Rules vs. discretion

Time Consistency: A Primer

The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.

For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.

In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable....

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Living Wills or Phoenix Plans: Making sure banks can rise from their ashes

Wills are for when you die. Living wills guide your affairs when you lose the capacity to act. We’re all mortal and fragile – not just people, but firms and banks, too. The Dodd-Frank Act of 2010 requires systemic intermediaries (and many others) to create “living wills” to guide their orderly resolution in bad times.

In August, these Dodd-Frank living wills made front-page business news when the FDIC and the Fed rejected those submitted by the biggest banks as inadequate. That should come as no surprise. In their current form, we doubt that living wills would do much to secure financial stability...

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Time-varying Capital Requirements: Rules vs. Discretion (again) 

Among its numerous, innovations Basel III proposes that national authorities use countercyclical capital buffers to temper booms in credit growth and asset prices. [...]

Will it work? Is such a system either practical or desirable? Our view is that regardless of how theoretically attractive, making such time-varying capital regulation discretionary is unlikely to work in practice. Rules would serve us all much better.
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