Arnold Kling  

Time Consistency

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Time consistency is one of those terms that economists throw around, and it has come up several times recently on this blog. It might be worth defining/explaining.

The situation arises when someone makes a commitment to take an action in the future. If the incentive to keep the commitment is the same as the incentive to make the commitment, then the example is time consistent. However, if the incentive to keep the commitment is significantly less than the incentive to make the commitment, then we say that the example is time-inconsistent or that there is a time-consistency problem.

For example, when I refinance a mortgage, I make a commitment to pay back the new loan in the future. Consider two cases.

1. I borrow $100,000 against my primary residence, which has a value of $200,000.

2. I borrow $400,000 against an investment property, which has a value of $200,000.

In case (1), my incentive to keep the commitment is not really any weaker than my incentive to make the commitment. There is no time consistency problem. In case (2), I have a strong incentive to make the commitment but only a weak incentive to keep the commitment. There is a time consistency problem.

If you make a commitment to go on a diet, starting tomorrow, there is a time consistency problem. Tomorrow when you go to a party and they serve chocolate cake, your incentive to keep your commitment will be weaker than today's incentive to make that commitment.

A bank regulator has an incentive to make a commitment to not bail out banks. By making this commitment, the regulator puts pressure on the market to control risk taking. However, when a failure occurs, the regulator often feels pressure to do the bailout. Thus, there is a time consistency problem.

Congress has an incentive to make a commitment to take future actions to reduce the deficit, such as cutting Medicare payments to doctors. However, when the time comes, the incentive will be to avoid painful cuts, as Bryan and many others have pointed out.

Health care legislation that is financed by future cuts in Medicare represents a classic time inconsistency problem.


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COMMENTS (12 to date)
SydB writes:

"Health care legislation that is financed by future cuts in Medicare represents a classic time inconsistency problem."


Similar to cutting taxes and arguing that the budgetary impact will, in the future, be resolved through increased tax revenues.

Robert Simmons writes:

100% wrong, SydB. You can argue that supply-side tax cut arguments are incorrect, or even done in bad faith. However, there is no time consistency problem, as the mechanism of increased tax revenues comes from the tax cuts themselves, not from future legislators raising rates. Big difference.
Starve-the-beast is probably more more like it, though I think that people truly thought they were solving a time consistency problem with it.

E. Barandiaran writes:

Indeed time inconsistency is quite common. As Arnold's examples (and the one by SydB's) show that we often know at the time of making a commitment that we may face a hard time to keep it.
The first time I read about was around 1972, in a Ph.D. thesis submitted by my friend L. Auenheimer to U. Chicago's Dept. of Economics. It was about the incentives that the Argentinian government could have to keep a promise of not printing more money to finance future deficits. To illustrate how difficult sometimes it's to keep this type of promise consider what happened with Argentina's stabilization plan of June 1985 (el Plan Austral): the government promised not to print more money but just in case it printed a lot of money the day before the announcement and left the new money in the safety box of a state bank other the central bank!! It took only a few day to use it. And the IMF said that the plan could work!!

SydB writes:

Robert: Supply sider's intention today to balance the budget with tax cuts is not matched by actions in the future to either raise taxes or cut the budget when their intentions don't work out.

It's a bit more complicated, but it's working off the same concept. Tax cuts today, inability to raise them tomorrow when the cuts don't work out.

Ryan Vann writes:

I agree with Mr. Simmons,

Time consistency was not the basis for the Laffer argument that tax cuts can increase revenues. I don't agree that people believed they were solving a time consistency problem though. It was a straight forward argument that reduced tax rates increase investment and spending thus creating more taxable output. To be certain, output was the point of focus, with revenue being secondary.

Nothing implied by the tax cut arguments suggests a commitment to a balance budget. If there is any time inconsistency in the argument, it has nothing to do with revenues or budget commitments but rather tax rate commitments.

hutch writes:

this reminds me of the episode of seinfeld when he makes a reservation for a rental car but when he gets there, they don't have any cars left. it's one of my favorite clips.

http://www.youtube.com/watch?v=2SIps4P_1CE

E. Barandiaran writes:

About tax cuts. I understood that SydB was talking about them as stabilization policy not as Laffer's long-run policy

Mark Brady writes:

"The situation arises when someone makes a commitment to take an action in the future. If the incentive to keep the commitment is the same as the incentive to make the commitment, then the example is time consistent. However, if the incentive to keep the commitment is significantly less than the incentive to make the commitment, then we say that the example is time-inconsistent or that there is a time-consistency problem."

Strictly speaking, time-inconsistency would arise if the incentive to keep the commitment were significantly different from the incentive to make the commitment.

I'm not aware of anyone making this point in the literature but it doesn't seem implausible that the incentive to keep a commitment might not strengthen as time passes.

A further observation. Although, generally speaking, it's probably a good thing if households and firms were to keep to their commitments, historical experience doesn't suggest to me that time-consistency is often, if ever, a good thing when governments make commitments. Speaking as a libertarian, if governments exhibit time-inconsistency it might well encourage people to be more skeptical of government in future!

Robert Simmons writes:

I was slightly unclear there. I meant that believers in starve-the-beast were trying to solve time consistency problems, not that supply-siders thought that or that supply-siders are starve-the-beast believers. Supply-siders thought that there wasn't a time consistency problem, so never worried about it. You may think that irresponsible, but it is a different problem.

Ryan Vann writes:

Mr. Simmons,

Yeah, that makes a lot more sense now. Thanks for clearing that up.

agnostic writes:

"it doesn't seem implausible that the incentive to keep a commitment might not strengthen as time passes."

Like when there are positive network effects. When you're an infant committing to a particular language A, you could have committed to another language B. As you grow up and develop more and stronger connections to A-speakers, the switching costs -- the costs of dropping your initial commitment -- go up.

The initial arbitrary choice of a standard doesn't matter as much as the continued commitment to the chosen standard. (To repeat: this only applies where the choice is arbitrary -- i.e. no difference in quality among choices is initially apparent).

So here the problem is the reverse of the decaying incentives case. There, we try to prop up the incentives over time. Here, we focus more on getting the initial choice right, as when major industry players explore the various standards before going with one.

Doc Merlin writes:

Heh, they say that people are irrational because of inconsistent time preferences, but how do you fix that? ... well... it seems anyone you put in charge will also have inconsistent time preferences.

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