints on
policymakers.
Sometimes a government has an incentive to deviate from a promised policy once private agents have
made decisions based on the policy. In this case, the government’s optimal policy is said to be time
inconsistent. For example, as discussed in Chapter 8, central banks can temporarily reduce
unemployment below the natural rate by generating unexpected inflation. At the same time, if inflation is
costly, central banks have an incentive to announce a policy of low money growth to reduce expected
(and hence actual) inflation. Combining these objectives, the central bank’s optimal policy is to
announce a tight monetary policy to convince the private sector that inflation will be low, but to actually
implement a looser policy to reduce unemployment (temporarily). If the central bank attempts to carry
out this program, however, it will lose credibility quickly, and the private sector will set wages and prices
in expectation of high inflation. This will eventually eliminate the ability of the central bank to reduce
unemployment below the natural rate and at the same time contribute to high inflation. In the long run,
the central bank’s program will have no effect on unemployment (it will return to the natural rate) but
will result in high inflation. Under these circumstances, economic performance would improve if the
central bank could commit itself credibly to maintain low money growth. In this case, the public’s
expectations would be consistent with low inflation, and the natural rate could be achieved with a lower
inflation rate. Thus, time inconsistency provides an argument for external restraints on government
actions.
External restraints are needed because self restraint may not be credible. However, care should be taken
to preserve flexibility in times of economic distress. For example, one way to impose an external
constraint on the central bank is to legislate a money growth rule. Such a restraint prevents the central
bank from cheating on policy targets (a desirable outcome), but also eliminates its ability to respond to
adverse shocks (an undesirable outcome). An alternative that is often superior is making the central bank
politically independent of the government in power and appointing a central banker with a known
distaste for inflation. The evidence suggests that central bank independence is associated with lower
inflation.
3.
Politics and Policy
Sections 24.1 and 24.2 assumed that policymakers were benevolent. In fact, politicians may act to
maximize their own reelection prospects. If voters are shortsighted, politicians have an incentive to
implement policies that generate short-run benefits, regardless of the long-run costs of these policies.
There is not much evidence in favor of this proposition in the United States. Until the 1980s and aside
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from the Great Depression, the ratio of government debt to GDP tended to increase only during wars.
Thus, the evolution of deficits and debts seemed to track economic circumstances rather than the
shortsightedness of voters. The bouts of increasing deficits and debt in the 1980s and 1990s appear to
have more to do with games among policymakers, as described below, than with the short-sightedness of
voters. Moreover, if voters were shortsighted, politicians could improve their changes of reelection
without much cost by generating expansions just before elections. Thus, there would be a political
business cycle, with growth highest in the final years of presidential administrations. In the postwar
period, U.S. growth has been highest in the final years of presidential administrations, but the difference
across years has been relatively small on average.
Another source of harmful policies is created by strategic games among policymakers. Substantial policy
disagreements occasionally result in wars of attrition between political parties that result in the
postponement of needed policies, such as deficit reduction. For example, the tax cuts of 1980s and the
early years of this decade seem to have been motivated in part by a desire to cut spending. In both
episodes, the tax cuts led to substantial increases in the deficit, and ultimately to concern about reducing
the deficit. In both cases, Republicans typically argued for spending cuts (in nondefense programs) and
Democrats for increased revenues. The deficits of the 1980s were eventually eliminated with spending
restraint (and the Clinton tax increases of 1993), but the surplus of the last years of the Clinton
administration was quickly reversed. The U.S. budget has moved into a large deficit, which is projected
to continue for some time. Republicans and Democrats now seem poised to engage in a war of attrition
over deficit reduction.
Some economists believe that the only way to break the current impasse is with some sort of legislative
or constitutional limit on fiscal policy. A problem with this approach is that it may limit needed fiscal
flexibility. For example, when the economy is in recession, policymakers should have the option of
fiscal stimulus. The problem is to impose an effective limit on fiscal policy, while preserving enough
flexibility to respond to changing economic circumstances. Another problem is the cyclical nature of the
government budget. Requiring a balanced budget during a recession would make the recession worse.
This is a difficult task. A balanced budget amendment to the Constitution, which has been advocated by
some, would need an escape clause for recession or other emergencies. How to define such an escape
clause without eviscerating the fiscal discipline remains a challenging problem.
V. PEDAGOGY
The discussion of time inconsistency provides an opportunity to revisit the issue of fixed exchange rates
and exchange rate crises. A credible commitment to a fixed exchange rate eliminates a government’s
ability to conduct discretionary monetary expansion. Thus, it has been argued, a credibly fixed exchange
rate will reduce inflation expectations and inflation. On the other hand, as numerous currency crises
indicate, it is difficult for governments to convince markets that they will not devalue or adopt a floating
rate in times of distress. Thus, there is an argument that some governments would do well to completely
tie their hands with respect to monetary policy by establishing a currency board or adopting the U.S.
dollar as their currency. Argentina's experience, however, demonstrates that even currency boards do not
eliminate expectations of devaluation.
VI. EXTENSIONS
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For students who know rudimentary calculus, instructors can present a simple formalization 1 of the time
inconsistency problem described in this chapter. Suppose the policymakers’ loss function can be written
as
L = (a/2)π2-b(π-πe).
In words, policymakers care about inflation and unemployment in excess of the natural rate. The first
term of the loss function reflects concern about inflation. The second term reflects concern about excess
unemployment, which is determined by the difference between actual and expected inflation.
If policymakers announce an intention to achieve zero inflation, and this is believed (πe=0), they have
two options. They can follow through on the announcement and produce zero inflation, in which case,
π=0, u=un, and L=0. Alternatively, they can act in a discretionary fashion, renege on their commitment,
and attempt to achieve the socially optimal rate of inflation, conditional on πe=0. Minimizing L, subject
to πe= 0, generates an optimal rate of inflation of b/a and a loss of (–b2/2a), which is smaller than the loss
achieved by following the announced rule. The gain is caused by the surprise inflation which lowers
unemployment below the natural rate. Note that the form of the loss function implies that the cost of
inflation is zero (at the margin) when inflation is zero, so there is always some gain to unanticipated
inflation.
The problem is that the private sector is aware of these incentives. Therefore, in the absence of some
credible mechanism that forces policymakers to adhere to their announced policy, the private sector will
never believe the announcement. Expecting that policymakers will act in a discretionary fashion, the
private sector will set πe= b/a. Because this constant value of πe does not alter the solution of the
policymaker’s optimization problem, the actual rate of inflation will indeed turn out to be π= b/a.
However, since this inflation rate is no longer a surprise, there are no employment gains and the loss
becomes L=(b2/2a), a worse outcome than would have been achieved by following the rules. Since
policymakers are assumed to be benevolent—i.e., their loss function accurately reflects social
preferences—society would be better off by removing their discretion if possible.
1
The formalization is based on Barro, Robert J. and David B. Gordon (1983), "Rules, Discretion, and Reputation in
a Model of Monetary Policy," Journal of Monetary Economics, 12:101-121.
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