We won’t know for some time yet whether we are living through a game-changing period in which a dominant economic paradigm is replaced by something else. We don’t yet know what the catchy label will be for it.
Yet some of our conventional notions about how states manage market expectations have already been upended in recent times. One of these concerns the politics of credible commitment, which doesn’t always work the way we think it should.
The phrase, perhaps most commonly associated with Douglass North, refers to government commitment to constrain its discretionary policy capabilities, often through some form of delegated governance, the better to reassure powerful and potentially hostile policy actors about what they will and will not do. Thus independent central banks, beyond democratic control and populist influences, are expected to be more credible in their commitment to securing low inflation rates. This will send signals to the markets, that is, to investors seeking signals about risk evaluation, that government is committed to orthodox monetary policy. This in turn is assumed to encourage investment and facilitate growth.
But even before the current crisis, something funny was going on. In a fascinating new research paper, my colleague Sebastian Dellepiane has thrown new light on the underlying logic of the British Labour Party’s surprise decision, as soon as they took power in 1997, after 18 years in the political wilderness, to make the Bank of England independent. It was widely interpreted at the time as the price Labour had to pay to gain the confidence of the City, and indeed it succeeded in this. For several years, it seemed that British economic policy was even more firmly in thrall to Conservative priorities than the Conservatives themselves had been. Chancellor Gordon Brown’s mantra of ‘prudence’ in tax and spending policy merely underscored the point.
But Dellepiane argues that Brown and his colleagues always intended this to be a transitional phase. Drawing on Elster’s work on constraint theory, he claims that they were not so much binding themselves as binding their political opponents and their market critics. Once they had changed the game-plan in everyone’s minds, once they had secured their credible commitment to low inflation, they were paradoxically freer than ever to engage in active tax and spending activity. Brown’s fiscal measures were always part of his political programme, but could not be openly avowed. But ‘redistribution by stealth’ resulted in a rising volume of public sector deficit during most of the 2000s. The politics of credible commitment, played out in the context of two-party politics, had facilitated exactly what it was meant to prevent.
An analogous observation may be made about European Monetary Union and the Stability and Growth Pact. Governments’ self-binding disciplines in the run-up to the Euro resulted in reasonably convincing convergence during the 1990s on inflation, interest rates, and debt. Governments sought to establish their credibility and win the benefits of currency stability, low interest rates, and frictionless trade. But the design of the SGP proved to have asymmetrical incentives to continue with self-binding. As Hallerberg and Bridwell have argued[i], the SGP rules interacted with domestic political institutions to produce asymmetrical outcomes. In countries which already possessed ‘fiscal contract’ decision-making systems, the SGP reinforced their practices, but in countries with strong delegated powers available to finance ministers, it had little effect. And large states were more likely to breach the rules than small ones.
So the politics of gaining credibility through self-binding turns out to have paradoxical outcomes. Gordon Brown deliberately used a self-binding monetary policy to enable activist fiscal policy. Governments’ self-binding adoption of the Euro had the unintended consequence of enabling asset price inflation in the peripheral countries and financial sector indiscipline in many other countries. The strong implication is that the consequences of self-binding depend on how the strategy interacts with domestic institutions and the configuration of domestic political interests. Neat economic theory trips over messy political reality once again.
[i] Hallerberg, Mark, and Joshua Bridwell. 2008. ‘Fiscal Policy Co-ordination and Discipline: The Crisis of the Stability and Growth Pact and Domestic Fiscal Regimes’, in The Euro at Ten: Europeanization, Power and Convergence, edited by Kenneth Dyson, 69-86. Oxford: Oxford University Press.