Richard DeKaser, Chief Economist
NationalCity.com/Economics
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