3 Framework for analysis
This section sets out a framework for identifying a small number of policy options for detailed quantitative analysis in future papers. The framework emphasises the need to conduct comparative institutional analysis and explicitly take into account uncertainty about the benefits and costs of different policy options.
3.1 Comparative institutional method
Standard economics texts teach that policy analysis should be conducted by deriving an optimal policy from an appropriately specified model. The rigours of formally deriving an optimal policy function requires that the model be highly stylised and omit important features and real world imperfections faced by policy makers. Most models omit transition issues and assume the policy maker knows the true structure and characteristics of the economy. Further, the optimising approach is not suitable in situations where the policy maker wishes to draw implications from two or more non-nested theoretical models.
These concerns are consistent with Coase (1964), who said that economists should always judge alternative arrangements as opposed to judging reality against some theory that is always bound to win. As Coase put it:
Contemplation of an optimal system may provide techniques of analysis that would otherwise have been missed and, in certain special cases, it may go far to providing a solution. But in general its influence has been pernicious. It has directed economists’ attention away from the main question, which is how alternative arrangements will actually work in practice. It has led economists to derive conclusions for economic policy from a study of an abstract market situation. … Until we realize that we are choosing between social arrangements which are all more or less failures, we are not likely to make much headway. (Coase, 1964, p.194-5)
In commenting on Coase’s approach to economic policy making, Gorringe (1992) considered that Coase’s concerns were aimed at those who do not think about or model the alternatives in an even-handed way. Gorringe gave the example of basing policy advice on an analysis of market failure without considering government failure (and vice versa).
The aim of comparing “real with real” does not imply that the traditional approach has nothing useful to offer. Rather, as indicated at the beginning of the quote above, the optimising approach retains an important role. Critical insights from the various models serve as important inputs to identifying and formulating candidate policies.
The comparative institutional method has direct application to Crown financial policy. Hansen (2003) shows that the economic models relevant to Crown financial policy derive from a wide range of theory literatures, including theories of optimal public debt management, time-consistency of fiscal and monetary policy, and the principal-agent approach to public sector management. The models are non-nested and their stylised nature ignores key uncertainties faced by policy makers.
Consistent with the comparative institutional method, the approach adopted in this paper is to identify three policy options that could potentially be put to the government for consideration. A key priority is that these policy options should be “implementable”, rather than strictly optimal in terms of any one theoretical model of Crown financial policy.
