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Tuesday, March 13, 2018

The policy posture as an incomplete contract

by Ajay Shah.

1. A complete contract defines behaviour under all states of nature. In the real world, all contracts are incomplete: the parties are inevitably placed before unforseen situations.. But there is a useful distinction between skimpy contracts (where a small range of possibilities are forseen) and thorough contracts (where behaviour under numerous states of nature is specified).

2. The fundamental feature of policy is that it is a statement about how government will behave in the future, and that can vary by the states of nature. Policy risk is the fear that the government will not, in fact, behave in the future as it has promised to behave today.

3. Private persons face zero policy risk when (a) the decision function of the government is fully specified under all states of nature and (b) there is no possibility of the policy being changed. E.g. it would be nice to have a law that guarantees free trade under all states of nature. However, achieving zero policy risk, and complete policy credibility, is like looking for a complete contract.

4. In the real world, there is policy risk because (a) laws are incomplete contracts (there are unforseen states of nature), (b) because laws embed space for executive discretion and (c) because the law can change. A well drafted law reduces policy risk by writing down behaviour under many states of nature, and reduces executive discretion.

5. No matter how well a law is written, there is always a zone of executive discretion and the possibility that the law will change. Low policy risk, then, comes from trust in the thought process, the policy instincts, of the policy establishment. While lawmakers and the executive have the power to do weird things, we attach low probabilities to those events if and only if we trust the intellectual capacity of the policy elite, and the checks and balances (the due process) that will shoot down bad ideas.

6. Consider protectionism in the US. The law was an incomplete contract, in that there was executive discretion to go back to protectionism on the grounds of national security. But for many decades, that event had a low probability because private persons trusted in the intellectual capacity and instincts of the policy elite. When a new populist regime sweeps aside the traditional policy elite, this confidence is lost.

7. In many countries, the old policy elite has been replaced by new populist regimes. This has given heightened policy risk.

8. Clear thinking on globalisation is the hallmark of professional capability in economics. My posterior distribution of policy capability moves a lot when I see a country that engages in protectionism.


I thank Josh Felman for useful discussions. 

1 comment:

  1. If we consider policy risk in terms of a probability distribution, we have the following obvious inferences:

    1) Investment for future (like large scale infrastructure) would be more forthcoming if the probability distribution is narrower and tilted towards business friendly policy

    2) democracies with equally competing ideologies will have the widest distributions. At any assessment point, the hypothetical investor will derive this distribution from mixed distribution rather than a single distribution

    3) Even in economies with single party rule or prevalence of single party, the distribution may tend to be wider if there are many competing ideologies or personal idiosyncracies with the single party. A good example could be Indian National Congress. It is to be noted that spectrum of diverse interest/idiologies within congress could be not less than combined variance of BJP & Left

    4) The probability distribution assessed by a foreign investor could be more wider than domestic investor due to information asymmetry. The variance in probability distribution of a foreign investor would not only include possibilities of executive discretion but also increased uncertainty due to lack of relevant information on the part of foreign investor. The later part is obviously going to be low for domestic investor and hence the probability distribution known to the domestic investor would be relatively narrower.

    Hence, the following type of economies are going to be most attractive for foreign investor:

    1) Benevolent monarchies with tilt towards desire of attracting investment
    2) Economies (democracies or monarchies) with lot of institutional controls on executive discretion

    However, the following types are going to be worst in terms of attractive foreign investment

    1) Democracies with more than one strong party (for example India) but with equal love for personal popularity and sense of pride in exercising executive discretion

    2) Democracies with never ending election schedule as populism becomes unavoidable in these economies (like India)

    3) Democracies driven more by personal cult rather than party ideology. Populism would be a natural by-product of such democracies unless and otherwise there is only one very strong popular leader

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