In the Money interview with me which Melissa Francis posted yesterday she delved into two of my First Principles—the importance of the rule of law and rules-based policy—pointing out that many people argue that in an economic crisis we need to suspend the rules and resort to discretion.
It’s an important issue, but as I said in the Hayek lecture of last year (and touched on in the interview) “a crisis is sometimes the worst time to deviate from rules. In a crisis, clarity about the strategy rather than more unpredictability is needed. This was very clear following the first bailout of the recent crisis—the Bear Stearns intervention, after which few knew what to expect the next time because no strategy was put forth. The sooner people can make their decisions with knowledge of the rules, the sooner recovery will come.”
Todd Zywicki wrote a beautiful essay on this issue last year entitled “Upholding the Rule of Law, in Season and Out of Season.” He gave several reasons why trying to stick to a set of rules or a strategy is so important in a crisis, noting that:
“During periods of economic dislocation…variables of the economic system are in even greater flux than usual” so “adherence to the bedrock predictability of the rule of law takes on special institutional significance.”
In a crisis, “the problem is one of reestablishing decentralized coordination rather than centralized prevention of threats. Political uncertainty about the integrity of contracts and regulatory policy undermines investor confidence and raises interest rates.”
In a crisis it is “necessary to restrain the opportunism of politicians and special interests that use the opportunity presented by the crisis to piggyback their own narrow interests, often with no relationship to the real problems.”
“Once discretion is unleashed during the crisis history tells us that the dissipation of the crisis does not promote a return to the rule of law—in fact, there is a ‘ratchet effect’ of government discretion as the post-crisis period brings about a consolidation of governmental discretion rather than new limits on it.”
And finally, “the mere potential for discretionary action promotes moral hazard, thereby creating the conditions for still further rounds of intervention.”
It is of course very hard for policymakers under extreme pressure in a crisis to remember these advantages and stick to a rules-based strategy. That is why, as Melissa Francis pointed out, resorting to discretion is unfortunately so common.