Economic Policy #2
Limits of Economic Policy


Limits of Economic Policy
•Uncertainty and risk
•The limits of confidence
•The limits of information
•Conflicts of interests
•Solution
•External limits
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Motivation
•Governments are not as omniscient and omnipotent as was implicitally assumed after WWII till
1970s.
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•Government interact with other players in imperfect information world and their EP have been
deeply affected by the rise of international interdependence.
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Uncertainty and risk
•Government doesn’t have extensive knowledge of the preferences of economic agents and of the
economic structure
•=> uncertainty about adequate choice of policy tools
•
•Many policy decisions have irreversible consequences
•=> ‘precautionary principle‘ of economic policymaking (e.g. joining eurozone), creating a
decision-under-uncertainty framework
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Surprises and outturns in 15 EU budgetary plans, 1998-2006
Nominal GDP growth, %
Nominal government revenue growth, %
Nominal government expenditure growth, %
Nominal government balance as percentage of GDP, %
“Positive” surprises
50
58
76
36
“Negative” surprises
50
42
24
64
In spite of higher-than-expected revenues, frequent expenditures overruns often have resulted in
the deficit exceeding target => governments do not manage public finances in a way to take into
account risks to revenues and expenditures.
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The limits of confidence: credibility problems #1
•
•Credibility problems arise from intertemporal inconsistency (often called time inconsistency), i.
e. temptation for government to mislead private agents in the name of general interest => ex post
and ex ante optimal policies do not coincide.
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The limits of confidence: credibility problems
•Example:
•Government announces it will scrap taxes on fixed capital to encourage investment. Then reneges on
its promise because it is socially optimal ex post to finance public goods by taxing capital. What
will be the result?
•
•Another application to monetary policy, exchange-rate policy, ..
•Unfulfilled promises undermine confidence in EP and hamper its effectiveness.
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Responsible and irresponsible credible behaviour #1
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Responsible and irresponsible credible behaviour #2
•Shorter-term expectations are more volatile, but volatility decreases as the expectation horizon
lenghtens > ECB has achieved a high degree of credibility. •But sometimes it may be important to be
credibly irresponsible (e.g. deflationary crisis)
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The limits of confidence: credibility problems (cont.)
•Solutions:
–Delegation to independent agencies: central banks, regulatory agencies,…
–Banish discretionary policies and follow fixed policy rules: inflation targeting, fiscal rules,
currency boards…
–Transparency
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The limits of confidence: moral hazard
•Moral hazard problems arise when likelihood of government intervention alters private behaviour
and induces more risk taking.
•Examples: IMF interventions in emerging countries, role of lender of last resort of the central
bank, public insurance schemes…
•Solution:
–make public intervention rare and costly (e.g. lender-of-last resort doctrine)
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The limits of information #1
•Policymakers do not have full access to information and it is used strategically by those with
access to it
•Risk of regulatory capture
•Major issue for
–regulation and supervision in technical areas (telecom, energy, finance…)
–contracts (e. g. for provision of government-financed services such as health care)
–internal organization of government
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The limits of information #2
•Theory:
–principal-agent model: the principal, who delegates a task to the agent, does not have full info
about agent’s capabilities and performance => suboptimal results
•
•Solution:
–incentive contracts, possibly within the government (such as performance-related compensation and
promotion, e.g. Walsh contract for central bankers)
•
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Conflict of interests #1
•Why politicians may deviate from general interest?
•
•shortsightedness (electoral cycles)
•pressures from interest groups (“pork-barrel politics”)
•reelection motivation (political business cycles)
•partisan behaviour
•divided electorate
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Conflict of interests #2
•Models:
•attrition wars, vote theory
•
•Solutions:
•Incentive contracts for politicians, procurement rules, antibribery, delegation to independent
agencies
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Evidence of politically-motivated decisions
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The median voter
•Voter chooses the party whose preferences are close to his or her own: voters V1 to V4 will for
example vote for candidate C1 and voters V5 to V9 to candidate C2.
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•
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•If there are only two parties (left-wing and right-wing), they will converge on the preference of
the median voter V5 => limited program differentiation
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Should policymaking be delegated?
•Technocrats are better in presence of:
–technical complexity (e.g. financial/safety regulation)
–judicial nature of decisions (merger control)
–undesirable trade-offs (public health and safety)
–intertemporal concerns (distributions across generations)
–significant international independence
–benefits to groups likely to engage into political lobbying
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Should policymaking be delegated?
•But decision needs to remain political when:
–social preferences are unstable
–policy involves unavoidable trade-offs
–policy involves significant redistributions within generations
•
–=> Today’s hot topics: balanced budget rules, fiscal councils
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Living with interdependences
Some indicators of international integration exceed level before WWI
 (e.g. trade openness), others do not (international migration flows).
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The pros and cons of coordination #1
•Arguments for coordination
–Global public goods
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–Policy spillovers
•Demand, price and interest rate spillover
•Competitiveness and the ’n-1’ problem (if all n countries behave the same way, the economic
indicator (e.g. exchange rates) will remain unchanged
–=> beggar-thy-neighbor policies
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The pros and cons of coordination #2
•Arguments against coordination
–Commitments not followed by actual policy decision
–Model and parameter uncertainty: imperfect information may lead to wrong choices
–Coordination as a form of collusion when seen as a coalition among policymakers to weaken market
discipline
–Partial coordination (e.g. within a subset of countries) may worsen policy outcome
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