Rules vs discretion
2009-02-07 · Original WordPress address
Will Wilkinson is "extremely suspicious of what strike me as intellectually contentious, ad hoc interventions into the economy aimed at expectation management."
He should be suspicious because when policy makers have discretion, outcomes are worse. This is because people know the government can cheat by trying to exploit short-term trade-offs between outcomes and inflation. Because the government has discretion and they can cheat, people expect governments will cheat and increase inflation --- by spending a bizzilion dollars for example --- thus increasing their expectations of future inflation. This high expected inflation translates to actual inflation and thus a worse outcome.
On the other hand, if policy makers can commit themselves to a particular policy and that commitment is credible, expectations of inflation are lower, actual inflation is lower and outcomes are better.
How do policy makers credibly commit themselves to policy rules? Well, they don't increase spending by almost 10% of GDP willy-nilly. Better is to have over 20 years of policies that lead to stable levels of inflation. Too bad we're going to get the former and no-longer have the latter.
(Lectures 11-14 here are a pretty good and thorough introduction to these ideas. I just found it from googling so there may be something better out there.)