The Time-Inconsistent Government Policymaker

Policy is conducted by rule if policymakers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement. Policy is conducted by discretion if policymakers are free to size up events as they occur and choose whatever policy they consider appropriate at the time.

When government policies are time-inconsistent, this means that it's a scenario in which the government has an incentive to renege on a previously announced policy once others have acted on that announcement. This destroys all credibility in the government-run economy, the state-owned economy. This happens today quite a bit. For example, to encourage investment, it would be announced that no taxes will be collected from capital income. But once factories are built, the government reneges in order to raise more tax revenue for welfare policies or war budgets. Or for example, to reduce inflation, the central bank even might announce that it will tighten monetary policy by reducing the money supply. But if faced with high unemployment, the central bank may be tempted to cut interest rates.

I read of an example a while back in which aid was given to an underdeveloped country that announced a fiscal reform plan. Once the aid was given, the reforms did not occur. Or maybe it was because the reforms did not occur that the aid was still given--because the donor countries didn't want to see the citizens starve.

One of the first problems that Alexander Hamilton dealt with then he was appointed first U.S. Secretary of the Treasury in 1789 was the time-inconsistencies of the debt plan. When our revolutionary government incurred the debts, it promised to honor them when the war was over. But after the war, many Americans advocated defaulting on the debt because repaying the creditors would require taxation, which is always costly and unpopular.

Hamilton opposed the time-inconsistent policy of repudiating the debt. He knew that the nation would likely need to borrow again sometime in the future. So in his First Report on the Public Credit, presented to Congress in 1790, he wrote

The ready answer to this question is, by good faith; by a punctual performance of contracts. States, like individuals, who observe their engagements are respected and trusted, while the reserve is the fate of those who pursue an opposite conduct.

So, honoring the debts, Hamilton opposed time-inconsistent discretionary policies. Today, unlike in Hamilton's time, when Congress debates spending priorities, no one seriously proposes defaulting on the public debt as a way to reduce taxes. In the case of public debt, everyone now agrees--or at least ought to--that the government should be committed to a fixed policy rule. Discretionary policies should not be within the power of policymakers. Actually, they shouldn't have the power to announce policies that would even tempt them to renege later. By this I mean things like involuntary taxation. It's too much of a cookie-jar for the inconsistent policymaker. Taxation should not be within their power, unless, it seems in the case of Hamilton, to repay the public debt. Which, by the way, we still owe.