Wednesday, 25 June 2014

Market 'discipline' and game theory

Hot off the presses at the APSR, a new article from Kelemen and Teo:
...we argue that balanced budget rules work by coordinating decentralized punishment of sovereigns by bond markets, rather than by posing a credible threat of judicial enforcement. Therefore, the clarity of the focal point provided by the rule, rather than the strength of its judicial enforcement mechanisms, determines its effectiveness.
Ok, so: bond markets are all about herd behaviour (focal points allow bond investors to guess what everyone else will do, and do the same thing).  Properly structured institutions are those that use herd behaviour to enforce balanced budgets, by having a well defined trigger for firing off a "stampede now" flare.

The authors judge the Eurozone's fiscal compact by this standard and find it wanting because its rules on budget deficits are insufficiently clear, due to its effort to make room for counter-cyclical policy by referring only to a "structural" budget deficit. In addition, the possibility of bailouts via the ESM reduces incentives to maintain balanced budgets. But all hope is not lost:
Nevertheless, because of the remaining uncertainty about the availability of bailouts for any given state and the extent of “private sector involvement” (including losses imposed on bondholders), bond markets can still play a constructive role in restraining excessive state borrowing. However, this will only be the case where bond markets are presented with sufficiently clear focal points.
As the authors recognize, their argument is structurally identical to the Hadfield-Weingast argument about the coordinating role of law. Like Hadfield and Weingast, they similarly dismiss the prospect of successful judicial enforcement a priori, implicitly suggesting that they are better informed about political realities than the leaders who haggled over enforcement rules vigorously.

More striking, however, is the way this framing of the issue slides into normative assertions. The equilibrium outcome (states follow budget rules because otherwise bond holders fall into a panic) is invested with a positive normative status that is not questioned. Despite quite explicitly conceptualising bond markets as driven by herd mentality, the only question they ask is the circumstances under which bond markets can be "constructive;" that is, how this herd mentality can successfully be turned into a doomsday machine to enforce budget rules. They simply don't consider the possibility that having doomsday machines around might not be the height of wisdom, nor the political implications of using markets as an enforcement mechanism to override democracy.

Another problem with this framing is that they evaluate fiscal rules only from the point of view of their enforceability, rather than whether or not they are a good idea for other reasons. Thus, they attack a budget rule making space for anti-cyclical spending for being unenforceable by bond markets, but never defend the idea that pro-cyclical economic policy is a good thing.  Enforceability is not a useful evaluative stance in any event, because it doesn't discriminate very well among different rules: "your budget deficit must never exceed 50% of GDP, wherever you are in the business cycle" would be brilliantly clear and thus enforceable, but presumably the authors wouldn't like it very much.

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