Should Policy Makers Be Restrained?

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Should PolicyMakers BeRestrained?
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• Is a balanced-budget amendment a good idea?

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Uncertainty and Policy

• Macroeconomic policy makers in general do not
  have all the knowledge required for solving
  economic problems.
• They rely on macroeconometric models, all of
  which give different answers for how to solve a
  particular problem.

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How Much DoMacroeconomists Actually Know?

• The Response of Output to a Monetary Expansion
  Predictions from 12 Models

There is substantial uncertainty about the
effects of policy.
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Uncertainty and Restraintson Policy Makers

• There is substantial uncertainty about the
  effects of macroeconomic policies. This
  uncertainty should probably lead policy makers to
  be more cautious, and to use less active policies.

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Expectations and Policy

• Until 20 years ago, the economy was seen as a
  machine. Methods of optimal control were being
  used to design macroeconomic policy.
• People and firms try to anticipate what policy
  makers will do. Hence, macroeconomic policy is a
  game between them. We dont need optimal control
  theory but rather game theory, which studies
  strategic interactions between players.

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Hijackings and Negotiations

• By giving up the option to negotiate, governments
  can prevent hijackings in the first place.
• Exactly the same logic is involved in the design
  of macroeconomic policy to control inflation and
  unemployment.

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Inflation and Unemployment Revisited

• The relation between unemployment and inflation
  is as follows

• Suppose the Fed announces that it will constant
  inflation, and wage setters believe that expected
  inflation will be zero. Then

• In the U.S., ? ? 1. If ? 0, then the announced
  policy calls for ? ?e 0, and uun.

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Inflation and Unemployment Revisited

• But the Fed could deviate from its stated policy
  and achieve an unemployment rate of 1 below the
  natural rate with just a 1 increase in the
  inflation rate.

• If ? 1 and ? 0, then (u?un.) ? 1.

• This incentive to deviate from the announced
  policy once the other player (in this case wage
  setters) has made its move is known as the time
  inconsistency of optimal policy.

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Inflation and Unemployment Revisited

• Wage setters wise up and begin to expect positive
  inflation of 1. Eventually, the economy returns
  to the natural rate of unemployment, but with
  higher inflation.

• By credibly committing not to do something that
  would appear desirable at the time, policy makers
  can achieve a better outcomeno inflation.

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Establishing Credibility

• Ways to deal with the problem of time
  inconsistency, without totally stripping
  policy-making power from the central bank,
  include
• Make the central bank independent. This way, the
  central bank resists political pressure to
  decrease unemployment.
• Choose a conservative central banker who dislikes
  inflation.

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Establishing Credibility

• Inflation and Central Bank Independence

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Politics and Policy

• If voters are short-sighted, the temptation for
  politicians to cut taxes may prove irresistible.
• With the right timing and short-sighted voters,
  political parties can win elections. Thus, we
  might expect a clear political business cycle,
  with higher growth on average before elections
  than after elections.
• However, there is little evidence of manipulation
  of the macroeconomy to win elections.

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Games BetweenPolicy Makers and Voters

• The Evolution of the Ratio of U.S. Debt to GDP,
  1900-2000

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Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations Growth During Democratic and Republican Administrations
GDP Growth ( per Year) GDP Growth ( per Year) GDP Growth ( per Year) GDP Growth ( per Year) GDP Growth ( per Year) GDP Growth ( per Year) GDP Growth ( per Year) GDP Growth ( per Year)
First First Second Second Third Third Fourth Fourth
Democratic
Truman 0.0 8.5 10.3 3.9
Kenney/Johnson 2.6 5.3 4.1 5.3
Johnson 5.8 5.8 2.9 4.1
Carter 4.7 5.3 2.5 ?0.2
Clinton I 2.7 4.0 2.7 3.6
Clinton II 4.4 4.3 4.1 4.1
Average Democratic 3.4 5.5 4.4 3.5
Republican
Eisenhower 4.0 ?1.3 5.6 2.1
Nixon 2.4 ?0.3 2.8 5.0
Nixon/Ford 5.2 ?0.5 ?1.3 4.9
Reagan I 1.9 ?2.5 3.6 6.4
Reagan II 3.6 3.0 2.7 3.0
Bush 2.5 1.2 ?0.7 2.6
Bush (George W) 1.1
Average Republican 3.3 ?0.1 2.1 4.0
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Games Between Policy Makers

• Game theorists refer to situations in which each
  side holds out, hoping the other side will give
  in, as wars of attrition. These wars usually
  result in delays in the implementation of policy.
• Also, each party worries more about either
  inflation or unemployment. We would expect, for
  example, to see stronger growth during Democratic
  administrations.

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The Case Against aBalanced-Budget Amendment

• A balanced-budget amendment would eliminate the
  problem of deficits, but it would also eliminate
  the use of fiscal policy as macroeconomic policy
  instrument.
• A constitutional amendment is not the only way to
  achieve deficit control and reduction.

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The Case For aBalanced-Budget Amendment

• Economists in favor of a balanced-budget
  amendment are more skeptical of the usefulness of
  macroeconomic policy in general, and of fiscal
  policy in particular.
• Lags in the legislative process prevent Congress
  from changing fiscal policy in time to stabilize
  the economy.
• Rules that Congress may impose on itself can be
  changed by a vote later on.