Rules vs Discretion

Abstract

At the heart of many debates over economic policy and the role of the government in the economy is disagreement over how effectively policymakers can diagnose and solve problems. If policymakers were omniscient, omnipotent, and reliable, they would be able to perfectly design policy to pursue society's economic goals. Of course, they are none of these. And to the extent that policymakers' information, tools, and motives are imperfect, they may do more harm than good in attempting to affect economic outcomes. Those who support a more active role for policymakers tend to be more optimistic about their knowledge, potency, and reliability; those who prefer a more passive role tend to be more skeptical. One way in which societies manage uncertainty over policymakers' effectiveness is by varying the extent to which policies are made by rules versus discretion. Rules, whether based on technocratic analysis or historical convention, 1 act like mathematical functions or machines: they take a set of inputs (i.e., data) and yield outputs (i.e., policies) with limited room for policymakers to adjust or influence them. Discretion is the opposite: it gives policymakers the authority to choose policy as they see best, regardless of what prominent rules suggest. When a society is more skeptical about policymakers' effectiveness, it is more likely to constrain them through the imposition of policymaking rules; when a society is more confident in its policymakers, discretion is preferred. Rules have the benefit of limiting the extent to which ignorant, weak, or malevolent policymakers can choose policies at odds with the society's goals. But no rule can be perfect, given our imperfect understanding of the economy and its unpredictability. Discretion allows policy to respond more flexibly than even the most flexible rule. Application in Monetary Policy Monetary policy provides perhaps the clearest application of the debate over rules vs. discretion. Central banks around the world wield enormous influence in their economies, primarily through their setting of interest rates. After the Great Depression of the 1930s, economists became generally convinced that monetary policy could play a major role in exacerbating or alleviating economic cycles. Central Banks' "monetary policy" became arguably the most important arrow in the policymaking quiver for management of the economy over the short term. 2 Despite general agreement that monetary policy could, in principle, alleviate economic cycles, some economists were skeptical that it could be practiced effectively enough to do more harm than good.