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Rules vs. discretion

Rules vs. discretion

Macroeconomic policy rules regimes inevitably entail discretion

Public Choice theory versions of the ‘rules versus discretion’ debate in Political Economy, such as Kydland and Prescott’s famous ‘Time inconsistency’ thesis (1977), or monetarist versions as in Friedman’s policy engineering approach which argues that an automatic, fixed money growth rule should supersede discretionary macroeconomic policy (1959), often assume a mechanistic process of automatic rules being technocratically administered. Such theories identify the motivation behind fiscal or monetary policy rules as preventing the demos from threatening fiscal probity and economic stability. A government’s fiscal stance, within these interpretations, seems to be arrived at according to a set of settled and technocratically assured principles of ‘sound’ fiscal policy. These accounts neglect the contingency of fiscal and monetary policy rules.

Indeed, the inevitability of discretion and flexibility in administering fiscal rules regimes renders these versions of the rules/discretion debate of limited use in framing our understanding of technocratic economic governance. To understand what fiscal rules actually do, and how they really work – we need to recognise that both rules and discretion are at play in operating fiscal rules. The application and operation of fiscal rules, far from being automatic and mechanistic, in fact involves extensive judgement, intuition and discretion. These are integral to fiscal evaluation.

Neo-liberal economists, embracing rational expectations, anticipate that publishing fiscal rules will transform outcomes via market actors incorporating these new economic policy parameters into their correct model of the economy. This mechanistic view of political economy is based on a ‘very narrow conception of the social’, misconceiving the social nature of fiscal rules, and the construction of fiscal credibility (see Best 2019: 626, 633-4; 2020). The real world of fiscal rules is more political and social than such rational expectations accounts admit.

Fiscal rules do not end discretionary policy-making, nor exert the iron fiscal discipline often mooted as their rationale. The degree of ‘daylight’ between the pre-suppositions of models, and practitioners’ and policy-makers’ thinking about how the economy actually works is something underplayed in many discussions of ‘rules versus discretion’. It is clear from the practitioners engaged in rules-based economic policy that what really matters for the conduct of policy or the evaluation of fiscal rules is not just the models, but also the judgements and intuitions exercised by practitioners on what comes out of the models, and what should go into the models next time.

Discretion, judgement and interpretation are inherent within any economic rules regime. Selecting techniques and making model assumptions are important aspects of the judgement and discretion inherent in operating macroeconomic policy rules. 

These judgements are often far from self-evident. In the case of the OBR, the most important ‘moving parts’ in all their forecasting processes are not the model and its calibration and parameters – important as they are.

Rather, it is the key judgements made by the three-person Budget Responsibility Committee about important but elusive concepts such as potential GDP, trend productivity, and the size of the output gap. These really drive the OBR’s narrative of the economy