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Rules vs discretion in central banking

Rules vs discretion in central banking
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First Published: Thu, Oct 13 2011. 11 27 PM IST

Jayachandran/Mint
Jayachandran/Mint
Updated: Thu, Oct 13 2011. 11 27 PM IST
The Reserve Bank of India (RBI) has been raising policy rates since March last year to combat near double-digit inflation. Over the last several months, it has had to do a tightrope walk in trying to achieve balance between growth and inflation. This is, therefore, an opportune moment to pause and ask the following question: Should monetary policy be guided by the goal of long-term growth and price stability or yield to short-term pressures to manage interest rates? Said differently, with respect to monetary policy, which of the following two options is better: insisting that our monetary policymakers stick to clear rules or granting policymakers broad discretion? As fears of the slowdown in Europe and stagnation in the US envelope us, the choice between these two options becomes important for the fiscal policy as well. I intend to explore which of these two options has been more potent in enhancing prosperity by drawing on research that has examined the effects of rules-based and discretionary policies on economic outcomes.
Jayachandran/Mint
Of course, fiscal and monetary policies always involve some combination of rules and discretion. Policymakers never simply employ one approach or another by itself. But they do, at different times and in response to different pressures, tend to emphasize one over the other. When policymakers lean in the direction of rules, they pursue less interventionist, more predictable, and more systematic policies. In monetary policy, rules-based policymaking corresponds to adhering to a steady and predictable strategy for adjusting interest rates or the money supply. In fiscal policy, policymakers set long-term debt, spending, and revenue policies and rely on “automatic stabilizers” to counteract booms or busts. Employment-creation schemes, unemployment benefits and other transfer programmes that are sensitive to changes in the business cycle are examples of such automatic stabilizers.
When policymakers lean towards discretion, by contrast, they pursue less predictable, more interventionist policies with a focus on short-term fine-tuning. In monetary policy, discretionary policymaking corresponds to the central bank seeking to influence or respond to momentary fluctuations in unemployment and inflation without a long-term strategy. The changes in interest rates undertaken by RBI are examples of discretionary monetary policy. Fiscal policy comes to involve targeted and temporary spending and tax changes, the goals of which are usually to produce a short-term stimulus. The fiscal stimulus provided by the United Progressive Alliance government immediately after the financial crisis is an example of such discretionary fiscal policy.
Rigorous academic research of the effect of rules-based and discretionary policies on economic outcomes has been conducted using the policy regimes in the US after World War II. Economic policy during the post-war period in the US has consisted of three major oscillations between rules-based and discretionary policy. The first swing moved towards more discretionary policies in the 1960s and 1970s; then came a shift towards more rules-based policies in the 1980s and 1990s. In the past decade, there has been a return to discretion. Remarkably, the same oscillations occurred simultaneously in both monetary and fiscal policies. Each of these swings had enormous consequences for the US economy. Taken together, they make for a historical proving ground in which one can study the effects of rules-based and discretionary policies on the economy.
So what, then, might we learn from this evidence about the effects of these policies on unemployment, inflation, economic stability, the frequency and depths of recessions, the length and strength of recoveries, and periods of economic growth?
The short answer is that rules-based policymaking wins in a canter in this two-horse race. In other words, laying down and sticking to consistent rules is crucial for conducting and evaluating economic policy.
Discretionary policies produce suboptimal results because they deny people the benefits of “policy commitments”. Such commitments—which give the public the sense that the basic rules of the game are steady and reliable—are essential to the proper functioning of a market economy. Commitment to a reasonably sound rule—even if it is very far from a perfect rule—is preferable to discretionary policies, however, well-intentioned or managed. Moreover, almost by definition, highly discretionary policy limits the ability of individuals and firms to plan, and so tends to distort market behaviour, driving it towards inefficient short-term responses and choices. Furthermore, since people’s expectations are heavily dependent on particular public policies, economic models that try to evaluate policy based entirely on extrapolating historical trends are bound to fail because they do not take policy changes into account. Extending that argument implies that economic models will break down if policymakers do not follow relatively consistent rules—and, therefore, those rules have an essential role to play in guiding policymakers towards sound decisions, and in helping them assess the effects of these decisions. Over time, discretionary policy will inevitably make for bad policy.
Krishnamurthy Subramanian is an assistant professor of finance at the Indian School of Business.
Note: This is the first part of a four-part series.Comments are welcome at theirview@livemint.com
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First Published: Thu, Oct 13 2011. 11 27 PM IST