Wednesday, May 16, 2012

Credibility is a Tool, Not a Goal

Modern economics reframed the issue in the language of credibility: the key to price stability is the credibility of the plan for price stability. Arguments based on faith are impossible to refute: if magic fails, it is because we do not believe enough in magic, if credibility fails to bring about the desired outcome, it is because our commitment is too weak to establish credibility.
Read it at The Financial Times
The dogma of ‘credibility’ endangers stability
By John Kay

It's interesting to compare the views on maintaining credibility of the Fed versus the so-called 'experts' on CNBC. In terms of the 'experts' it often seems that they retain significant credibility regardless of whether or not their predictions prove correct. Meanwhile central banks remain fearful of losing credibility if short-run inflation moves too far from its stated target. Similarly, governments often follow through on commitments to earn credibility, in spite of the potential political costs.  

Credibility is obviously important to some degree, but it seems that central banks and political parties frequently underestimate the stickiness of credibility and overestimate its value. Kay’s article highlights the detriment of placing too much value in solely pursuing credibility.

More important than focusing on credibility is ensuring the intended goals will actually lead to desirable outcomes. Central banks may be able to gain credibility in maintaining price stability but it matters relatively little if price stability fails to result in economic growth and full employment. Governments can credibly commit to reducing spending but it won’t matter if it leads the public to vote for the opposition.

The ability of central banks and governments to credibly follow through on commitments ultimately relies on their ability to maintain support for the policies. Causality of the issue mentioned by Kay may therefore flow in the opposite direction. The key to credibility is planning for an outcome the people will support.

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