Wednesday, October 10, 2007

International Agreements as Commitment Mechanisms

One argument for trade agreements is that they tie the hands of governments, and may provide a way to "lock in" market-oriented economic reforms. The reforms may lead to higher investment, but only if businesses are confident that the policies will stay in place - the trade deals improve the credibility of the policies (that is, they are a "commitment device"). A similar argument has been made for fixed exchange rates - they are a way for a previously inflation-prone government to credibly commit itself to a more stringent monetary policy (which is necessary to maintain the currency peg). Much of this argument derives from Kydland and Prescott's study of the "time consistency" problem - the Nobel Prize site has a good description. But isn't it anti-democratic for a current government to tie the hands of its successors? On his blog, Dani Rodrik explains how to tell the difference between "the good and bad kind of external discipline."


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