Many people seem to assume that placing intelligent people in positions of power and then granting these individuals broad discretionary powers to do as they see fit is the best way to go about solving the world’s many problems. However, this idea is often an illusion. In many cases, simple policy rules would produce far better outcomes than affording wise individuals substantial influence.
Over the last few years, the most severe public policy problem in the developed world has undoubtedly been persistently high unemployment. Especially here in the United States, it is very difficult to argue that discretionary fiscal policies have satisfactorily dealt with this most pressing issue.
The difference between rules-based policies and discretionary policies is subtle yet important. “Discretionary policy” refers to a situation in which a group of people is given the power to determine and change government policies as it sees fit. This contrasts with a “rules-based policy,” whereby government policies are set by a fixed rule, and government officials’ sole job is to conduct policy in accordance with that rule.
The period from 1985 to 2007 is often referred to as “the Great Moderation” due to the relative macroeconomic stability of these years. This stability was arguably due, in large part, to the fact that the federal government’s macroeconomic policies were determined by relatively fixed rules — the Federal Reserve essentially followed an interest-rate rule and Congress largely abstained from discretionary fiscal policy.
By early 2008, though, discretionary macroeconomic policies were back in favor, largely because the Federal Reserve’s policy rule seemed incapable of dealing with the recession. Since then, Congress has adopted several short-term, discretionary stimulus packages, and the Fed has sporadically increased the quantity of bank reserves. Despite these largely unprecedented discretionary policy actions, unemployment has now been above 8 percent for over three years. This recent experiment with discretionary macroeconomic policies has failed.
Contrary to popular belief, it is very difficult to make a convincing empirical case that the discretionary fiscal stimulus policies of the last four years have been successful. Yes, states that received more in federal stimulus money have had less severe downturns than states that received less. If Congress passed a stimulus bill that gave $1 million to each Dartmouth Greek organization, I’m pretty sure that this would cause a statistically significant increase in alcohol sales in the Hanover area. But that does not necessarily prove that this policy increased overall employment or gross domestic product for the entire country.
Instead of relying on wise government officials to use their discretionary powers to solve future macroeconomic problems, it would be far better to adopt simple and straightforward policy rules. Yes, it is not hard to come up with theoretical arguments against any given policy rule. But I find it hard to believe that a decent monetary policy rule — an NGDP level target, for instance — would have performed as poorly as the discretionary policies of the last four years.
One of the key problems with discretionary policy is that no single individual can truly understand the entire economy and all of its complex inter-linkages. In fact, discretionary policy actions intended to reduce macroeconomic instability could unintentionally increase instability. Furthermore, given that government officials’ interests may not be entirely in line with the interest of the general public, it is important that the general public be able to easily judge policymakers’ actions. As a result, it would be far better for policymakers to be bound by policy rules than given discretionary authority — an appropriate policy rule could provide both an acceptable level of stability and a means by which the public could judge whether policy makers have been behaving in an acceptable manner.
However, even if policymakers were perfectly omniscient and altruistic, rules would still be preferable to discretion. The reasons relate to “dynamic inconsistency” and are beyond the scope of this column.
In short, it is wrong to think that we will solve the world’s troubles by giving government officials ever more discretionary powers. In many cases, especially those relating to macroeconomic stabilization, it would be far better to adopt simple policy rules.