Rules versus Discretion: Insights from Behavioral

Economics
Share
For half a century now, the rules versus discretion debate in monetary economics has focused on
the so-called time inconsistency problem. The problem is that, although a discretionary central bank
might promise not to allow the inflation rate to rise above zero (or some other ideal value), the fact
that an inflation surprise can boost employment and output in the short run will tempt it to break its
promise. Realizing this, market participants will anticipate higher inflation. The long-run result is a
higher inflation rate with no improvement in either employment or output. By limiting the central
bankers options, a monetary rule solves the time inconsistency problem.
An earlier rules-versus-discretion debate had taken place in the 1920s and 1930s.1 The later one,
which was inspired by the stagflation of the 1970s, differed in that it was influenced by the New
Classical revolution that was taking place around the same time. Consequently, the later critics of
monetary discretion, including Finn Kydland and Edward Prescott, Guillermo Calvo, Benn McCallum,
Robert Barro and David Gordon, and John Taylor,2 differed from their predecessors by building their
arguments on the premise that central bankers were both well (if not quite perfectly) informed and well
intentioned. Discretion, according to them, leads to less than ideal outcomes not because central
bankers are ignorant or misguided, but because of misaligned incentives.
Naturally, champions of discretionary monetary policy also regarded monetary policy makers as wellmeaning and well-informed experts. Their counterargument was simply that such experts could in
principle out-perform any rule. Well-trained monetary technocrats might, after all, resist the short-run
temptation to take advantage of established inflation expectations by creating inflation surprises.
But just how likely is it that technocrats will behave well in practice? Even such a technocraticallyinclined proponent of discretion as Joseph Stiglitz recognizes that the decisions made by the central
bank are not just technical decisions; they involve trades-offs, judgments.. .3 Will such judgments
typically be wise ones? Although the sub-discipline didnt even exist when the rules-versus-discretion
debate was revived in the 1970s, let alone when it was first aired in the 1920s, the findings of
behavioral economists are the natural place to turn to for answers to this question. At least some of
those answers seem to decidedly favor the rules side of the rules-versus-discretion debate.
As Nobel winning economist and psychologist Daniel Kahneman has observed, experts suffer from all
sorts of biases that result in bad decisions and outcomes. Building upon the work of Paul Meehl,4
Kahneman argues that expert decisions can be inferior to simple algorithms (like a Taylor Rule)
because experts try to be clever, think outside the box, and consider complex combinations of
features in making their predictions.5
In the studies reviewed (and sometimes conducted by) Kahneman, experts are always looking for that
one additional data point that suggests a different course of action. Fed officials have behaved that

way lately in repeatedly insisting that their decisions will be data-dependent, without actually saying
what data they have in mind or how its components will be weighted. Kahneman also notes that
experts are often inconsistent, giving different answers to the same (or similar) question. Here, too,
Fed experts conform to the theory, thereby making it difficult if not impossible for market participants
to grasp the direction of monetary policy. Kahneman reaches the surprising conclusion that to
maximize predictive accuracy, final decisions should be left to formulas, especially in low-validity
environments.6 With respect to monetary policy, that conclusion would seem to favor a policy rule
over discretion.
In research conducted with psychologist Gary Klein, Kahneman has also investigated the conditions
that are or are not favorable to discretionary decision making. Previous scholars had found that
firefighters often have surprisingly good intuition about such things as when the floor of a burning
building is about to collapse.7 Kahneman and Klein find, however, that such expert skills must be built
up over time. Novice firefighters do not possess them in the way that veterans do.
Interestingly, Fed officials often liken themselves to firefighters. If the analogy is a good one, and
Kaheman and Klein are also correct, then having long (14 year) terms for Fed governors is a good
idea. Unfortunately, Fed governors seldom serve more than a modest fraction of their maximum
terms. As major economic crises and downturns happen only so often every 13 years in case of
U.S. crises, according to Reinhart and Rogoff8 relatively few Fed governors ever experience more
than one crisis, and most are unlikely to witness more than two cyclical turning points. For a Fed
staffed by such novices, the case for rules is especially strong. Indeed, because monetary policy
operates with long and variable lags, as Milton Friedman famously put it, even seasoned Fed
governors cannot be counted on to employ discretion responsibly.
To summarize these implications of behavioral economics, experts can be expected to employ their
discretion advantageously when 1) they operate in a regular, predictable environment, and 2) there is
an opportunity for learning via repeated practice. Neither of these conditions characterize monetary
policy. Behavioral economics has sometimes been presented as an avenue to justify government
intervention to correct the failings of ordinary people. But the same literature reminds us that even
the most expert policymakers also suffer from a variety of biases. Just as default rules may be useful
in minimizing consumer errors, monetary rules can serve to minimize errors of monetary policy.
____________________
[1] For an overview of earlier debates see Robert Hetzel, The Rules versus Discretion Debate Over
Monetary Policy in the 1920s. Federal Reserve Bank of Richmond Economic Review ( November
1985), p. 1-12 and George Tavlas, In Old Chicago: Simons, Friedman and the Development of
Monetary-Policy Rules. Journal of Money, Credit and Banking 47(1) (January 2015), p. 99-121.
[2] Finn E. Kydland and Edward C. Prescott, Rules rather than discretion: The inconsistency of
optimal plans, Journal of Political Economy, 85(3) (June 1977), p. 473-490; Guillermo A. Calvo, On
the Time Consistency of Optimal Policy in a Monetary Economy, Econometrica 46(6) (November
1978), p. 1411-1428; Bennett T. McCallum, Monetarist Rules in the Light of Recent Experience,

American Economic Review 74(2) (May 1984), p. 388-91; Robert J. Barro and David B. Gordon,
Rules, Discretion, and Reputation in a Model of Monetary Policy, Journal of Monetary Economics
12(1) (July 1983), p. 101-121; Robert J. Barro and David B. Gordon, A Positive Theory of Monetary
Policy in a Natural-Rate Model, Journal of Political Economy 91(4) (August 1983), p. 589-610; and
John B. Taylor, What Would Nominal GNP Targeting Do to the Business Cycle? Carnegie-Rochester
Conference Series on Public Policy 22 (9) (January 1995), p. 61-84.
[3] Joseph Stiglitz. Central Banking in a Democratic Society, De Economist 146(2) (July 1998), p.
199-226.
[5] Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus, and Giroux, 2011).
Especially chapters 21 and 22.
Topics: Tags: