Policy Credibility Concept

Time Consistency

Time consistent policy is policy that will be sustained as circumstances change over time. Adhering to a policy rule may require pursuing a policy at a particular point in time that is not optimal at that time. In contrast, policy that is time inconsistent will be reversed in the future due to predictable developments over time.

Consider the following simple example. Suppose privatization is beneficial for the government and the government faces no penalty for future re-nationalization. Once the government privatizes a set of enterprises, its optimal policy is to re-nationalize the enterprises so that the enterprises can be privatized again. Buyers, recognizing this, will not participate in the privatization. Thus the privatization policy will fail because it is time inconsistent.

A literary example of the issue of time consistency is the story of Ulysses and the sirens. Sirens were creatures whose beautiful singing lured sea ships to doom on rocks near where the sirens sang. Ulysses knew that when he heard the sirens sing he would be unable to resist demanding control of his ship and steering to an inevitable end on the rocks near where the sirens sang. His solution was to order his crew to bind him to the mast before he came within earshot of the sirens. He then would be safe from the temptation of their song.

From an economic perspective, the issue of time consistency emphasizes the problem of predictably changing incentives over time. One approach to achieving time consistency in government policy is to limit policy to rules that the government will have an incentive to pursue in all normal future circumstances. Another approach is to develop capacity for commitment to a policy path. A commitment mechanism is a means for removing the risk of opportunistic policy in particular contingencies.

Commitment mechanisms are closely related to more general factors that enhance policy credibility. Integration into the world economy can strengthen commitment to policies that foster private investment. A government can enter into agreements with other governments or international institutions to make deviations from prudent trade and macroeconomic policy more difficult for itself. The GATT, the European Union, and the CFA Franc Zone are examples of such international arrangements. Domestic institutions can also foster policy commitment. For example, an independent Central Bank can help to insulate monetary policy from short-term budget pressures. A valued reputation for pursuing particular types of policies can also serve as an assurance that such policy will be pursued consistently despite adverse short-term incentives.

Policy Credibility Learning Module