Fear of Commitment and of Being Committed

Myron Scholes (at least I think it was Scholes), in an article in the AER P&P in 1998 or so claimed that the shockwaves that followed the Russian default resulted from a policy failure of the IMF. In particular, he claimed (or at least hinted) that the IMF should have mitigated the contagion by some form of bailout. I think that this mentality is analogous to the idea that the decision of policymakers to prevent the Lehman bankruptcy in September of 2008 was a failure of policy. (A regular NPR reporter -- I've forgotten who, exactly, but he was reporting on from Spain, I think, on the expanding crisis in Europe -- recently accurately claimed that the concensus opinion among economists was now that this decision was a mistake; I believe this claim is right.)

My view is that the idea that these decisions represented failure of policy is exactly wrong. What these episodes show is, in my opinion, exactly the defining moment of strategy. Economic theory shows very clearly that optimal policy requires commitment to follow a path that may be viewed as short-term suboptimal. If this theory holds any lesson for practice, and I think it does, then this means that we citizens of the real world are destined to observe enlightened policymakers making some hard choices that may be interpreted as wrong ones from some short-run point of view.

So let's go deeper: What is the objective function of our policymaker? Well, the objective of the long-term policymaker that defines "optimal" or "first-best" policy is long-run societal welfare. But in practice, it may be that the objective function of the policymaker in power in 2008 considers, at best, only welfare form 2008 on. And his objective function may be even more different: it may consider only his own tenure in power. Moreover, his own longevity in power is closely connected to public opinion. If, in fact, the policymaker has committed to maximization of long-run societal welfare, then his hands are tied; his decision is very likely to be quite painful in the short-run. The long-run gain would come in the form of reinforcing (or perhaps even establishing) in the minds of other players in the economy that the policy to be followed is, in fact, the optimal time-inconsistent one, that our policymaker has long-run welfare in mind.

So here is my claim: the popular perception that the policymakers failed in 2008 is perfectly consistent with the fact (as I believe it to be) that the decision to allow Lehman to fail was the optimal one. The short term pain felt by the public and the policymakers may be exactly the pain of following a time-inconsistent policy. The benefit, however, may come in the form of establishing in the minds of other players that our policymaker has the ability to commit.

[A sensible formalization of this claim may go further: the game I seem to be describing entails some private information available to the policymaker as to his own type distinguished by the nature of his ability to commit or perhaps the nature of his objective function. ]