Rules versus Discretion--Posner's Comment

I am not competent to offer an opinion on macroeconomic policy. But I can, with some confidence, say this about Becker's proposal that the Federal Reserve Board adopt a rule approach to adjusting the money supply to limit inflations and recessions: there is no way in the existing legal regime to make such a rule enforceable. The Board is a creature of Congress. If it resists strong political pressures, Congress can retaliate. Unlike the Supreme Court, the Board has no constitutional standing. And even the Supreme Court, which Congress could not abolish without a constitutional amendment, is not immune from political pressures, because Congress can limit the Court's jurisdiction and controls the Court's budget. Moreover, political pressures influence who is appointed to the Court--and to the Fed as well. And Congress can pass laws that would impede or even nullify Fed policy, as by raising or lowering taxes or running deficits or surpluses in the federal budget. Therefore, it might well be a mistake for the Fed to surrender discretion in favor of a rule approach. Discretion enables the Fed to bend in the face of political pressure; rigid adherence to rules might cause the Fed to break in the face of particularly intense such pressure. I understand that some central banks do follow a rule approach, but they may operate in a political context different from ours--I do not know. The larger question is whether any public official can be totally nonpolitical in a democratic (perhaps in any) system. I suspect not. On the broader issue of rules versus discretion, I doubt that generalization is possible. Rules have great virtues, but they are limited because they are necessarily based on information possessed by the rulemaker when the rule was made. No rulemaker is omniscient. After the rule is promulgated, unforeseen circumstances are likely to arise to which the rule will be maladapted. The inflexibility of rules has to be traded off against the benefits in simplicity, clarity, and ease of compliance and application that rules confer. The tradeoff will not always favor rules. There are three alternatives to rules. One is standards. A fixed speed limit is a rule; negligence is a standard. A standard is less definite than a rule, which is a minus, but it is more flexible, which is a plus. It would be impossible to anticipate every possible cause of an accident (driving above 60 m.p.h. at night, in snow, in heavy traffic, on a divided highway, or in an SUV, etc.) and make a rule that would declare each cause to be either culpable or excusable. The negligence standard enables a court to determine liability as cases arise, on the basis of a weighing of the costs and benefits of measures that would have avoided the particular accident. One way to state the difference between rules and standards is that standards enable information obtained after promulgation to be incorporated into the law without need for formal rulemaking. When for example Congress passes a vague statute, thus leaving it to the judges enforcing the statute to fill in the details, in effect the judges are enlisted in the legislative process. An example is the per se rules of antitrust laws, which are judge-made rules supplementing the general directives in the antitrust statutes. Another alternative to rules is discretion, which differs from a standard in not being enforceable in court. For example, prosecutors in our system have discretion whether or not to prosecute a particular person for a particular crime. Unless a prosecutor bases an exercise of his discretion on an invidious ground, such as race or religion, a court will not review that exercise. Discretion in the criminal law is a way of introducing needed flexibility without creating loopholes through which criminals could escape the law. Criminal laws tend as a result to be overinclusive. People are constantly cutting corners of various sorts, often not realizing that by doing so they actually are violating a criminal statute. Prosecutors are, quite wisely, not given sufficient resources to prosecute every crime, but instead are given discretion to allocate their limited resources as they see fit. They can overlook the minor crimes without worrying that the criminal law contains loopholes that may enable a major criminal to elude justice. Similarly, no driver actually obeys all the driving laws, but police rarely bother to ticket anyone who exceeds the posted speed limit by less than 5 or 10 m.p.h. Suppose the posted speed limit is 60 m.p.h., but the de facto speed limit is 70. If the posted speed limit were raised to the "realistic" speed limit of 70, many drivers would drive faster because the police would not have enough resources to catch all the speeders, so the realistic speed limit would rise. Moreover, police would lack flexibility to ticket the occasional driver who was driving above the posted but below the de facto speed limit but who the police believed should be ticketed anyway because he was driving erratically--weaving, tailgating, etc. Of course they could ticket him for these activities, but it would be harder to determine and prove them, compared to detecting speed with a radar gun. The third alternative is presumptions or guidelines, which have the structure of rules--that is, are simple and definite--but which allow discretion in enforcement. An example is the federal sentencing guidelines, which enable a defendant, a judge, and probation officers to determine a definite range for a sentence for a particular crime committed by a person having particular characteristics (such as criminal history), but allow the judge to sentence outside the range if he can give a good reason for doing so based on sentencing factors set forth by Congress. This approach makes sense when there is a need for guidance but strict rules would be too inflexible. The merger guidelines used by the Justice Department and the Federal Trade Commission are a further illustration of the presumption/guideline approach. They enable firms contemplating mergers to have a pretty good idea in advance of whether the merger will provoke a challenge from one of the enforcement agencies. The firms can go to the agency assigned to their proposed merger before the merger is consummated and get a definitive determination of whether it will be challenged. This procedure enables the lawyers and economists at the agency to decide whether the proposal is consistent with the spirit as well as the letter of the guideline.

Comments

[ChinaCoalWatch]

I don't have much to add about the Fed and rules except that, as we all know, Central Bank Macroeconomics is a constantly developing and inexact Science. Any set of rules, even standards or presumptions-based, would need an amendment process which would still be prone to the the problems of inertia, discretion, non-transparency, and political pressure.

As for the rest of Judge Posner's post - about the propriety of either rules, standards, discretion or rebuttable presumptions in different areas of the law - it should be mandatory reading for all new Law students to provide a perspective on their field of study and to inform them of the impossibility of perfection and the need for flexibility and judgment.

In that sense, I am reminded of my contracts professor's quoting of A. L. Corbin, "Certainty in the law is largely an illusion at best, and altogether too high a price may be paid in the effort to attain it." 3 CORBIN § 609, at 689 (rev. ed. 1960).

[Jim Moser]

Posner's responds to Becker's apllication of rules in the case of continuous events by describing the limitations of rules applied to discrete events. That difference is not trivial. A cost-benefit analysis of rule enforcement applied to discrete events such as speeding will, as Posner suggests, limit enforcement.

However, suppose one were to publicly announce an intent to continuously drive 10 mph over the posted speed limit. This alters the cost-benefit of prosecution vis a vis the one-time violation. This example accords better with the monetary policy issue. Failure of the Fed to respond to inflation above a pre-set target has a continuing effect on inflation. Hence, when ascertaining cost & benefit one must integrate over the period where these are being incurred.

[OregonGuy]

You might want to review Becker, "Crime and Punishment: An Economic Approach". (The Journal of Political Economy, 1968.)

In Oregon we get the "auto-ten". In Washington, you get zero. And their fines are considerable.

And you know it driving into the state. The only way around it is with a radar detector...and hope that you aren't being tailed.

[Mike Sproul]

According to the real bills doctrine, the only rule the Fed should follow is to acquire a dollar's worth of assets whenever it issues a new dollar. That way, any additional dollars are adequately backed by additional Fed assets, and there will be no inflation. One thing the Fed should NOT do is arbitrarily restrict the supply of money--a sure recipe for recession.

Please google "real bills doctrine" before posting any knee-jerk reactions to the above.

[Mike Sproul]

According to the real bills doctrine, if the supply of money grows by 10% and the assets of the central bank also grow by 10%, there will be no inflation. Since the Fed never issues a dollar without acquiring a dollar's worth of bonds in return, the only rule the Fed needs to follow is to adequately back whatever amount of money that it issues. This will result in zero inflation without arbitrarily restricting the quantity of money.

[Vishesh Narayen]

"Discretion enables the Fed to bend in the face of political pressure; rigid adherence to rules might cause the Fed to break in the face of particularly intense such pressure."

It's not clear here which alternative you believe is better. Presumably, you'd agree that resistance to political pressure is, in general, a good thing. An external rules-based approach would allow the Fed to escape day-to-day liability for its decisions and resist political proessure except in the most extreme circumstances (which is probably when you'd want them to depart from rules anyway).

[Jack]

Mike...... and using your model, when we are sent an external price increase such as the oil shock of the 70's or today, one would argue in favor of doing nothing. After all the dollars gobbled up by increased energy costs are not their to bid up the prices or increase the demand for products in general. But! then and now that appears to be exactly what the Fed is doing to little or no avail and perhaps making things worse; ie interest rates being higher for those large projects that might combat high energy costs, or, at minimum, keep more of the energy dollars here. In short, if we are not bold enough to challenge the obvious energy price collusion, there is little to do but to let the price increase working its way through the economy.

I see very little sense in "fighting inflation" when we, and much of the world is operating at well below capacity and wages increases for working folk have been slim to none. Jack

[Nicholas]

Random questions:?

1) How do you differentiate between price inflation and monetary inflation? If a measure such as the CPI always has the same bias, does it matter? Does it require us to consider more variables than the Taylor rule dictates?

2) How would a rules based approach apply in the case of economic shocks??

3) Without saying as much, don't you think that the Fed has bought into the modeling approach based on how little they've deviated from Taylor (which came out in 93, I believe)? Milton Friedman claimed that the Fed had essentially acted in robot fashion during the Greenspan/Bernake era.?

http://macroblog.typepad.com/macroblog/images/taylor_rule.gif

[Jack]

Nicholas, I've many of your "random" questions as well and they never seem to answer them.

Personally, I think the Fed is all too secretive about their methodology. In addition to your questions, how large a role is played by the Fed favoring interest rates to attract, or keep? foreign bond holders? Come to think of it were they to dump all forms of secrecy the market would adjust as it saw the direction developing. Even in crises such as the LTC meltdown, the big investors where aware and were even called in to help finesse the patch-up.

If you ever find any answer as to why they treat external price shocks with "inflation" fighting tools, please be sure to post them for the rest of us! Jack

[Dominic]

Jack,

There is good reason for the fed's 'secrecy'. Inflation is largely determined by expectations. If inflation rises but interest rates to stay steady, the effect is that any money you have becomes less valuable (if you have $100 in the bank at 5% interest, but inflation is at 3%, your wealth is going up at 2%. If inflation rises to 4%, your wealth will only rise by 1%).

If you expected this to happen, you might decide it was better to spend the money. If everyone decides to do this at the same time, aggregate demand goes up. This pushes up prices, since more people are suddenly trying to buy the same number of things (if sellers don't want to run into supply shortages, they will push up prices - if you don't think this can happen quickly, think of a contractor with too many jobs and not enough time).

So the result of people expecting inflation to go up without a change in interest rates will be... inflation! Even if their expectation was based on rumor or nonsense!

So the fed steps in and tells everyone "we'll never let inflation go higher than 3%". If everyone believes the fed, inflation will never go higher than 3% even if the fed does nothing. They can leave interest rates at 2-4% (very low) in order to stimulate the economy, but it doesn't cause inflation because everyone believes the fed would raise interest rates if inflation did occur.

So the Chair of the Fed's main job is to lie - to convince people they'll do something that they really don't want to do. If they are legally obliged to do so, such as in Hong Kong, there's no question. But then they wouldn't get the benefit of cheating.

[Dominic]

I should rectify a mistake I made. Hong Kong has a legally binding exchange rate, not inflation rate. Sorry. (Ironically, the result of Hong Kong's exchange rate laws are that they have absolutely no control over inflation, rather than the complete control I implied without thinking).

[Jack]

Dominic: Thanks, and we're on about the same page in terms of understanding the traditional role of the Fed. Your second paragraph illustrates what I speak of as the classic version But it's a long time since we've experienced a capacity limited market. For example housing starts have dropped by a million from what the capacity was a couple years ago. Is there any doubt that Dell or nearly any supplier of electronics would have any trouble doubling there production. A key symptom of demand pull inflation would be that of wages increasing as companies became stretched and bid to steal employees from existing jobs. No sign of that, with perhaps the exception of a few specialists in certain fields.

So what we're dealing with is a cost push type of "inflation" wherein the extra cost is that of energy pricing that we can't (or refuse?) to address. So, what would happen if nothing is done? The prices of energy intensive products will rise, but! the dollars soaked up by the energy premiums are not there to "chase" other goods, so there's an inherent deflationary effect due to the dollars devoted to energy with over a billion per day being sent out of our economy. Some may come back, but we run trade deficits with most and with the rest of the world as well.

As for the "secrecy" to combat inflationary expectations, despite the countless articles from "economists" over the last few years that "energy increases would not be recession provoking" any one could predict that a year or so of high energy prices would increase the costs of most goods. Also, Wall Street fund managers have access to the same econometric modeling as does the Fed, so there isn't much to keep secret.

Lastly, I'd suggest that perhaps the Fed has become something of an anachronism. For example this week's easing makes short term money a bit cheaper. But what would we expect it to do for housing? Well, if the easing is seen as inflation producing, the 10 year bond yields, on which mortgages are based would likely rise (to higher interest rates) and further slow home sales which slows the sales of much which we produce here; appliances, furniture, etc.

I don't know how it all shakes out, but with globalism, imports, and outsourcing playing larger roles that the Fed is not what it used to be. sure there's the immediate reaction of a flurry of stock activity as a point is to be gleaned, or to show the boss the traders are still awake? but the fundamentals seem changed very little.

[Glenn]

I am a bit worried about Fed's rate cut. It seems that you will be rewarded rather than penalised if you don't care about risk management. The moral hazard issue will pave the way for even bigger problem. That said, a rule-based approach will be very difficult to implement. Like every proponent to government intervention, he/she will come up with a justification of market failure.

A question for for Prof Posner, what is the difference between discretion and guidelines. Thks.

[Pawel]

The Gentelman shook the financial markets alone playing against one of the central banks as I good remember. Sometimes only the cooperation between central banks saved the stability of the markets. Telling the truth we have stable financial markets because only a few person or corporation are able or want to play against central banks.The same situation as with a policeman. It is not the black belt in karate preasumbly possesed by a cop stops you to offend the policeman but the system standing behind him (The policemen on the streets are not usually masters of martial arts). Each government consists of Minister of Health ,
Minister of Science and Higher Education,
Minister of Interior and Administration,
Minister of National Defence,,Minister, Member of the Council of Ministers, Minister of Economy, Minister of Justice, Ministry of Defence among others. As they used to say - "When diplomacy stops war begins". So let me make conclusions. The tools of central bankers look very feeble but who wanted to challenge the government(s)? But the quick, smart action can deregulate the financial markets.

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