On the other hand, the power over taxation and expenditure is almost equally important and basically regulated by constitutions. Historical origins of constitutions show that the taxation played a prominent role in the emergence of the modern state and democracies. And hence, almost every modern constitution has a provision or provisions about the power to taxation.
Here, the question is whether there is any plausible justification for having independent central banks and having almost no coordination between parliaments (as fiscal policy makers) and central banks (as monetary policy makers) and what is the logic behind the prescription of the constitutions and laws on having two separate and almost independent policy makers for fiscal and monetary policy which seem to be pursuing one common goal. At first blush and intuitively, it seems that having one institution taking care of both monetary and fiscal policies is better than having two coordinate institutions and also it intuitively seems plausible that the coordinate institutions are preferred to uncoordinated ones. In order to deal with this problem we should first delve deeply into the incentive systems that they might have and study the incentives of both monetary policy-making and fiscal policy making institutions.
Incentives of Fiscal and Monetary Policy Making Authorities
Each of these two institutions might have different incentives and the incentives are basically dependent upon many factors among which the institutional design is of critical importance. On the other hand, their incentives are also dependent upon the effects of the policy instruments of these two institutions which I will categorize those policies into two general categories of expansionary and contractionary policies.
Institutionally and somewhat traditionally, Central Banks are in charge of the stability of the economy by controlling inflation rate and accordingly, many central bankers think that they should control inflation rate before dealing with many other policy objectives. Controlling price stability is not as easy as it appears. There are lots of complexities involved and it requires playing many different games in many different manipulated contexts. For example, when they try to beat the inflation with increasing interest rate by manipulating the policy instruments they have at their disposal, there will be concerns about unemployment and in turn if they want to have the expansionary policies to beat the unemployment there will be other problems, since fiscal expansion will increase the real interest rates, rising interest rates will make capital accumulation for the businesses extremely hard and hence slowing the growth of the aggregate supply, when the central bankers want to beat the inflation by increasing interest rate, they will found themselves under pressure of diminishing growth. On the other hand, monetary expansion has the effect of decreasing the interest rates and hence easing capital formation and increasing aggregate supply but the cost is higher inflation, something that central bankers do not like at all. Though there are lots of complexities in pursuing one or more policies, for the sake of simplicity, we assume that Central Banks can achieve their targets by instruments they are legally and institutionally conferred.
In addition to these formal incentives and objectives these institutions have, there are other incentives which might be helpful in analyzing the behavior of the two institutions. For example, parliament and administration who are mutually in charge of the fiscal policy making are both elected bodies of the government and they tend to be mostly in favor of short sighted popular policies and hence pursue expansionary policies, but expansionary policies also lead to huge budget deficits, and one of the key concerns about the government budget deficit comes into play when we want to consider the impact of savings on economic growth. Since savings will result in capital formation and capital formation in growth, government's huge borrowing may have a crowd out effect on the private firms' borrowings, because large government borrowing will deplete the borrowing resources for the private firms and in the long run will inhibit economic growth. Now, we might be able to see why dealing with the budget deficit is not as easy as it seems.
On the contrary, the Central Bankers with their longer tenure, are assumed to be in charge of long term economic policies (mostly because of the fact that the tenure of the chairmen of the central banks outlive the tenure of the office of the elected bodies of the government) and their first concerns by law or in fact is dealing with inflation and having a price stability. This might explain why the Central Bankers prefer the contractionary policies and because the administration and the parliaments are elected bodies, they prefer the expansionary policies to deal with at least problems that they face today and to pass the burden of the problems to the next generation of law makers and hence increasingly increasing the budget deficit through time.
Furthermore, nevertheless they have different objective and opinions about the state of the economy and also they have different views about the instruments that should be used to deal with the problems encountered in an economy, we assume both of these institutions making rational decision with respect to the status of the economy. What gives rise to a game theoretic setting in this context is not that one of these or both of these institutions might have perverse incentives, we assume that both of them are benign policy makers and do what they think to be beneficial for the economy. Otherwise, we could have a very complicated settings which should have broken down to many other games to be solved, so for the sake of simplicity we assume they are benign and their difference on policy issues is rooted in the fact that they have different opinions on dealing with the economic issues except the fact that the fiscal policies tend to be expansionary and monetary policies tend to be contractionary. In addition to the above mentioned complexities, there are externalities associated with every decision or policy that each of the players on the other player, this is exactly what gives rise to the game theoretic setting in this context.
The question firstly arises is why these two bodies should not be consolidated into one body so that we have a single body deciding on the fiscal and monetary policy? If the answer to the above question is no, we should think of the coordination between these two major policy makers of the nations. Why should not we have a single authority to decide about the coordination issues between Central bank which is in charge of the monetary policy and the parliament which is in charge of the fiscal policies?
In this simple model, among the possible mix of coordination, i.e., a single unified policy maker, uncoordinated policy makers, and coordinate policy making (leader follower arrangement), I choose two uncoordinated policy makers playing a simultaneous game and then an uncoordinated leader follower arrangement in which the two institutions will engage in a sequential game and will analyze the two situations to see if it fits well with the optimal total payoff which the society as a whole pursues from both monetary and fiscal policy. So, I will confine myself to the study of two uncoordinated policymakers which best fits with reality of the many legal and political systems with regard to the fiscal and monetary policy making.
The model: Designing the Game
In designing the game we should take into account at least three elements of the game i.e., players, strategies and the payoffs. For analytical ease we will simplify our game as much as possible so that by isolation and then adding other elements and considerations into our simple model we can develop a better and much complicated model.
Players are central Bankers (Assumed as the sole monetary policy makers) and Parliaments (as a single body considered as the fiscal policy maker, though the executive has a great deal of say in designing the budget and there are game played in drafting the budget between the administration and the parliament, for the ease of analysis, we just consider the parliament as the ultimate decision maker in this study.)
Strategies come from incentives. As partly discussed above, incentives of the central banks can be categorized as macroeconomic stabilization and controlling the inflation. Central banks are perceived to pursue long run economic objectives. On the other hand, the growth, having higher output and the unemployment are the two most important concerns of the fiscal policy makers who are perceived to pursue the short run economic objectives. So it seems plausible for central bankers to embark on the contractionary policies and for the parliaments to pursue expansionary policies. Therefore, I will group the strategies into two inclusive strategies: expansionary or contractionary fiscal or monetary policies. Although these strategies could be divided into its composing elements and make some other games within the larger game played by the central bankers and parliaments, for the sake of simplicity, we assume that the result of those sub-games will constitute expansionary or contractionary policies at large.
Timing: This game could be formulated both simultaneously and sequentially in which once parliament leads and Central Bank follows and once central bank leads and government follows. But in this short study first we will limit it to a simultaneous move, as it evident, simultaneity does not mean that the decisions are taken at the same time, but it also implies simultaneity when the other player is not aware of the other player's strategy. After analyzing the simultaneous game, we will turn to the sequential game and will study the case in which these two institutions of governments acting asynchronously and repeatedly.
Payoffs: In this game, which is a kind of prisoner's dilemma, we assume 4 is the best payoff and 1 is the worst for every player. And in the combination of the two outcomes, we assume that the expansion by the monetary policy and contraction by the fiscal policy is preferable for the both (3, 3) to the contraction of monetary policy and expansion of the fiscal policy (2, 2).
The above matrix illustrates the payoffs for both players trying both strategies. The best response from the monetary policy making authority to the expansionary policies from the fiscal policy maker, is to take contractionary measures and hence get 2 instead of one, and the best response of Central Bank to the contractionary policy of the parliament is to have a contractionary policy (4 is preferred to 1). On the other hand, the best response to the expansionary policy of central bank is to take the contractionary policy for the parliament and the best response to contractionary policy of the central bank is to take the expansionary policy. So the Nash equilibrium which is the intersection of Nash strategies is the pair (2, 2) which is not a Pareto optimal or is a bad equilibrium. Although in this step of analysis, it seems that the coordination of these two major economic policy makers might yield higher payoffs by moving from bad equilibrium to a good one (or Pareto Optimal equilibrium), we shall see that, if the game is played repeatedly, the good equilibrium could be achieved.
More on Timing & Repetition:
Let's have a more realistic approach to this setting, by realistic, I mean that, in reality almost always we have a sequential game played by the parliaments and the Central Bankers. It means that there is a leader follower arrangement in which first one player decides what to do and then the other having seen the other player's move, moves. In this context it gets more complicated to find out who gets to move first. In reality, we observe that the central bankers make their policies more frequently than the fiscal policy makers. Fiscal policy makers usually make their policies annually and the monetary policy makers do it almost every other week or monthly depending on the different legal frameworks, but generally they make their policies more frequently.
In this case, too, suppose that first the fiscal authority moves and decides how much to tax and spend. Making this decision, it is fully aware that the fed is watching them and will respond with a strategy which will maximize its payoffs, so as the above matrix shows parliament will anticipate that the response of the central bank will be contraction, so it will respond with expansion. The fiscal policy maker will predict that the Central bank will play contraction, whatever the parliament's decision is. So the parliament will decide to play expansion, so we will be in (a sub-optimal) Nash equilibrium again. The same line reasoning can be applied to the case that the central bank moves first and the parliament follows. In this case too, the central bank knows that the dominant strategy for the parliament is expansion and then responds with contraction and once again, we have the (sub-optimal) Nash equilibrium.
What will repetition contribute to this setting? In other words, what will happen if we have a repeated game in this setting, the assumption which best fits the reality, it means not only parliaments and central banks play a sequential game, but also they play a repeated game too. In this sense, as anticipated, the follower knows that his decision in the first period will affect the leader's decision in the second period and acting rationally, it will take it into account. So this repeated interaction should play an important role in giving a spontaneous order to the interaction between parliament and central bank so that in the long run they can achieve a Pareto optimum (3, 3) and reduce the losses arising from the difference between 2 (which was attained in a one shot game) and 3 attained in a repeated game. In fact having this kind of arrangement (uncoordinated fiscal and monetary policy making) is equal to creating a system of checks and balances in which the Central Banks can discipline the fiscal policy and also the Parliaments can exercise certain degrees of discipline on the Central Bankers. So this interaction in time and repetition will make the leader to make decisions and take actions more in tune with and taking into account the targets and the objectives of the follower. And in turn, it will cause the follower to do so as well. This spontaneous cooperation (and not coordination) will emerge because they are entering an almost never ending game, if the game were a game of finite repetition, one might argue that because game will be finished at some point, by backward induction, none of the players might not enter a cooperation because they know that the other player will be cheating in the last game and so every player might think that it might be screwed up, therefore, neither player has the incentive to enter that cooperation, but since both the players know that the game will be played infinitely and more importantly, if by any change there would be a disruption in the continuity, no players know the period in which the game might be disrupted, they will end up playing cooperatively, and will move from the sub-optimal equilibrium to the optimal one.
The other objection might be that, because generally the tenure of the members of the parliaments ends after around 4 years, because of the lame duck effect that these limitations over the tenure might cause for the members of the parliament, we should expect a disruption in the repetition of the game, but this objection misses another important point and that is it ignores the fact that the members of the parliament have the incentive to be reelected, and this reelection which in almost most countries, is infinite. So, the incentive to be reelected as a member of parliament infinitely, can guarantee an infinity to the game played by both monetary and fiscal authorities and hence the cooperation and achieving a Pareto-optimum equilibrium. On the contrary, the limitation on the participation in consecutive elections to be elected to be a president might cause the lame duck effect, so one might guess why constitutions did not granted the fiscal policy making to presidents (executive power) instead of parliaments. Although this problem might be mitigated in countries with small number of established parties competing with each other over taking over the government.
All in all, quite contrary to the intuition, it seems that the uncoordinated fiscal and monetary policy making may yield higher payoffs and result in an optimal equilibrium than the coordinated one which might impose the one political or economic ideology over a system which if turns out to be false, might have catastrophic effects on the economy. These higher payoffs will emerge from the repetition of the games played by the fiscal and monetary policy making authorities under specific circumstances and having particular infrastructures such as the free and repeated and fair elections and established political parties.
