The Credibility Problem

Richard DeKaser, Chief Economist

Suppose you wanted to build a home on an uninhabited island, but a hurricane could someday wipe you out. If the government had a clear rule that assistance would never be provided, you might abandon the project. The island would likely remain vacant and the government wouldn’t encourage risky, and potentially costly, behavior.

But if the government’s assistance policies were ambiguous, and you knew of homeowners bailed out by the government after natural disaster struck, you might go ahead. If you could persuade a bunch of friends to join you on the island with homes of their own, thereby increasing the odds of a government rescue, you’d be even more inclined to build. And in so doing, your very actions might increase the odds of government assistance.

For analyzing situations like this, Finn Kydland and Edward Prescott received the Nobel Prize in economics in early November 2004. Generally, they recognized that even wise and clear government polices may be challenged when circumstances change, especially if the rest of us understand how our behavior might force such changes.

The true power in their work, however, is the solution to this “credibility problem,” as it’s come to be known. Because even wise and forward-thinking government policy Makers cannot anticipate the behaviors of others, or all future circumstances, everyone tends to be better off when the government emphasizes fixed rules over flexible policy discretion.
This solution is most evident in monetary policy, where central banks have adopted inflation targeting as their simple rule. In the U.S., for example, persistent inflation over 3% is surely met with rising interest rates until enough economic slack reduces price

pressures. The opposite happens when inflation dips toward 1%, or lower. The beauty of this approach is that a clear articulation of the simple rule---backed up with consistent and credible policy actions---actually promotes the desired outcome.

Fiscal policy once had a simple rule, too. Between 1990 and 2002 there was a pay-as-you-go (PAYGO) rule that required new spending programs to be financed with specific revenue increases (e.g. taxes). Conversely, tax cuts had to be matched with spending reductions. Lobbyists knew that pushing for new spending programs or tax cuts would provoke countervailing pressures, so they largely gave up.

Alas, the demise of PAYGO has given way to unrestrained spending increases and tax cuts over the past few years. Given this lack of discipline, don’t you think there ought to be a RULE?

Authorization to reprint article granted by
Jim Couburn,
National City Bank Marine Division