Strategic Credibility in Game Theory & Economic Development

1. North and Thomas -V- Credibility

2. Formal Definition: • A strategy is credible if it is optimal to follow it under all conceivable circumstances • A strategy must be optimal even under circumstances that should never arise, given the strategy Game theory: Subgame perfection

3. Example Protect 1, 2 G Invest -1, x Confiscate Payoff to: I, G I Protect 0, 0 G Don’t Invest 0, 1 Confiscate x<2. Is always protect a credible strategy? x>2. What is the outcome?

4. Commitment Problems • Investment • Slow growth • Capital flight • Interest rates • Crowding out investors • Drain on government revenues • Inflation • Disincentives to save • Disincentives to invest

5. Excessive taxation in Russia Revenues per ton $115 Costs - production 30 - transport, export costs, currency conversion 20 - export taxes 26 - excise tax 4.50 - royalties 9.20 - mineral resources tax 11.50 - other taxes 7 Total costs -------------------------------------108.20 Profit ------------------------------------------- $6.80 Profit tax --------------------------------------- 2.58 NET Profit ------------------------------------- $4.22 Source: Watson, 1994

6. Inflation - why do we have it? P Keynes Sa Pb Pa Db Da Y Ya Yb

7. Inflation - why do we have it? • Problems: • Open economies • fiscal stimulus - decrease the exchange rate • monetary stimulus - capital flight • Rational expectations • But, still a short-term temptation - inflation • Costs? • Quantitative evidence • Growth, investment, quality of life, corruption, income inequalities

8. North and Thomas:Constraints → credibility Implications: • Institutions explain development • Globalization and convergence • England & Netherlands vs. Spain & France

9. Spain • 1560-1581: Spain vs. Turkey • 1560’s: Netherland’s revolt • 1580: Annex Portugal • 1588: Spanish Armada sinks • 1618-1648: 30 years’ war • 1635-1659: France vs. Spain • 1640’s: Portugal revolts

10. Spain • External threat Absolutism (tax autonomy) • No rivals • Transaction costs → tax Mesta (sheep), not land • Overextension → war → high discount rate • Defaults → high interest rates • Forced loans, confiscation → • low investment • destruction of capital markets • merchants bankrupted • Silver from New world → inflation, trade deficit

11. France • Elimination of rivals Absolutism (tax autonomy) • Crisis of 100 years’ war • Transaction costs → • distortionary taxation • guilds • monopolies

12. Netherlands • Good administration (Dukes of Burgundy) → stable property rights (land, labor, capital) • Commerce • Lending at interest, negotiable notes (3% interest rates) • Rapid adjustment to comparative advantage (English cloth)

13. England • Low external threat • Enforcement problems (why not in France?) • Common law overturned some royal monopolies • Puritan revolution, Restoration 1688 • Constraints → lower interest rates → increase in royal power Constraints on Tudors and Stuarts • Independent nobility and merchants

14. How do you critique N&T? • Assumptions • Hypotheses • Research design • Evidence • Conclusions