Adobe Systems Limits of Economic Policy 1 Economic Policy Limits of Economic Policy Adobe Systems Limits of Economic Policy 2 Economic Policy ̶the actions that states (governments, central banks) take in the economic field ̶ > Institutions Adobe Systems Limits of Economic Policy 3 The expansion of the role of the public sector ̶The 20th century saw a gradual but large expansion in the role of the state in the economy because: ̶Political and ideological factors ̶ ̶Marxist and socialistic thinking (government should play significant role in redistributing income, shift toward and „mixed“ economy) ̶ ̶Keynesian thinking (countries with large public sector were believed to be less subject to business cycles) ̶ Adobe Systems Limits of Economic Policy 4 Adobe Systems Limits of Economic Policy 5 The expansion of the role of the public sector ̶It was implicitly (if not explicitly) assumed that: ̶The governments had abilities lacking in the private sector (better managerial skills, higher level of expertise, sufficient amounts of capital) ̶ ̶The actions of the public sector were driven by the objective of promoting social welfare ̶ ̶Economic decisions were made in rational and transparent way ̶Policymakers have all relevant info and full control over the policy instruments Adobe Systems Limits of Economic Policy 6 Socialist economy at some point Image with no description Adobe Systems Limits of Economic Policy 7 Nationalization in Western Europe ̶France ̶1945: Crédit lyonnais, Société générale, Renault ̶ ̶1946: Electricite de France, Gaz de France ̶ ̶Spain ̶1944: Iberia ̶ ̶1945: 79 % of Telefónica ̶ ̶Sweden ̶1939-1948: private railway companies ̶ ̶1957: the mining company LKAB ̶ ̶United Kingdom ̶1946: Coal industry ̶ ̶1947: Central Electricity Generating Board ̶ ̶1948: National rail and inland water transport ̶ ̶1967: British Steel Corporation ̶ Adobe Systems Limits of Economic Policy 8 The end of naive picture ̶Governments are not as omniscient and omnipotent as was implicitly assumed after WWII till 1970s. ̶ ̶There are five main limits to the “traditional” approach to EP: ̶Governments have imperfect knowledge about the structure of economy and of future risks ̶ ̶Firms and households devise they own strategies and they react to (and anticipate) economic policy measures ̶ ̶Governments may not be able to convince private agents that they will actually do what they have announced ̶ ̶Policymakers may not have the information they need to take decisions ̶ ̶Policymakers may not pursue the general interest ̶ Adobe Systems Limits of Economic Policy 9 Sweden´s governemnt spending The Myth Of Sweden's Socialist Utopia – Liberty and Common Sense Adobe Systems Limits of Economic Policy 10 The limits of knowledge: uncertainty and risk ̶The government does not have all the information to take action, but it cannot wait until it has all the information. ̶Government is not able to predict the consequences of some action exactly => uncertainty about adequate choice of policy tools ̶Many policy decisions have irreversible consequences => e.g., joining Eurozone Adobe Systems Limits of Economic Policy 11 Uncertainty and risk Exchange rate: 25,3 Crude oil Brent: 83 USD Adobe Systems Limits of Economic Policy 12 Current forecast risks and uncertainty ̶epidemic situation ̶ ̶global supply chains ̶ ̶structural changes in the economy (Green Deal) ̶ ̶deferred consumption ̶ ̶overvaluation of property prices Adobe Systems Limits of Economic Policy 13 Time lags ̶Cognitive delay ̶ ̶Planning delay ̶ ̶Administrative delay ̶ ̶Implementation delay ̶ ̶Efficiency delay ̶ ̶Monetary Policy – 18 months time lag ̶ ̶Fiscal Policy 6 – 24 months time lag ̶ Adobe Systems Limits of Economic Policy 14 CS: Next Generation EU ̶EU's recovery plan from the pandemic ̶ ̶over €800 billion ̶ ̶The aim is to mitigate the economic and social impact of the coronavirus pandemic, to make European economies and societies more sustainable and resilient, and to prepare them for the challenges and opportunities of the green and digital transformation. ̶ ̶The first money will arrive in the 2nd half of 2021 ̶ ̶Do economies need fiscal expansion? ̶ Adobe Systems Limits of Economic Policy 15 CS: Next Generation EU GDP Country 2020 2021 2022 Belgium -6,30% 5,40% 3,70% Germany -4,80% 3,60% 4,60% Estonia -2,90% 4,90% 3,80% Ireland -3,40% 7,20% 5,10% Greece -8,20% 4,30% 6,00% Spain -10,80% 6,20% 6,30% France -7,90% 6,00% 4,20% Italy -8,90% 5,00% 4,20% Netherlands -3,70% 3,30% 3,30% Austria -6,30% 3,80% 4,50% Slovakia -4,80% 4,90% 5,30% Czech Republic -5,60% 3,90% 4,50% Sweeden -2,80% 4,60% 3,90% EU -6,00% 4,80% 4,50% Adobe Systems Limits of Economic Policy 16 The limits of confidence: credibility problems ̶Credibility problems arise from intertemporal inconsistency (time inconsistency) ̶ ̶time inconsistency: temptation for government to mislead private agents in the name of general interest => ex post and ex ante optimal policies do not coincide. Adobe Systems Limits of Economic Policy 17 The limits of confidence: credibility problems ̶Example: Government announces it will scarp taxes on fixed capital to encourage investment. Then forgive 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, management of the public debt ̶ ̶Unfulfilled promises undermine confidence in EP and hamper its effectiveness. ̶ ̶How can the credibility problem be solved? Adobe Systems Limits of Economic Policy 18 The limits of confidence: credibility problems ̶Solutions: ̶ ̶Delegation to independent agencies: central banks, regulatory agencies,… ̶ ̶Banish discretionary policies and follow fixed policy rules: inflation targeting, fiscal rules, agreements for the promotion and protection of investments ̶ ̶Transparency ̶ Adobe Systems Limits of Economic Policy 19 Examples of Agreement for the promotion and protection of investments Adobe Systems Limits of Economic Policy 20 The limits of confidence: moral hazard ̶Moral hazard problems arise when probability of government intervention changes private behavior and induces more risk taking ̶ ̶Examples: IMF interventions in emerging countries, role of lender of last resort of the central bank, public insurance schemes… ̶ ̶How can the credibility problem be solved? Adobe Systems Limits of Economic Policy 21 The limits of confidence: moral hazard ̶Solution: ̶make public intervention rare and costly ̶ The impact of supplementary health insurance on doctors' visits Hansoo Ko 2020 Adobe Systems Limits of Economic Policy 22 The limits of information ̶Policymakers do not have full access to all information ̶ ̶Information is used strategically by those with access to it ̶ ̶Risk of regulatory capture (regulatory agencies may come to be dominated by the interests they regulate and not by the public interest) ̶ ̶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 Adobe Systems Limits of Economic Policy 23 The limits of information: example ̶Gosplan – central planning commission in Soviet Union ̶ ̶Information had companies: ̶Over-estimated their need for inputs ̶ ̶Under-estimated their productivity ̶ ̶ ̶Friedrich A. Hayek: The Use of Knowledge in Society Adobe Systems Limits of Economic Policy 24 The limits of information: example ̶Principal-agent model ̶ ̶Relationship between landers and borrowers, producers and consumers,… ̶ ̶ Adobe Systems Limits of Economic Policy 25 The limits of information ̶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 (such as performance-related compensation and promotion, e.g., Walsh contract for central bankers – wage negatively dependent on the difference between the actual and the target inflation rate.) Adobe Systems Limits of Economic Policy 26 Conflict of interests ̶Why may politicians deviate from general interest? ̶ ̶short-sightedness (electoral cycles) ̶ ̶pressures from interest groups ̶ ̶re-election motivation (political business cycles) ̶ ̶partisan behaviour (favour the majority that supports political parties in government) Adobe Systems Limits of Economic Policy 27 Conflict of interests ̶Solutions: ̶ ̶Incentive contracts for politicians ̶ ̶Procurement rules ̶ ̶Anti-bribery laws ̶ ̶Delegation to independent agencies Adobe Systems Limits of Economic Policy 28 Evidence of politically‐motivated decisions Adobe Systems Limits of Economic Policy 29 The median voter theory ̶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 parties (left‐wing and right‐wing), they will converge on the preference of the median voter V5 => limited program differentiation Adobe Systems Limits of Economic Policy 30 The median voter Adobe Systems Limits of Economic Policy 31 Should policymaking be delegated? ̶Technocrats are better in presence of: ̶technical complexity (e.g., financial/safety regulation) ̶ ̶stable social preferences ̶ ̶the decisions in question and their effects are not easily observable by voters (merger control) ̶ ̶the decision with vulnerable to time inconsistency ̶ ̶the decision affect the distribution of income between generations Adobe Systems Limits of Economic Policy 32 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 Adobe Systems Limits of Economic Policy 33 Reference textbook ̶Benassy-Quéré, A. et al. Economic Policy: Theory and practise. Oxford University Press, 2010. Chap. 2.1 Adobe Systems Limits of Economic Policy 34