Do Regulatory and Balanced Budget Requirements Risk Exacerbating Economic Cycles? Or a Paradox of Prudence?

Abstract

Regulations established for economic agents and policy rules established for governments incorporate distilled wisdom based on (usually unhappy) experience as to what works and what doesn’t. At times, however, these rules require action that appears to run contrary to common sense. At the heart of this question is the classic debate over rules versus discretion in public policy. Automatic rules designed to build in prudent behaviour for an individual entity, whether it be a person, a bank or insurer, or a country, can, in certain circumstances lead to the paradox of prudence noted by Paul Samuelson. Those circumstances arise when the individual entities cease to behave as uncorrelated individuals and become a correlated herd, all heading in the same direction – often because of the same external shock. However, the alternative of discretionary eclecticism has often turned into a slippery. The question thus becomes which is the lesser of the two evils – the rigidity of the rule or the slippery slope of discretionary eclecticism. This note argues in favour of setting rules that meet with common sense and meeting them in the normal course, but not necessarily meeting them. The overwhelming importance of prior credibility is stressed.

Keywords: Policy Rules, Discretion

JEL Classification: E61