Wednesday, June 06, 2007

Credibility-Commitment Problem

This is in fact the first thing that was exciting enough to talk about here! That's why I'm breaking my promise not to post anything until the end of the exams. Quite fittingly, this is exactly the problem I will talk about, the inability of people to keep their promises!

The inability of an actor to credibly commit to a long-term decision, goal or promise arises from the mismatch of short-term and long-term interests, i.e. the time inconsistency problem. (I will draw upon the works of Majone and Rodrik here.) The actor knows what's best for him/her in the long-run and makes a promise. But such a situation arises now that the actor feels compelled to deviate from the optimal long-term strategy. The other actors in the interaction expect this, and the prevailing outcome is suboptimal. The inability of an actors to generate trust on others hurts them before everone else.

The first example Rodrik gives is a democratic country's attitude towards a dictator abroad. The democratic country disapproves of the undemocratic regime and the dictator's illegitimate actions and promises to impose sanctions on the dictator. However, when the possibility of his own people toppling him becomes a reality, the Westerners agree to provide him exile to prevent a civil war. This does not exactly have the effect of discouraging the dictator from being a dictator!

Another example is a government striving to get a multinational company invest in its territory. It provides various incentives to lure the company, but the company isn't sure whether those incentives will be reversed after it undertakes the costly investment. If the government cannot find a way to convince the company, it may well lose a big opportunity that will create much output and employment.

Then there is monetary policy. The government knows that it should stick to a low-inflation policy. (We are assuming there is no independent central bank.) However, a recession (and/or large government debt) makes it very attractive to create surprise inflation. That way, the government will be able to boost output and employment by diminishing real costs. Moreover, it will be able to reduce the real value of its debt. The other players know this and adjust their expectations. Because they expect higher inflation, they bargain for higher wages. In the end the economy ends up having a higher inflation rate than it could have had the government been able to credibly commit to price stability (for a given unemployment level.)

This problem is exacerbated by the fact that elected officials stay in office only for a limited time. The long-term gains of sticking to a policy are after the next election, while the short-term gains from deviation are here and now (the shorter the time horizon in the game, the greater the incentives to cheat.) Moreover, newly elected governments can always renege on their predecessors' promises.

Governments have to come up with ways to tie their own hands. Delegation of powers to an independent, unelected agency with different interests may be the solution. This is the reason behind the creation of independent central banks. Governments give the responsibility of monetary policy to an independent body that doesn't have to care about the next election, but faces great reputational costs from deviating from its optimal long-run policy. However, a national central bank can still be persuaded to respond to a deep recession or unsustainable government debt. Therefore, joining a fixed-exchange rate regime or the Eurozone is an even more credible commitment device. By giving up control over their monetary policies countries attach a new cost to surprise inflation. When they can no longer devalue their currency, higher inflation directly translates into a loss of competitiveness in the world market.

Delegation of powers is not limited to monetary policy. Member states in the EU delegated powers of agenda-setting and law enforcement to the European Commission, which brings them to the European Court of Justice if they violate the Competition Policy. If they didn't tie their own hands this way, it would be politically impossible for them to cut state aid. But then their own exporters would also suffer from state aid abroad.

The credibility-commitment problem, of course, affects our daily lives as well. The grand example is how people never show up for study groups! And I'm sure we all heard of the ham-egg sandwich.


Pratik Dattani said...

So what if we lived under a President with a 10-year term, appointed by a committee of technocrats. The technocrats are elected (by the public) officials for 10 year terms each such that the President would spend 5 years under one elected panel, and 5 years under the next. The President can be replaced through some x majoirty in the committee. The committee can be voted out by a Parliament (I'm not quite sure how they might interact...perhaps the committee would be a kind of quasi-cabinet for the President?) only through a no-confidence motion. But a no-confidence motion is an exceptional event, so Parliament would be loathe to ask for it too often, for fear of upsetting people/markets etc. Oh, and all the terms of Prez/committee are extendable to 2 terms.

lightcapsule said...

Let's say a president faces an econonomic or foreign policy crisis towards the end of his first term. The president answers to the cabinet of "technocrats", who still have another 5 years before their term expires, so they will prioritize long-term gains over short-term losses. Here we overcome the credibility-commitment problem.

What if the cabinet faces a crisis situation towards the end of its first term? Here the division of responsibilities between the president and the cabinet matters. I assume that the cabinet has policy-making powers, and the president cannot veto or reverse its decisions. In that case, members of the cabinet would still face the credibility-commitment problem. (Technocrats are no longer technocrats once they run in elections.)

What do you think?