Graf v dokumentu a pero LIMITS OF ECONOMIC POLICY II. Economic Policy — the actions that states (governments, central banks) take in the economic field Policymaker Objectives Instruments Limits Political context Institutions 2 Limits of Economic Policy The expansion of the role of the public sector 3 Limits of Economic Policy —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 a „mixed“ economy) — — Keynesian thinking (countries with large public sector were believed to be less subject to business cycles) 4 Limits of Economic Policy The expansion of the role of the public sector 5 Limits of Economic Policy — 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 Socialist economy at some point 6 Limits of Economic Policy Nationalisation in Western Europe 7 Limits of Economic Policy — France —1945: Crédit lyonnais, Société générale, Renault —1946: Electricite de France, Gaz de France — — — — — —Sweden —1939-1948: private railway companies —1957: the mining company LKAB — — — — — — — —Spain —1944: Iberia —1945: 79 % of Telefónica — — — — — — —United Kingdom —1946: Coal industry —1947: Central Electricity Generating Board —1948: National rail and inland water transport —1967: British Steel Corporation The end of naive picture 8 Limits of Economic Policy Sweden´s government spending 9 Limits of Economic Policy The limits of knowledge: uncertainty and risk 10 Limits of Economic Policy — A government is not able to predict the consequences of some action exactly => uncertainty about adequate choice of policy tools — The government does not have all the information to take action, but it cannot wait until it has all the information. — — Many policy decisions have irreversible consequences => e.g., joining Eurozone Uncertainty and risk Exchange rate: 24,6 Crude oil Brent: 91 USD 11 Limits of Economic Policy Current forecast risks and uncertainty •Cut of natural gas supplies from Russia to the European Union •COVID-19 •Inflation expectations •Fiscal consolidation •Labour market •Integration of refugees from Ukraine •Overvaluation of residential property prices • 12 Limits of Economic Policy Time lags Monetary Policy – 18 months 13 Limits of Economic Policy The limits of confidence: credibility problems 14 Limits of Economic Policy — Arise from intertemporal inconsistency = time inconsistency — = a temptation for government to mislead private agents in the name of general interest ex post and ex ante optimal policies do not coincide. The limits of confidence: credibility problems 15 Limits of Economic Policy — Example: — A government announces a decrease of taxes on fixed capital to encourage investment. Then it abandons the 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? The limits of confidence: credibility problems 16 Limits of Economic Policy — 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 Examples of Agreement for the promotion and protection of investments 17 Limits of Economic Policy The limits of confidence: moral hazard 18 Limits of Economic Policy — 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? The limits of confidence: moral hazard The impact of supplementary health insurance on doctors' visits — A solution: — Make public intervention rare and costly 19 Limits of Economic Policy Hansoo Ko (2020) The limits of confidence: moral hazard 20 Limits of Economic Policy The limits of information 21 Limits of Economic Policy — Policymakers do not have full access to all information — Information 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 organisation of government The limits of information 22 Limits of Economic Policy — Gosplan = a central planning commission in the Soviet Union — — Companies had information — Over-estimated their need for inputs — — Under-estimated their productivity — — — https://mises.org/library/use-knowledge-society — The limits of information 23 Limits of Economic Policy — Principal-agent model — e.g. a relationship between lenders and borrowers, producers and consumers — —Theory: — Principal-agent model: the principal, who delegates a task to the agent, does not have 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 – the wage negatively dependent on the difference between the actual and the target inflation rate. Conflict of interests 24 Limits of Economic Policy — Why may politicians deviate from general interest? — — Short-sightedness (electoral cycles) — — Pressures from interest groups (“pork‐barrel politics”) — — Reelection motivation (political business cycles) — — Partisan behavior — — Divided electorate Conflict of interests 25 Limits of Economic Policy — Solutions: — — Incentive contracts for politicians — — Procurement rules — — Anti-bribery laws — — Delegation to independent agencies Evidence of politically‐motivated decisions 26 Limits of Economic Policy The median voter — A voter chooses the party whose preferences are close to his or her own: e.g. 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 a limited programme differentiation 27 Limits of Economic Policy The median voter 28 Limits of Economic Policy Should policymaking be delegated? 29 Limits of Economic Policy —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 Should policymaking be delegated? 30 Limits of Economic Policy — But decision needs to remain political when: — Social preferences are unstable — — Policy involves unavoidable trade‐offs — — Policy involves significant redistributions within generations Reference textbook 31 Limits of Economic Policy — Benassy-Quéré, A. et al. Economic Policy: Theory and practise. Oxford University Press, 2010. Chap. 2.1 j0299125