Economic Policy
Theory and Practice
SECOND EDITION
Agnès Bénassy-Quéré, Benoît Cœuré, Pierre Jacquet, and Jean Pisani-Ferry
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Foreword
This book is a book I would have loved to write. Indeed, this is a book I long wanted to write. I wanted to do so out of guilt. For a long time, I have felt that my graduate textbook written with Stan Fischer sent the wrong message. We had made the choice to present models and their logic rather than their applications. The justification was a perfectly good one—namely, that we wanted to show the intellectual structure of macroeconomic theory first. But, de facto, the lack of serious empirics sent another message: that theory was largely divorced from practice and from facts. That message is wrong: theory without facts is much too easy and of very little use. I also wanted to write such a book out of a desire to share with students my excitement about moving between theory, facts, and policy. It is traditional to do so in undergraduate textbooks, at least in the United States. Those textbooks are full of discussions about policy debates—about the effects of policy choices on the economy. I thought it would be even more fun to do so with graduate students who have more tools, both theoretical and econometric, at their disposal.
Agnès Bénassy-Quéré, Benoît Cœuré, Pierre Jacquet, and Jean PisaniFerry have beaten me to it. I am happy they did so because they have done a better job than I could have hoped to.
To give a sense of what they have achieved, I shall take one example, the creation or reform of fiscal frameworks like the European Stability and
Growth Pact (SGP). To come to an intelligent set of recommendations, think of all the elements you need to put together:
• You need to understand what sustainability means in theory and in practice, what the costs of not abiding by sustainability are, and how to assess sustainability. When does a debt-to-gross domestic product ratio become truly excessive? What happens then? How fast can you reach that threshold? How fast can you move away from it?
• You need to understand the long-term effects of deficits and debt on output and its composition. How do deficits and debt affect output in the medium and long run? How do they affect the interest rate, the net foreign debt position, the capital stock? What is the cost in terms of lost consumption in the future? Which generations gain, which generations lose?
• You need to understand the short-term effects of deficits and how countercyclical fiscal policy can help in the short run. Do deficits affect activity in the same way, whether they come from tax cuts or spending increases? How important are expectation effects? Can the anticipation of large deficits in the future lead to a decrease in consumption and investment and a decrease in output today? When is this more likely to happen?
• You need to understand the macroeconomic costs of decreased policy flexibility. Are constraints on deficits and debt consistent with an appropriate response of fiscal policy to shocks? What explains sustained divergences within the euro area during the first 10 years? Were such divergences avoidable? Then you need to determine whether and to what extent fiscal policy is the right tool to deal with country-specific shocks and to what extent it can (should) substitute for the lack of an independent monetary policy. Finally, you need to figure out how much policy space is left to governments after they have fought the new Great Recession and rescued their banks.
• You need to think about how to define the rules in practice. How should debt be defined? How should implicit liabilities, coming from Social Security and other promises to future generations, be treated? If rules are defined in terms of deficits and debt, what are the most appropriate definitions of the two concepts for the question at hand? How should rules deal with privatization revenues? Should rules apply to gross debt or to net debt? Should the budget be separated between a current account and a capital account? Should the deficit rules apply only to the government current account? Can rules be enforced by politicians, or do we need to set up independent committees?
• You need to think about political-economy issues. Why are rules needed in the first place—to protect people from their governments, or to protect the governments from themselves? How can a particular set of rules be manipulated or distorted by a national government? How will sanctions against a misbehaving government be imposed? Will these sanctions be credible ex ante? Is international coordination, such as in the G20 framework, an advantage or a diversion from every government’s duties?
To answer these questions, you need many conceptual tools. Among them are a dynamic general equilibrium model with overlapping generations, a model of short-run fluctuations with careful treatment of expectations, politicaleconomy models to think about the case for rules, and agency models to help you think about the design of specific rules. In each case, with guidance from theory, you need to look at the evidence to get a sense of which theoretical arguments are more relevant. This is not easy to do. Courses will typically give you the theoretical tools without much incentive to apply them and leave you to use them on your own without much practical training. This is not what this book does. It motivates you to use tools, gives you the tools, and shows you how they can be employed.
Last, but not least, this book is among the very first that offer students a rigorous and comprehensive treatment of the global financial crisis and the Great Recession that followed. The authors do not try to cast a veil over the conceptual difficulties economists face when they reflect on the causes of the crisis, on the limitations of traditional approaches that the crisis has uncovered, maybe on the excessive faith in theory, and on the need for more theoretical work to better understand the crisis and make sure it does not happen again. But they do not throw the baby out with the bath water and claim that economists have “mistaken beauty for truth,” as was suggested by Paul Krugman. On the contrary, they show how existing theories can be used, cross-fertilized, and replaced in a historical context to understand the crisis better. This is the way forward.
In short, this book trains you to be a good macroeconomist—a good economist. It instills the right attitude and gives you the right methodology: to build solidly on theory, to use the theory to look at the data, and then to go back and forth between the two until a coherent picture forms. As I was reading the book, I felt again the excitement that comes with doing research on macroeconomics. I hope this excitement is contagious, and I wish you a very good read.
Olivier Blanchard, C. Fred Bergsten Senior Fellow, Peterson Institute for International Economics
Preface
This is a book for those who are eager to find out what shapes, or should shape, economic policy: the major stylized facts that capture the messages from history; the theories that help make sense of these facts and analyze the impact of policy decisions; the controversies that surround policy choices; the rules and institutions that contribute to determining them; and, last but not least, the way experience, theories, and institutions interact.
The first edition of this book—in French—dates back to 2004. This is the second English edition. Meanwhile, Italian and Chinese translations were published, and the fourth French edition (prepared in parallel to the English one) was released in late 2017. Each vintage has been noticeably different from the previous one. The original book arose from a seminar designed to build a bridge between the students’ theoretical baggage and economic policymaking, which many of them planned to embrace as a profession, and this second English edition follows the same approach. Not only is this new edition more insightful, more precise, and more comprehensive than the previous one, but it also incorporates the new analytical insights and new practical responses developed in response to the major economic policy challenges that arose in the past 15 years and that have revisited the way many issues are looked at and many problems are approached.
Over the past decade, the world has been hit by the global financial crisis and the Great Recession (uppercase letters reflect the trauma it has caused), prompting a rediscovery of finance by an economic profession that had long assumed that the financial plumbing was flawless; Europe’s currency area has come through a near-death experience; inflation has almost disappeared, while forgotten deflation concerns have reemerged; public debt has soared, and the threat of sovereign insolvency that was regarded as the sad privilege of developing countries has reached the advanced world; emerging countries have come of age; income inequality has risen to the forefront, first of political controversies and, gradually, of policy discussions; and the nature of labor has structurally changed. New questions have prompted new research and called for new responses rooted in theory and informed by practical experience.
This new edition fully takes this major renewal into account. It provides the reader with an up-to-date overview of economic policy as it is discussed, designed, and implemented. All chapters have been thoroughly reviewed, some have been entirely rewritten. A new chapter on financial stability has been introduced. The result, we believe, is a book like no other.
The Interaction Between Research and Practice
This book stands at the crossroads between theory and practice. Our premise is that the all-too-frequent disconnect between them is detrimental to both good policy and good research. We posit that going back and forth between practice and theory enlightens practice and helps construct better theories.
All four of us are teachers; all of us combine, or have combined, research and policy advice: we have been advisors, experts, members or chairs of consultative bodies, senior officials, central bankers, researchers in think tanks, and commentators at a national, European, or international level. We have been confronted with the reality of economic policy-making in different places—and this has changed the way we understand, teach, and use economic theory.
We have learned from experience that research can be the victim of its own internal logic and ignore important, sometimes even vital, economic insights. We have also learned that ignorance of the lessons of History and neglect of theoretical advances can make policy ineffective, even toxic.
The global financial crisis will have a long-lasting effect on policy-making and economic theory. Some of the mechanisms at play before and during the crisis had been identified and studied in the aftermath of previous crises, while others have been updated or altogether uncovered. In a first step, in order to fight financial disruption, to revitalize the economy, and to design new crisis-prevention schemes, economists tapped knowledge which had been buried deep in economic textbooks, drawing lessons from economic history; they attempted to avoid repeating past mistakes; and they rehabilitated models which had been considered mere theoretical curiosities. In a second
step, new research was initiated. Some of it was very theoretical and aimed to identify sources and contagion channels of financial fragility and to renew our approach to risk management; some of it was empirical and aimed to sharpen our understanding of the impact of economic policy or to explore previously overlooked dimensions, such as income inequality or systemic risk. In this book, we survey this research and discuss its contribution to economic policy, in particular in Chapters 4–6 devoted to fiscal policy, monetary policy, and financial stability.
In Europe, the crisis has uncovered specific deficiencies in the way economic thinking and policy-making interact. The creation of a supranational currency was an undertaking (one may say, an experiment) of unprecedented ambition. Many of the pitfalls that were encountered could have been foreseen, at least in part. Heterogeneity within the currency area, inadequate adjustment mechanisms to asymmetric shocks, self-reinforcing price divergence, and weak incentives to fiscal responsibility, to mention but a few, were well-known issues. They had been identified from the outset by academics, and their significance could be inferred from historical experience. Other challenges related to the non-pooling of bank risk or the lack of a lender of last resort to governments had been identified by some but had not been subject to a complete diagnosis. A deeper, more genuine dialogue between researchers and policymakers could have helped anticipate and prevent the euro area crisis. Unfortunately, however, policy complacency set in after the launch of the euro, and, for long, policymakers seemed more interested in the analyses that justified their choices than in those that questioned them. A genuine dialogue intensified only when it appeared that the euro was under mortal threat.
The Responsibility of Economists
The more theory and policy interact, the greater the responsibility of economists. This raises several issues related to their integrity, their intellectual openness, and their ability to debate.
Let’s face it: The crisis has cast suspicion on the economic profession. Economists have been blamed for being blind, complacent, or even captured. They have been charged with intellectual conformism, excessive trust in market mechanisms, being too close to the world of finance, and being weak with the powerful. After the euro area crisis, they have been accused of drawing biased conclusions on the costs and benefits of monetary integration (that is, underestimating the former and overestimating the latter). They have been diagnosed with an acute myopia which leads them to take interest only in social interactions with a pecuniary nature, to focus on the accumulation of wealth more than on its distribution, and to ignore the damage caused by growth and the political forces that shape economic institutions. And they have sometimes been blamed for focusing on specialized, “elegant” models
at the expense of understanding a complex reality—for mistaking beauty for truth, as cogently expressed by Paul Krugman.
As for integrity, it is fair to acknowledge that professional economists, while lecturing others about the importance of incentives, have for too long turned a blind eye to their own conflicts of interests. Beyond the pecuniary dimension, which should not be overlooked, economists must be aware that being too close to any professional constituency—including politicians and government technocrats—risks blunting their critical sense. After the crisis, their professional ethics have been questioned. This has already prompted greater disclosure, for example in professional journals, an effort which needs to be further advanced. Full transparency on potential conflicts of interest must be ensured.
As for the criticism of being intellectually blind, it is often based on a mistaken preconception. Economic theory is not the Trojan horse of free-market, small government, minimal redistribution mindset some believe it is in liberal circles. Several recent recipients of the Nobel Memorial Prize in Economics have devoted their research to inequalities, poverty, and government intervention, or to the limited rationality of economic agents. Economists do regard the market as an efficient tool to allocate resources, but they are equally concerned with its failures and unequal distributional effects, and they have designed instruments to identify and correct them.
Democracy would benefit if participants in the public debate made a better (and more informed) use of economic analysis. Economists are not ideologues: they devote an increasing part of their time to empirical work and experiments, tapping a rapidly expanding trove of data. Nowadays, unlike a few decades ago, the bulk of research published in top economic journals is empirical. And theory remains essential to identify the key parameters which will make a policy successful and to guide empirical analysis beyond the surface of pure statistical regularities.
Some economists may see themselves more as advocates—of market efficiency, of economic openness, of price stability or of (de)growth—than as scientists or engineers. And when confronted by politicians, civil society actors, or experts of other disciplines, some cautious and balanced researchers may also tend to simplify their points excessively and overplay their social role. Policymakers often make a biased use of the outcome of research, placing an excessive weight on work that merely confirms their priors. In the mid-2000s, scholars of finance or of the euro too often struck a Panglossian tone, while those who struck a note of caution were largely ignored. In such cases, admittedly, the culprit is less research than the relationship between research and policy, and economists share the blame. And methodological arrogance is unwarranted. When it comes to the myopia and apparent irrationality of individuals, economists often hide behind Elinor Ostrom or Richard Thaler (both Nobel-Prize winners) who have endeavored to understand nonmonetary interactions, non-pecuniary incentives, and collective action. And they emphasize that concepts such as utility, intertemporal maximization, or
social welfare give them all the necessary instruments to build a multifaceted approach to public action, far from the simple religion of growth. This is all true but easily misleading. Economists should be more open to the finding of other social sciences. The strength of their discipline does not come from any inherent superiority of what George Stigler once celebrated as the “imperial science,” but from the blend of analytical rigor and empirical relevance that their profession has been able to develop. They should heed Keynes’s invitation to model themselves on the humility and competence of dentists.
A Unique Structure
Economic textbooks typically cover economic theory in a given field— macroeconomics, microeconomics, finance, international trade, etc.—and use real-life stories to illustrate theoretical results. Their representation of economic policy instruments and of the decision-making process often remains rudimentary and abstract: the decision-maker is supposed to choose without constraints the interest rate or the level of public spending, whereas in real life such decisions involve complex processes.
Conversely, many excellent essays on economic policy are more concerned with describing the ebb and flow of new ideas and institutions than with discussing their theoretical underpinnings. They are informative but frustrating. Our book aims to fill that gap. We present the main analytical tools—theoretical and empirical instruments, or old and new—that are relevant to addressing real-life policy issues; we explain how these instruments can be used to identify policy trade-offs and guide the policymakers’ choices; and we discuss the theoretical uncertainties, blind spots, and controversies that justify cultivating humility and caution when formulating policy advice and that make the job of economists so challenging and rewarding. We hope that this book will provide the reader with the necessary tools to understand and participate in the debates which will develop in the years to come.
There are nine chapters. The first three set out the general framework of economic policy-making. Chapter 1 describes the methodological foundations and toolbox essentials that will be used in the rest of the book. Chapter 2 adds a note of caution: it outlines the limits of government intervention and the political-economy reasons that may render it suboptimal. Chapter 3 introduces the plurality of policy-making within and between sovereign nations. Chapters 4–9 cover six domains of economic policy: fiscal policy (Chapter 4), monetary policy (Chapter 5), financial stability (Chapter 6), international capital integration and foreign exchange policy (Chapter 7), tax policy (Chapter 8), and long-term growth policies (Chapter 9). Chapter 6 is entirely new and benefited from comments by Laurence Boone, Lorenzo Cappiello, Anne Le Lorier, and Peter Praet, whom we would like to thank here. Each of these six chapters is structured in a similar way: the first section outlines stylized facts derived from
recent economic history, the second section introduces the theoretical models policymakers should have command (or at least a knowledge) of, and the third section presents the main policy options. There are many cross-references between the six chapters, but they are written in such a way that each of them can be read on its own.
This book is by no means comprehensive. We cover macroeconomics in a broad sense, focusing successively on money, the budget, finance, exchange rate, taxation, and growth. We have chosen not to address, or address only at the margin, a number of otherwise important areas of economic policy, such as competition policy, social protection, labor policies, international trade, or climate change. We have also decided not to write specific chapters on international economic policy, regional (and especially European) integration, or the management of local governments. Chapter 3 summarizes what economic theory has to say on the assignment of policy instruments to different levels of government and on the difficulties of global governance; however, in any policy domain, some levers are global, some are regional, some are national, and some are local, and we have therefore addressed them in conjunction in each of the six thematic chapters.
Economists are often blamed for resorting to technical vocabulary as a way of protecting themselves from inconvenient questions. To help the reader overcome semantic barriers, we have been careful to define all key concepts at least once in the book and to signal these terms with italics. The index at the end of the book provides a complete list of keywords with the corresponding pages where they are defined and illustrated.
Additionally, we have parked most mathematical developments in technical boxes. We see mathematics neither as the purpose of economic science nor as the instrument that would allow us to draw a line between truth and ideology. As Paul Romer once noted, mathematics can be used in support of ideology, and, conversely, some seminal theoretical articles mentioned in this book do not show any equations. Mathematics is nevertheless unique in mapping in a coherent and rigorous way a set of assumptions into conclusions. It is also the basis for statistical tools allowing us to confront assumptions with real-world data. As a language, it is, however, fitter to expose a flow of rigorous reasoning than to explain it and present its conclusions. We give examples of how it can be used, but we also make the reasoning explicit in more literary ways.
As “reading assistance,” each chapter includes many charts and tables because our approach fundamentally relies on facts. It also includes theoretical and descriptive boxes. Additionally, there are extensive bibliographical references so that the reader can dig further into any of the issues covered.
Conclusion
We express our gratitude to all those who have encouraged us and who have helped make this joint endeavor a reality. We owe a lot to our students, whose
questions and criticisms have greatly improved the relevance, accuracy, and legibility of this book. We also thank our colleagues and friends who have commented on previous versions. Writing on economic policy requires us to update data and facts tirelessly. For this last edition, we have benefited from particularly effective assistance by Paul Berenberg-Gossler, Pranav Garg, and Amélie Schurich-Rey. Without them, this book would be less caught up with today’s debates.
Paris, Florence, Frankfurt, New Delhi, March 2018
1 Concepts
1.1 A Primer on Economic Policy
1.1.1 The economist and the Prince: Three alternative approaches
1.1.2 What do policymakers do?
1.2 The Whys and Hows of Public Intervention
1.2.1 The three functions of economic policy
1.2.2 Why intervene?
1.3 Economic Policy Evaluation
1.3.1 Decision criteria
1.3.2 Experiments and ex post evaluation
1.3.3 Collateral effects
Conclusion
Notes
References
Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.
John Maynard Keynes (1936; chapt. 24, part 5)
The last sentences of The General Theory of Employment, Interest and Price by the famous British economist are a fetish quotation for economists who take
them as an acknowledgment of their social role. Yet they also express the complexity of the links between theory and economic policy. They suggest that economic expertise can neither be regarded as the servant nor as the master of political decision. It does influence it, but in an indirect way and with delay.1
However, Keynes (1931, part V, chapt. 2, last sentence) also expressed detached irony about the economists’ pretense to determine the policymakers’ choice:
If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.
The interaction between economic ideas and political motivations was aptly characterized in the classics as political economy.2 This type of interaction between power and knowledge is certainly not specific to the economic discipline. It arises in all fields where public decision relies at least partially on scientific or technical expertise. For reasons we develop later in this chapter and throughout the book, however, it is more pronounced in economics and more general in the social sciences than, say, in geology or biology.
This chapter introduces the main themes of economic policy analysis. We start in Section 1.1 with a discussion of the various approaches to economic policy an economist can adopt. In Section 1.2, we discuss the arguments for and against public intervention, both from a micro- and a macroeconomic standpoint. Finally, Section 1.3 is devoted to the evaluation of economic policy choices and deals with both criteria and instruments.
1.1 A Primer on Economic Policy
1.1.1 The economist and the Prince: Three alternative approaches
An economist can adopt diverse attitudes vis-à-vis policy decisions: she or he can limit herself to studying their effects on the economy (positive economics), she can seek to influence them through recommendations that draw on her expertise (normative economics), or, finally, she can take them as a topic for research and study their determinants (political economy or political economics). All three approaches coexist in today’s economics.
a) Positive economics
In positive economics, the economist takes the point of view of an outside observer and aims to determine the channels through which public decisions affect private behavior and outcomes. For example, she analyzes the effects of a tightening of monetary policy, an increase in public expenditure, a tax reform, or a new labor market regulation. Economic policy choices are regarded as entirely exogenous, meaning that they are not determined within the model
that explains the economy and whose variables—such as prices, incomes, output, and the like—they influence.
Positive economics therefore approaches economic policy with the same concepts and methods as those used to study other economic phenomena: for example, there is hardly a difference between studying the effects of a rise in the central bank money lending rate on nonfinancial agents and analyzing the effects of an exogenous rise in the risk premium which banks require for lending to private agents; similarly, the effects of a rise in the minimum wage can be analyzed within the same framework and with the same tools as those of a strengthening of the bargaining power of trade unions.
b) Normative economics
The second approach is called normative economics. The economist here adopts the posture of an adviser to a supposedly benevolent Prince—or political master—and examines which set of decisions can best serve explicit public policy purposes, such as reducing unemployment, improving the standard of living, or safeguarding the environment. The public decision-maker is regarded as a social planner and the economist as an engineer who tells him or her how to select adequate means for reaching certain ends, meaning how to design policies and then how to implement them. Economists are certainly not short of policy advice, and they generally do not need a request from the Prince to express their views. In all cases, however, they make explicit or implicit assumptions about social preferences that cannot be derived solely from economic theory.
Normative economics relies on the knowledge base of positive economics to assess the effects of different possible decisions. However, it also requires a metric within which to compare alternative situations. Assume that a government wants to reduce unemployment and suppose that two competing policies may lead to this result but at the price, for the first one, of a lowering of the employees’ average wage income and, for the second one, of an increase in wage inequality. Choosing between these two solutions requires assessing the social cost of each of those policies against the social benefit of lowering unemployment. This implies defining a preference order between situations, each characterized by the unemployment rate, the average wage income level, and a measure of inequality. Constructing such a ranking raises considerable conceptual and practical difficulties.
Furthermore, normative economics frequently implies giving up the firstbest solution that would be reached in the absence of informational, institutional, or political constraints for a second-best solution, one that respects those constraints.3
Let us take the example of carbon dioxide emissions, which governments have committed to limit to curb global warming. A first-best solution consists in creating a global carbon dioxide tax to incite companies to use less
carbon-intensive energy sources. The carbon tax, however, hurts powerful special interests, such as those of car makers or oil-producing companies; requires international coordination and implementation; and is disputed on equity grounds by developing countries. The climate agreement reached in Paris in December 2015 therefore leaves participating countries free to choose the means they intend to rely on to reduce emissions.
Some governments consider making existing government policies “greener,” say by restricting public tenders to companies which meet carbon dioxide emission standards. Such a second-best solution, however, bears significant unintended consequences. It distorts economic choices by making the implicit price of carbon dioxide differ across the economy, and, moreover, due to limited competition among providers, taxpayers may ultimately bear the cost of the policy in place of the owners of the companies—who would be better placed to steer their behavior.
Economists involved in public decisions face many such constraints. The question they face is typically not “how can unemployment be reduced?” but “in view of the stance and prejudices of the main players— government departments, majority and opposition in Parliament, and various stakeholders—what is the most cost-effective proposal consistent with the government’s overall policy philosophy and commitments already publicly undertaken?” This second question obviously is a very weak version of the first one, but major economic decisions are very often taken this way. Economists may understandably be tempted to abstain from participating in such decisions. But, as Herbert Stein, a chairman of the Council of Economic Advisors under US presidents Richard Nixon and Gerald Ford, used to say, “Economists do not know very much [about economics. But] other people, including the politicians who make economic policy, know even less” (Stein, 1986, p. xi). Returning to the ivory tower may thus be an undesirable option.
Second-best recommendations nevertheless raise important difficulties. The second-best optimum can in fact be inferior to the initial situation in welfare terms. An example of an inferior second-best solution can be found in trade policy: liberalization on a regional basis only can divert trade from an efficient global producer to a less efficient regional partner, which worsens the allocation of resources in comparison to a situation of uniform tariff protection.4 What is perceived as a small step in the right direction therefore does not necessarily improve upon the status quo; on the contrary, it can reduce welfare.
Beyond this disturbing result, modern public economics emphasizes the equally formidable difficulty associated with the existence of asymmetric information between the public decision-maker, the agents in charge of implementing policies, and those who bear the consequences. Not unlike Soviet central planning, the traditional approach of economic policy postulated that the decision-maker had perfect information (in fact, he or she was frequently assumed to know better than private agents) and perfect control over the implementation of his decisions. The reality, of course, is that the
decision-maker has both an incomplete knowledge of reality and an imperfect command of policy implementation. Take the regulator in charge of a specific sector (e.g., telecommunications). He gets information on costs, returns on investment, or demand elasticity largely from the companies that he is responsible for controlling. For the latter, this information has strategic value. They have every reason not to be fully transparent or to provide biased information. When dealing with them, the regulator therefore suffers an informational disadvantage even when he supplements the information provided by the regulated companies with indirect indications derived from observing market prices and quantities.
Likewise, government bodies responsible for policy implementation are not flawless transmitters: they often do not pass on adequate information from below or instructions from above. For example, even if teachers from the education ministry have first-hand knowledge of the situation in their classes, the minister in charge may not have accurate overall information, which obviously affects the quality of his or her decisions. Reciprocally, the minister’s policy may not be considered adequate by the teachers who have their own views on education policy, and this affects its implementation and effectiveness.
The importance of information asymmetries for private markets was first highlighted in research by 2001 Nobel laureates George Akerlof, Michael Spence, and Joseph Stiglitz, but it was Jean-Jacques Laffont5 and Jean Tirole who worked out their consequences for public economics. They initiated research on the design of contracts that encourage agents to reveal the information which they would otherwise keep for themselves (thereby allowing regulators to take more appropriate decisions). Such contracts are examples of mechanism design, meaning the design of optimal institutions or procedures to deliver social outcomes. Mechanism design covers issues ranging from auctions of public assets, voting procedures for public decisions, regulations to curb private behaviors, or contracts between the government and private contractors. All such mechanisms should be designed in a way that delivers the expected outcome while overcoming the government’s lack of information.6 Key to this outcome, as explained by Nobel Prize laureate Eric Maskin, is incentive compatibility:
Because mechanism designers do not generally know which outcomes are optimal in advance, they have to proceed more indirectly than simply prescribing outcomes by fiat; in particular, the mechanisms designed must generate the information needed as they are executed. The problem is exacerbated by the fact that the individuals who do have this critical information—the citizens in the public good case or the buyers in the asset-selling example—have their own objectives and so may not have the incentive to behave in a way that reveals what they know. Thus, the mechanisms must be incentive compatible.
(Eric Maskin, 2007, p. 3)
