Commitment, rules, and discretion.

• Author: Plosser, Charles I.

The debate regarding rules versus discretion in the conduct of monetary policy is an old one dating back at least to Henry Simons (1936). His famous paper in the Journal of Political Economy, entitled "Rules versus Authorities in Monetary Policy" is a classic. Simons's view stressed the importance of establishing the "rules of the game" as opposed to the "delegation of legislative powers," that granted "authorities" to central banks. Today we would characterize authorities as discretionary powers in contrast to rules. He rightly struggled with these concepts and their implications for a free society in the classical liberal sense. His conclusion was that establishing rules of the game was clearly preferable and the lesser of two evils when it came to monetary policy.

The modern version of the debate surrounding rules versus discretion is best captured in the work of Finn Kydland and Edward Prescott (1977), again in the Journal of Political Economy and titled "Rules Rather than Discretion: The Inconsistency of Optimal Plans." They showed that a regime that precommits policymakers to behave in a particular way is preferable to a regime that allows policymakers pure discretion--that is, to choose a policy independently at each point in time.

The idea is very counterintuitive to most people and particularly unappealing to many policymakers. After all, the policymaker could choose the same set of actions under discretion as he could under commitment. So it would seem that a discretionary policy can certainly be no worse than a policy that entails precommitment. Therefore, the argument goes, there is value in retaining "flexibility," or as some monetary policymakers I know used to say, "optionality," so that decisions can respond "appropriately" to current events. Thanks to Kydland and Prescott and others, we now know that this argument is flawed. The fatal flaw in this conventional wisdom stems from its failure to recognize the important role played by expectations of future policy in economic decisions made today.

Expectations, Commitment, and Discretion

Expectations of the future play a crucial role in all sorts of decisions. This is particularly evident in financial markets, where investment decisions and the valuation of securities depend importantly on assessments of future economic outcomes. But it is equally true for individuals buying a home or a car, and for businesses considering capital expenditures.

Before going further, it is useful to be a bit more precise and define what I mean by "commitment" and "discretion." Commitment essentially means that policymakers deliver on past promises about future actions. Discretion, on the other hand, means the policymaker is not bound by previous actions or plans and thus is free to make an independent decision every period.

Discretion means the policymaker may find it preferable to change his or her mind, or re-optimize, and do something other than what was promised. The temptation to renege on previous promises or plans is what economists refer to as the time-inconsistency problem, and it has surprisingly troublesome consequences. In particular, it can mean that outcomes under a discretionary regime are likely to be worse than those under a regime where the policymaker is constrained to follow through on previous commitments.

To illustrate the issue, consider the case of patent protection. Research and development (R&D) by the private sector is an important source of innovation in our economy. From new drugs to computers, research has led to new products that have enhanced our health and productivity. Thus, investment in research generates important returns that contribute to the improvements in living standards both here and around the world.

To encourage such investment, governments often seek to ensure that private returns to innovation are sufficient to elicit the socially optimal amount of investment in new ideas. In practice, governments often give temporary monopoly rights to companies and individuals, in the form of a patent, as a means of assuring...