Since the seminal work of Kydland and Prescott (1977), it has been understood that policymaking under discretion can lead to a substantially worse outcome than policymaking under commitment. Many economists believe that discretionary policymaking is important for understanding central issues in monetary policy1 and fiscal policy.2 Although there are now many different models of discretionary policymaking, there are two common and essential aspects in all models: (i) private agents make current choices that affect the evolution of state variables on the basis of beliefs about future policy, and (ii) future policymakers take these state variables as historically determined when choosing their optimal actions. Further, within the models of this large literature, there is typically a cost arising from the fact that the discretionary policymaker cannot manage expectations, so that the resulting equilibrium is inefficient relative to that arising with a committed policymaker.
Another potential impact of discretion, however, is that more than one equilibrium may result from the central interaction between private sector choice of state variables, private sector beliefs about future policy, and future policy reaction to state variables. Some of these discretionary equilibria are better than others in terms of the welfare of the members of the society. An economy may get stuck in a relatively bad equilibrium, so that there can be even greater costs of policy discretion.
Recent work on discretionary monetary policy by King and Wolman (2004) shows how dynamic multiple equilibria can arise in a simple "plain vanilla" New Keynesian macroeconomic model of monopolistic competition and sticky prices of the variety that is now standard in macroeconomic research and policy analysis. In that context, a discretionary monetary authority adopts a policy rule that fosters strategic complementarity between the actions of pricesetters. In turn, that strategic complementarity makes for dynamic multiple equilibria, as in a large literature on the boundary of game theory and macroeconomics concerning coordination games in aggregate economies.3 In the terminology of Cooper and John (1988), the standard New Keynesian model can give rise to a "coordination failure."
The objective of this article is to construct a very simple and transparent real model in which dynamic multiple equilibria are a consequence of discretionary policymaking for the same economic reasons as in the monetary policy literature. The model is inspired by a brief discussion in Kydland and Prescott (1977) about the interaction of individual location decisions and policy response to disasters such as floods:
The issues [of time inconsistency arise] in many well-known problems of public policy. For example, suppose the socially desirable outcome is not to have houses built in a particular floodplain but, given that they are there, to take certain costly flood-control measures. If the government's policy were not to build the dams and levees needed for flood protection and agents knew this was the case, even if houses were built there, rational agents would not live in the flood plains. But the rational agent knows that, if he and others build houses there, the government will take the necessary flood-control measures. Consequently, in the absence of a law prohibiting the construction of houses in the floodplain, houses are built there, and the army corps of engineers subsequently builds the dams and levees. (Kydland and Prescott, "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy 85: 477)
The essence of the situation just described is that there is a strategic interaction between the private sector and the government. Accordingly, following much recent literature on policymaking under discretion and commitment, we will make use of game-theoretic constructs to discuss the interaction between private location decisions and the government dam-building decision. …