Undercover Economist

Promises, promises and why it pays not to break them

By raising the top rate of income tax to 50 per cent, Alistair Darling broke a manifesto promise not to do so in the lifetime of this parliament. It was a self-imposed rule whose spirit had already been ignored; now he doesn’t even bother to pretend.

We can leave to one side the merits of the policy itself; both its costs (driving away entrepreneurs) and its benefits (raising revenue) seem to be exaggerated. What interests me more is the value of government promises.

They can be fragile things. Governments can sign contracts, of course, but without strong constitutional oversight, they can violate those contracts. In any case, contracts do not usually apply to the generosity of future state pensions, to tax rates, or to the changing regulatory climate. When citizens, foreigners and businesses make their decisions, then, they have to guess at how the government will behave in future. A government that lacks credibility will invite a hesitant and economically wasteful response.

Politicians from developing countries know that a reputation for whimsicality can send foreign investors running for cover. Some of those politicians do not much care, and their citizens suffer as a result. Yet the governments of rich countries have a credibility problem, too, and it can be costly.

Gordon Brown’s first flourish as chancellor was to give independence to the Bank of England, a decision that economists continue to applaud, precisely because it adds credibility to the fight against inflation. That fight is much easier for a credible general.

Inflation is a constant temptation for governments. It temporarily creates economic activity because, until people figure out what has happened, they mistakenly feel richer. Mervyn King, with less need to court popularity, finds it easier to resist the temptation. It is not credible for Gordon Brown to promise low inflation; it is more credible for him to say that, having given King his authority, he will not revoke that decision.

Other credibility problems are harder to fix. The multiple incarnations of Washington’s efforts to create a market for toxic securities have foundered, and one reason is that the government cannot credibly promise not to offer further bail-outs. A hedge fund might be tempted to buy some trashy assets from a bank, but the bank may quite reasonably expect that if the assets stay where they are, weighing down the balance sheet, further government support will be forthcoming. The two sides will not be able to agree a price.

The problem exists in medicine, too. Governments occasionally override patents, or threaten to do so, in times of emergency. The makers of anti-anthrax drug Cipro and flu-fighter Tamiflu have both had their arms twisted in recent years. Pharmaceutical companies contemplating investing billions of dollars in an HIV vaccine must be given pause for thought by this; does anyone seriously think that the inventor of such a vaccine would be allowed to charge what the market would bear, free of political interference? And so a vaccine becomes less likely.

All this is a shame, but perhaps inevitable. Movies about heists, cons and double-crosses are gripping because the criminals cannot make binding promises to each other, and so resort to tricks and violence. While it is fun to watch, it cannot be much fun to experience.

That is why the credibility of government promises matters. There is little that can restrain a government making a fleetingly popular decision. Constitutional oversight can help, but so can years of reputation-building and precedent. Every little lie has a long-term cost.

Also published at ft.com.

9th of May, 2009Undercover Economist • Comments off