The Credibility Problem

Richard DeKaser 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 earlier this month. Generally, they recognized that even wise and clear government policies may be challenged when circumstances change, especially if the rest of us understand how our behavior might force such changes. Expecting investment tax credits during a recession, for example, might suppress investment activity during normal times and actually increase the probability of a recession occurring!

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. Businesses become wary of raising prices, suspecting that finely tuned monetary policies will prevent them from taking hold.

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. In effect, giving Peter a tax break meant reducing Paul’s favorite spending program, and, Paul’s spending program couldn’t grow without a new tax on Peter. Sure enough, the PAYGO rule promoted the desired outcome. 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 years. According to the latest projection from the Congressional Budget Office, federal budget deficits will total $2.3 trillion over the next decade, before things really start to deteriorate. In the meantime, uncertainty surrounding the timing and character of any eventual fix only hurts the economy.

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