Economic	
  Policy	
  #02	
  
Limits	
  of	
  Economic	
  Policy	
  
The	
  expansion	
  of	
  the	
  role	
  of	
  the	
  public	
  
sector	
  	
  	
  #1	
  
The	
  20th	
  century	
  saw	
  a	
  gradual	
  but	
  large	
  expansion	
  in	
  the	
  
role	
  of	
  the	
  state	
  in	
  the	
  economy	
  because	
  of	
  
•  poli?cal	
  and	
  ideological	
  factors	
  
•  marxist	
  and	
  socialist	
  thinking	
  (governments	
  should	
  play	
  
significant	
  role	
  in	
  redistribu?ng	
  income,	
  shiE	
  toward	
  a	
  
“mixed”	
  economy)	
  	
  
•  Keynesian	
  thinking	
  (countries	
  with	
  large	
  public	
  sector	
  
were	
  believed	
  to	
  be	
  less	
  subject	
  to	
  business	
  cycles)	
  
•  technical	
  development	
  in	
  economics	
  (concept	
  of	
  
government	
  failures)	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   2	
  
The	
  expansion	
  of	
  the	
  role	
  of	
  the	
  public	
  
sector	
  	
  	
  #2	
  
It	
  was	
  implicitly	
  (if	
  not	
  explicitly)	
  assumed	
  that:	
  
•  the	
  governments	
  had	
  abili?es	
  lacking	
  in	
  the	
  private	
  
sector	
  (beKer	
  managerial	
  skills,	
  higher	
  level	
  of	
  
exper?se,	
  sufficient	
  amounts	
  of	
  capital)	
  
•  the	
  ac?ons	
  of	
  the	
  public	
  sector	
  were	
  driven	
  by	
  the	
  
objec?ve	
  of	
  promo?ng	
  social	
  welfare	
  
•  the	
  public	
  sector	
  was	
  monolithic	
  and	
  economic	
  
decisions	
  were	
  made	
  in	
  ra?onal	
  and	
  transparent	
  way	
  
•  policy	
  decisions	
  were	
  reversible	
  
•  policymakers	
  have	
  all	
  relevant	
  info	
  and	
  full	
  control	
  
over	
  the	
  policy	
  instruments	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   3	
  
The	
  end	
  of	
  naive	
  picture	
  
Governments	
  are	
  not	
  as	
  omniscient	
  and	
  omnipotent	
  as	
  was	
  
implicitly	
  assumed	
  aEer	
  WWII	
  ?ll	
  1970s.	
  
	
  
There	
  are	
  four	
  main	
  limits	
  to	
  the	
  “tradi?onal”	
  approach	
  to	
  
EP:	
  
1.	
  Governments	
  have	
  imperfect	
  knowledge	
  about	
  the	
  
structure	
  of	
  economy	
  and	
  of	
  future	
  risks.	
  
2.	
  Governments	
  may	
  not	
  be	
  able	
  to	
  convince	
  private	
  agents	
  
that	
  they	
  will	
  actually	
  do	
  what	
  they	
  have	
  announced.	
  
	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   4	
  
The	
  end	
  of	
  naive	
  picture	
  
3.	
  Policymakers	
  may	
  not	
  have	
  the	
  informa?on	
  they	
  need	
  to	
  
take	
  decisions.	
  
4.	
  Policymakers	
  may	
  not	
  pursue	
  the	
  general	
  interest.	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   5	
  
1.	
  Uncertainty	
  and	
  risk	
  
Government	
  is	
  not	
  able	
  to	
  predict	
  the	
  consequences	
  of	
  
some	
  ac?on	
  exactly	
  
=>	
  uncertainty	
  about	
  adequate	
  choice	
  of	
  policy	
  tools	
  
	
  
Many	
  policy	
  decisions	
  have	
  irreversible	
  consequences	
  
=>	
  ‘precau1onary	
  principle‘	
  of	
  economic	
  policymaking	
  (e.g.	
  
joining	
  eurozone),	
  crea?ng	
  a	
  decision-­‐under-­‐uncertainty	
  
framework	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   6	
  
CS:	
  Surprises	
  and	
  ouKurns	
  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,	
  %	
  
“Posi?ve”	
  
surprises	
  
50	
   58	
   76	
   36	
  
“Nega?ve”	
  
surprises	
  
50	
   42	
   24	
   64	
  
In	
  spite	
  of	
  higher-­‐than-­‐expected	
  revenues,	
  frequent	
  expenditures	
  
overruns	
  oEen	
  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.	
  
	
   EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   7	
  
2.	
  The	
  limits	
  of	
  confidence:	
  credibility	
  
problems	
  #1	
  
	
  
Credibility	
  problems	
  arise	
  from	
  intertemporal	
  inconsistency	
  
(oEen	
  called	
  /me	
  inconsistency),	
  i.	
  e.	
  tempta?on	
  for	
  
government	
  to	
  mislead	
  private	
  agents	
  in	
  the	
  name	
  of	
  
general	
  interest	
  =>	
  ex	
  post	
  and	
  ex	
  ante	
  op?mal	
  policies	
  do	
  
not	
  coincide.	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   8	
  
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	
  op?mal	
  ex	
  post	
  to	
  finance	
  public	
  goods	
  
by	
  taxing	
  capital.	
  What	
  will	
  be	
  the	
  result?	
  
	
  
Another	
  applica?on	
  to	
  monetary	
  policy,	
  exchange-­‐rate	
  
policy,	
  ..	
  
Unfulfilled	
  promises	
  undermine	
  confidence	
  in	
  EP	
  and	
  
hamper	
  its	
  effec?veness.	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   9	
  
CS.	
  Responsible	
  and	
  irresponsible	
  
credible	
  behaviour	
  #1	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   10	
  
CS.	
  Responsible	
  and	
  irresponsible	
  
credible	
  behaviour	
  #2	
  
•  Shorter-­‐term	
  expecta?ons	
  are	
  more	
  vola?le,	
  but	
  
vola?lity	
  decreases	
  as	
  the	
  expecta?on	
  horizon	
  lenghtens	
  
>	
  ECB	
  has	
  achieved	
  a	
  high	
  degree	
  of	
  credibility.	
  
•  But	
  some?mes	
  it	
  may	
  be	
  important	
  to	
  be	
  credibly	
  
irresponsible	
  (e.g.	
  defla?onary	
  crisis)	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   11	
  
The	
  limits	
  of	
  confidence:	
  credibility	
  
problems	
  (cont.)	
  
•  Solu?ons:	
  
–  Delega?on	
  to	
  independent	
  agencies:	
  central	
  banks,	
  
regulatory	
  agencies,…	
  
–  Banish	
  discre1onary	
  policies	
  and	
  follow	
  fixed	
  policy	
  
rules:	
  infla?on	
  targe?ng,	
  fiscal	
  rules,	
  currency	
  
boards…	
  
–  Transparency	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   12	
  
The	
  limits	
  of	
  confidence:	
  moral	
  hazard	
  
Moral	
  hazard	
  problems	
  arise	
  when	
  likelihood	
  of	
  
government	
  interven?on	
  alters	
  private	
  behaviour	
  and	
  
induces	
  more	
  risk	
  taking.	
  
Examples:	
  IMF	
  interven?ons	
  in	
  emerging	
  countries,	
  role	
  of	
  
lender	
  of	
  last	
  resort	
  of	
  the	
  central	
  bank,	
  public	
  insurance	
  
schemes…	
  
Solu?on:	
  
–  make	
  public	
  interven?on	
  rare	
  and	
  costly	
  (e.g.	
  lender-­‐
of-­‐last	
  resort	
  doctrine)	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   13	
  
3.	
  The	
  limits	
  of	
  informa?on	
  #1	
  
•  Policymakers	
  do	
  not	
  have	
  full	
  access	
  to	
  informa?on	
  and	
  
it	
  is	
  used	
  strategically	
  by	
  those	
  with	
  access	
  to	
  it	
  
•  Risk	
  of	
  regulatory	
  capture	
  
•  Major	
  issue	
  for	
  
–  regula?on	
  and	
  supervision	
  in	
  technical	
  areas	
  
(telecom,	
  energy,	
  finance…)	
  
–  contracts	
  (e.	
  g.	
  for	
  provision	
  of	
  government-­‐financed	
  
services	
  such	
  as	
  health	
  care)	
  
–  internal	
  organiza?on	
  of	
  government	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   14	
  
The	
  limits	
  of	
  informa?on	
  #2	
  
•  Theory:	
  	
  
–  principal-­‐agent	
  model:	
  the	
  principal,	
  who	
  delegates	
  a	
  
task	
  to	
  the	
  agent,	
  does	
  not	
  have	
  full	
  info	
  about	
  
agent’s	
  capabili?es	
  and	
  performance	
  =>	
  subop?mal	
  
results	
  
•  Solu?on:	
  	
  
–  incen?ve	
  contracts,	
  possibly	
  within	
  the	
  government	
  
(such	
  as	
  performance-­‐related	
  compensa?on	
  and	
  
promo?on,	
  e.g.	
  Walsh	
  contract	
  for	
  central	
  bankers)	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   15	
  
4.	
  Conflict	
  of	
  interests	
  #1	
  
Why	
  poli?cians	
  may	
  deviate	
  from	
  general	
  interest?	
  
	
  
•  shortsightedness	
  (electoral	
  cycles)	
  
•  pressures	
  from	
  interest	
  groups	
  (“pork-­‐barrel	
  poli?cs”)	
  
•  reelec?on	
  mo?va?on	
  (poli?cal	
  business	
  cycles)	
  
•  par?san	
  behaviour	
  
•  divided	
  electorate	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   16	
  
Conflict	
  of	
  interests	
  #2	
  
Models:	
  	
  
•  aKri?on	
  wars,	
  vote	
  theory	
  
	
  
Solu?ons:	
  
•  Incen?ve	
  contracts	
  for	
  poli?cians,	
  procurement	
  rules,	
  
an?bribery,	
  delega?on	
  to	
  independent	
  agencies	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   17	
  
Evidence	
  of	
  poli?cally-­‐mo?vated	
  
decisions	
  
e limits of benevolence
deviate from
electoral cycles)
t group (“pork-
ion
Evidence of politically-motivated decisions
, vote theory
ontracts for
ent rules, anti-
independent
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   18	
  
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.	
  
	
  
	
  
	
  
	
  
	
  
If	
  there	
  are	
  only	
  two	
  par?es	
  (leE-­‐wing	
  and	
  right-­‐wing),	
  they	
  
will	
  converge	
  on	
  the	
  preference	
  of	
  the	
  median	
  voter	
  V5	
  =>	
  
limited	
  program	
  differen/a/on	
  
The median voter
Hotelling, 1929; Black, 1948
• 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 for candidate C2.
• Outcome = limited program differentiation
• Suppose left-wing and right-wing parties disagree on the level of government transfers.
Voters will choose the median level of transfers. Except under very specific assumptions,
this coincides neither with the ‘Benthamian’ choice (maximize average welfare) nor with
the ‘Rawlsian’ choice (concentrate transfers on the poorest)
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   19	
  
Should	
  policymaking	
  be	
  delegated?	
  
•  Technocrats	
  are	
  beKer	
  in	
  presence	
  of:	
  
–  technical	
  complexity	
  (e.g.	
  financial/safety	
  regula?on)	
  
–  judicial	
  nature	
  of	
  decisions	
  (merger	
  control)	
  
–  undesirable	
  trade-­‐offs	
  (public	
  health	
  and	
  safety)	
  
–  intertemporal	
  concerns	
  (distribu?ons	
  across	
  
genera?ons)	
  
–  significant	
  interna?onal	
  independence	
  
–  benefits	
  to	
  groups	
  likely	
  to	
  engage	
  into	
  poli?cal	
  
lobbying	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   20	
  
Should	
  policymaking	
  be	
  delegated?	
  	
  
•  But	
  decision	
  needs	
  to	
  remain	
  poli?cal	
  when:	
  
–  social	
  preferences	
  are	
  unstable	
  
–  policy	
  involves	
  unavoidable	
  trade-­‐offs	
  
–  policy	
  involves	
  significant	
  redistribu?ons	
  within	
  
genera?ons	
  
	
  
=>	
  Today’s	
  hot	
  topics:	
  balanced	
  budget	
  rules,	
  fiscal	
  
councils	
  
EP#02:	
  Limits	
  of	
  Economic	
  Policy	
   21	
  
Reference	
  textbook	
  
Bénassy-­‐Quéré,	
  A.	
  et	
  al.	
  Economic	
  Policy	
  :	
  
Theory	
  and	
  prac1se.	
  Oxford	
  University	
  Press,	
  
2010.	
  Chap.	
  2.1	
  
22	
  EP#02:	
  Limits	
  of	
  Economic	
  Policy