Rules versus discretion

posted in: Economics, MFin, Students | 0

A long standing theme in macroeconomic policy is the question, when is it best for policy makers to be tied to a rule and when should they have freedom to decide what to do (“discretion”). It’s easiest to see why this matters in the matter of setting interest rates to steer the economy. A rule such as “keep inflation down to 2% or less” is clear and unambiguous, though the correct interest rate to set to meet that goal still requires judgement.

A politically motivated central bank, or one which is directly under the control of the government, might prefer a much looser rule (eg “try to keep inflation down but not at the expense of high unemployment”). In practice, the government might be tempted to keep interest rates down ahead of an election, to avoid politically costly unemployment, but at the price of higher inflation. This discretion would tend to mean higher inflation in general and a less credible central bank.

So many central banks are now independent of government and are given a rule that is intended to enhance their credibility and achieve a better overall policy outcome than a more discretion-based regime might achieve.

Of course there are times, perhaps rare, when following the rule might be disastrous. If the economy is struggling with incipient deflation and may tip into a debt depression costing years of high unemployment then a simple rule on inflation isn’t enough. We would then want the central bank to use whatever means it could to avoid the deflation.

But it’s hard to craft a rule that tells the central bank what to do all the time, in all states of the world. It becomes either a very complex rule or it, in effect, gives them discretion to make their best choice. The US Federal Reserve Board has a dual mandate to hit low inflation and high employment and use its discretion as to how best to do so. Some US politicians would prefer to abolish the employment mandate and stick to the simple rule on low inflation. This is like the European Central Bank’s rule and that of the Bank of England. There is no perfect solution but during the worrying times we face, I’m happy that the Fed has some freedom of manoeuvre and a Chairman with skin thick enough to ignore the Republicans’ criticism.

More generally, life goes best when there is some predictability but occasionally unexpected or unique situations occur. We have shifted the emphasis on the MFin degree this year towards more rules and less discretion. Students should be able to know with some certainty, what they’re supposed to do and when. If they don’t do it they get a penalty. There is no room for an argument and the MFin team have given up their discretion. But this risks a situation when some really exceptional thing happens and the rules should be broken, just once. But how to tell when that situation arises? Well, they use their discretion!

A major reason for having more rules and fewer guidelines is that there are always one or two people who will treat guidelines as an invitation to negotiate. This can lead to a lot of time and energy being wasted on trying to wriggle out of a commitment or deadline. So long as the team are believed to have discretion then the student thinks it’s worth haggling. Even if he (it’s usually a he) doesn’t get what he wants, he’s wasted other people’s time.

So there is a risk in having more and stricter rules, but I hope it’s justified by the saving in time, energy and raised blood pressure that the negotiators cause. We shall see.

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