Allan Drazen. 2000. Political Economy in Macroeconomics

Allan Drazen. 2000. "The Time-Consistency Problem" and "Laws, Institutions, and Delegated Authority," in Alan Drazen, Political Economy in Macroeconomics (Princeton, NJ: Princeton University Press): 101-165. Chapters 4 and 5.

Chapter 4: This chapter just gives examples of time-inconsistency in policy choices that might arise. They all arise from heterogeneous preferences/conflicts of interests. 

Terms:

1. Time-inconsistency is said to arise if, though nothing has ostensibly changed, the policy chosen for time t+s chosen at time t is different from the policy chosen for time t+s at time t+s. 

I. Introduction

• The puzzle: why does time-inconsistency arise if the fundamental characteristics of the policymaking environment does not appear to have changed?  
• A conflict of interests of some sort is necessary for time inconsistency to arise.
• Time inconsistent policy is interesting when it is chosen to maximized the welfare of those who are misled.

II. A Simple Model of Capital Taxation

• There are two time periods. 
• In the first period:
• The government announces the tax rates it will implement in period two.
• The individual being taxed has an exogenous endowment and chooses consumption level and capital accumulation to be used in the second period
• In the second period:
• The government implements a tax rate on the capital the individual saved in the first period and the labor the individual gives in the second period.
• The individual gets the payoff from government spending and from consumption, which are functions of the capital saved from the first period and the labor the individual supplies in the second period.
• Time-inconsistent solution: the tax policy the government announces for time period 2 while in period 1 is different from the tax policy the government actually implements at time period 2. Occurs whenever ex post capital elasticity is less than the ex ante elasticity.
• In the first period, the government will announce a tax vector with a low rate to encourage capital accumulation.
• In the second period, the government will carry out a tax that is different from the one announced in the first period and there is nothing people can do about it because they can't really change the capital supply anymore.
• Precommitment solution: the tax policy the government would announce in the first period when it has a mechanism to commit to it and not reoptimize in the second period.
• The precommitment solution is the same as the time-consistent solution that results when individuals take government preferences into account when they choose their income allocations and when governments take into account individual preferences into account when they choose their tax policies.

III. Explaining Time-Inconsistency in the Model of Capital Taxation

• People cannot operate for their own good when they are subject to pre-existing constraints or distortions.
• Sequential policymaking is a necessary but not a sufficient condition for the possibility of time consistency to arise. 
• What is essential to the phenomenon of time inconsistency is conflict of interests in the second time period (ex post heterogeneity).
• The dependence of utility on aggregate allocations induces a source of conflict among agents, which is crucial for the possibility of a time-inconsistency problem.

IV. A Basic Model of Monetary Policy

• The policymaker chooses optimal inflation taking expected inflation as given. 
• The conflict of interests which lie behind the possibility of time inconsistency:
• Mirroring the capital tax problem, heterogeneity of interests in a representative agent model results in conflict of interests. Each individual wants to minimize the error of his own forecast of future inflation, but would like everyone else to under-predict inflation so that the economy-wide average prediction implies low unemployment.
• Conflict not in the capital tax example: conflict of interests between policymakers with different objectives, reflecting perhaps a conflict of interests between the different constituencies they represent. Conflict occurs when the natural rate of unemployment that the fiscal authority finds optimal is not the same as the natural rate that the monetary authority finds optimal; the fiscal authority has an incentive to increase economic activity and thus drive up short-term inflation.

V. Equilibrium Solutions for All Models

• Optimum is achieved when the policymaker is led at time t+s to carry out the policy announced at t, rather than some other policy, and it is "common knowledge" that he will indeed carry out the policy.

VI. Commitment vs. Flexibility

• There might be gains to ensuring commitment, but in the real world, unforeseen and unforecastable events occur so that the optimal policy at time t+s cannot always be identified at time t. 
• Escape clauses allow for commitment and flexibility.

Chapter 5: This chapter provides solutions to time-inconsistency problems. This chapter concentrates on how the policymaking environment can make policy credible, that is, how institutions or the creation of external circumstances (broadly defined) can lead to the expectation that announced policies will be carried out.

I. Introduction

• When policymaking is viewed as a sequence of decisions, so that the government can reoptimize at every point, the problem of time consistency can be viewed as reflecting changes in incentives over time. Time t decisions lead to an evolution of state variables which give a policymaker the incentive to deviate at time t+s from his previously optimal policy.
• Example: the decision to impose taxes on capital in a time-inconsistent way reflects the accumulation of capital, an accumulation that was induced by the government's previous policies. Hence, with the policymaker's narrowly defined objective function unchanged over time, time inconsistency may be thought of as due to change in the environment brought about by the policymaker himself.
• Time inconsistency can be avoided if a policymaker at time t can choose policy in such a way that state variables at time t+s imply that it is optimal not to deviate at t+s from the previously optimal policy. 
• One way to make current policy credible is by building a reputation by engendering the expectation that certain policies will be followed in the future on the basis of actions that have been observed in the past. 

II. Laws, Constitutions, and Social Contracts

• There are important differences between promises which have no legal backing and laws (including widely accepted norms) in analyzing solutions to the time inconsistency problem.
1. Laws have penalties attached to them so that there are explicit costs to breaking the law. Similarly, social norms have recognized costs associated with not following them.
2. Explicit laws or widely recognized social norms make noncompliance more visible and hence more costly. 
• Since laws make policies credible only to the extent that the penalties which enforce the laws are themselves credible, enhancing credibility depends on choosing the optimum structure of penalties to do this. 
• Laws (and institutions more generally) can enhance credibility by raising the cost and lowering the benefit from deviating from a given policy. 
• Effective commitment follows from the extreme difficulty in changing a law once it is given constitutional status.
• Constitutions can make policy more credible because it does the following:
• Restrict government's use of authority. 
• Set out the basic processes of policymaking—laws about how collective choices should be made.
• Treat issues that are more fundamental than others, such as basic rights of liberties.
• Provide stringent amendment procedures than other laws.
• Unwritten agreements that have force because they are generally agreed upon go by several names: social contracts, social conventions, social norms.
• Social norm - a pattern of behavior that is customary, expected, and self-enforcing. 

III. Delegation of Authority

• Delegation from a principal (the government) to an agent (the agency/authority) might occur for the following reasons:
•  The agent may have greater expertise and experience regarding a policy area.
• Governments are required to handle a large number of issues, each of which may be extremely complex, making it impossible for a single policymaker to make all decisions. The number and complexity of issues makes delegation essential.
• The principal and agent can sign an incentive contract to eliminate agent bias in policy choices and ensure optimal outcomes. The contract institutionalizes the incentives for compliance; the cost of changing an institutional structure is higher than changing a policy in itself.

IV. Fiscal Structures for Time Consistency

• A government can bequeath to its successor government a specific debt structure, such as setting maturing debt in each period equal to tax revenue net of government spending, to eliminate the incentive for its successor to change tax rates and thus try to reduce its debt obligations. 

Avner Greif. 1994. Cultural Beliefs and the Organization of Society

Avner Greif. "Cultural Beliefs and the Organization of Society," Journal of Political Economy 102, 5 (1994): 912-950.

The paper models an economic transaction central to two trading societies (the premodern Muslim and Latin worlds) to examine the relations between culture and societal organization in the related multiple equilibria game.

1. Cultural Beliefs and the Organization of Society
• Cultural beliefs: the ideas and thoughts common to several individuals that govern interaction and different from knowledge in that they are not empirically discovered or analytically proved; how individuals (without coordination) expect others to act in various contingencies.
• Unlike strategies, cultural beliefs are qualities of individuals in the sense that cultural beliefs that were crystallized with respect to a specific game affect decisions in historically subsequent strategic situations. Past cultural beliefs provide focal points and coordinate expectations, thereby influencing equilibrium selection and society's enforcement institutions. 
• Organizations: the endogenous human constructs that alter the rules of the game and, whenever applicable, have to be an equilibrium.
• They reinforce the cultural beliefs that led to their adoption.
• Enforcement institutions are composed of cultural beliefs and the rules of the game. They may change in the long run as individuals attempt to improve their lot by establishing organizations that alter the rules of the game via players, information, payoffs. 
• Necessary condition for organizational change: those that initiate it expect to gain from it, based on cultural expectations.
• Once a specific organization is introduced, it influences the rules of historically subsequent games and hence the resulting societal organization. 
2. Agency Relations and Cultural Beliefs
• The societies of the eleventh century begin examined:
1. Genoa - long-distance overseas trade was central to Genoa's economy.
2. Muslim Mediterranean - Maghribi traders (Jewish merchants) were involved in large-scale, long distance trade all over the Mediterranean. 
• The merchant-agent commitment problem:
• Merchants needed to travel overseas to trade centers or obtain merchandise or hire agents who would do so and handle the merchandise. But an agent might embezzle the merchant's goods.
• For agents to be employed, the organization of society had to enable them to commit themselves ex ante to be honest ex post after receiving the merchant's goods. 
• Strategies of collectivist and individualist societies for dealing with agency relations:
• Premise for differences in strategies: in collectivist societies everyone is expected to respond to whatever has transpired between any specific merchant and agent; the opposite holds true for individualist societies and players are expected to be indifferent.
• In both societies, a merchant hires, for a wage, an unemployed agent whom he hires as long as cheating or forced separation does not occur.
• Differences: 
1. Under the individualist strategy, a merchant randomly hires an unemployed agent; under the collectivist strategy, a merchant randomly hires only from among the unemployed agents who have never cheated. 
2. Under the individualist equilibrium, merchants do not invest to acquire information because history has no value and an agent's wage is independent of it. Under a collectivist equilibrium, the optimal wage is a function of an agent's history and the merchant will invest. 
• In equilibrium for both individualist and collectivist societies, merchants randomly hire unemployed agents and agents never cheat. 
3. The Maghribis and Genoese: Origin and Manifestations of Diverse Cultural Beliefs
• Historical records indicate that cultural "focal points" as well as social and political events in the early development of Magribis and Genoese societies were likely to be instrumental in shaping diverse cultural beliefs and the related equilibria in these groups.
• Magribis - a collectivist equilibrium was a natural focal point.
• Genoese - an individualist equilibrium was the natural focal point. 
• Historical evidence indicates that the Maghribis invested in sharing information and the Genoese did not.
4. Within the Boundaries of the Game: Cultural Beliefs, Social Patterns or Agency Relations, and Wealth Distribution
• Under collectivist cultural beliefs, a merchant who cheated in the past (when he was hired as an agent) can no longer rely on collective punishment to deter his agent from cheating him and therefore has to pay a higher wage to keep the agent honest. Merchants acting as agents lose out in the long run, so merchants strictly prefer to hire other merchants as agents.
• Under individualist cultural beliefs, a merchant who cheats while providing agency services does not have to pay more to his agents in the future and hence a merchant is not motivate to employ another merchant. 
• Under individualist cultural beliefs, a society reaches a vertical social structure for a larger set of initial conditions than under collectivist cultural beliefs, where a society reaches a horizontal social structure for a larger set of initial conditions. 
• Maghribi trader relations with horizontal agency relations--merchants hiring merchants to act as agents--confirms this.
• Genoese traders with vertical agency relations--wealthy merchants rarely, if ever, functioning as agents and poor agents rarely, if ever, functioned as merchants--also confirms this.
• Vertical agency relations allowed greater upward mobility for the poorer than horizontal relations since in vertical agency relations, the ability to commit is negatively related to wealth. 
5. Transcending the Boundaries of the Game: Segregated and Integrated Societies
• A joint economy is segregated if, given the initial conditions, merchants from each economy strictly prefer to hire agents from their own economy.
• A joint economy is integrated if, given the initial conditions, merchants from at least on economy are indifferent about the original economy of their agents. 
• In response to geographical expansion of tradeable territories, there is some doubt whether collective punishment works in intereconomy agency relations; the uncertainty contributes to a higher optimal wage in a collectivist economy. As the merchants' cost of establishing intereconomy agency relations is higher than the cost of establishing intraeconomy agency relations, only the latter will be initiated and segregation would result (unless efficiency gains of intereconomy agency relations are sufficiently large).
• For two individualistic economies, intereconomy and intraeconomy optimal wages are the same because the uncertainty mentioned previously in the last bullet point is irrelevant for the determination of the optimal wage. Efficiency gains from intereconomy agency relations will motivate merchants to establish them.
• When intereconomy agency relations become possible between a collectivist and an individualist economy, a collectivist merchant would not initiate intereconomy agency relations regardless of the uncertainty regarding the individualist merchants' responses unless efficiency gains from interagency relations are high enough. 
• Because the collectivist economy's wage is lower, individualist merchants may find it optimal to establish intereconomy relations even if such relations do not imply efficiency gains. 
6. Transcending the Boundaries of the Game: Organizational Evolution
• In a collectivist society, coordinating collective punishment and what constitutes "improper" behavior is likely to be based on informal mechanisms such as customs and oral tradition.
• In an individualist society, formal legal and political enforcement organizations are needed to support collective actions and to facilitate exchange. A formal legal code is likely required to facilitate exchange by coordinating expectations.
7. Conclusions
1. Differences in the societal organization of the two trading societies can be consistently accounted for as reflecting diverse cultural beliefs.
2. The theoretical and historical importance of culture in might determine societal organizations, lead to path dependence of institutional frameworks, and in forestall successful intersociety adoption of institutions.
3. The collectivist system is more efficient in supporting intraeconomy agency relations and requires less costly formal organizations (such as law courts), but it restricts efficient intereconomy agency relations.
4. The individualist system does not restrict intereconomy agency relations but is less efficient in supporting intraeconomy relations and requires costly formal organizations. 

James D. Morrow. 1999. The Strategic Setting of Choices: Signaling, Commitment, and Negotiation in International Politics

James D. Morrow, “The Strategic Setting of Choices: Signaling, Commitment, and Negotiation in International Politics,” in Lake and Powell, Strategic Choice, pp. 77-114.

Summary by Taylor

Main Point: Both strategic settings and preferences determine actors’ choices, and the choices of many actors determine outcomes.  Since the choices of other actors affect the final result, an actor cannot simply chose a course that will lead to its desired outcome.  From this, three different strategic problems (among others) arise: signaling, commitment, and bargaining. Understanding domestic politics is necessary to understanding strategic choice.