Time Inconsistency and Free-Riding in a Monetary Union

We analyze the setting of monetary and nonmonetary policies in monetary unions. We show that in these unions a time inconsistency problem in monetary policy leads to a novel type of free-rider problem in the setting of nonmonetary policies, such as labor market policy, fiscal policy, and bank regulation. The free-rider problem leads the union’s members to pursue lax nonmonetary policies that induce the monetary authority to generate high inflation. The free-rider problem can be mitigated by imposing constraints on the nonmonetary policies, like unionwide rules on labor market policy, debt constraints on members’ fiscal policy, and unionwide regulation of banks. When there is no time inconsistency problem, there is no free-rider problem, and constraints on nonmonetary policies are unnecessary and possibly harmful. ∗The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Since the 1990s, interest has grown in the design of monetary unions–groups of political units (countries or states or provinces) that have a great deal of independence in setting fiscal and other nonmonetary policies, but that share a central monetary authority, an independent entity which sets a single monetary policy for all the members of the union. In practice, some monetary unions have worked poorly while others have worked well. Argentina is an example of an unsuccessful one; the United States, a successful one; and the jury is still out on the European Union. Why are some monetary unions successful and others not? Here we develop a theory that answers this question. The time inconsistency problem in monetary policy is at the heart of our theory. We argue that under some circumstances, this monetary policy problem leads to a novel type of free-rider problem in the setting of nonmonetary policies by union members. Free-riding union members pursue lax nonmonetary policies that benefit themselves individually, but that induce the monetary authority to pursue policies that generate high inflation for the whole union. One way to eliminate both problems is to directly solve the time inconsistency problem in monetary policy. As is well-known, in theory, at least, this problem can be solved by imposing commitment or reputational mechanisms on the monetary authority. When either type of mechanism is in place, there is no free-rider problem, so that directly solving the time inconsistency problem indirectly solves the free-rider problem too. In practice, of course, it is difficult to change the degree of effective commitment, say, by developing a reputation. For our purposes, we will simply assume as necessary that a monetary authority either has or does not have a time inconsistency problem. More interestingly, we show that solving a monetary union’s free-rider problem helps mitigate its time inconsistency problem in monetary policy. The free-rider problem can be solved by imposing unionwide constraints on nonmonetary policies, such as rules on labor market policies, debt constraints on fiscal policy, and regulation of banks. When union members’ nonmonetary policy options are limited, the monetary authority is less likely to be induced to act in ways that increase inflation. The constraints thus do not necessarily eliminate the time inconsistency problem, but they do at least reduce it. We first make these points in a general theoretical setup. Our model has governments that set nonmonetary policies noncooperatively, private agents that behave competitively, and a benevolent monetary authority that chooses the inflation rate. The monetary authority’s optimal inflation rate depends on the decisions of private agents and on the individual governments’ nonmonetary policies. Private agents make their decisions anticipating the choice of the monetary authority. Governments choose their nonmonetary policies anticipating the choices of both private agents and the monetary authority. In our setup, the free-rider problem is quite different from that in the existing literature. In the standard formulation of the free-rider problem, decision makers are directly linked; the actions of each decision maker directly affect the payoffs of others. Our setup has no such direct links. Here the nonmonetary policy of each government affects the common inflation rate and thus indirectly affects the payoffs of other governments. This indirect link does not, however, suffice to generate a free-rider problem. We use an envelope argument to prove that. Here the source of the free-rider problem is, rather, the behavior of forward-looking private agents when the monetary authority cannot commit to a policy. Without such commitment, a change in nonmonetary policy by one of the union’s member governments induces the private agents to predict a change in unionwide inflation, and this predicted change induces them to change their decisions. Because each government cares about the decisions of its own private agents, a change in nonmonetary policy by any member government affects the welfare of them all. This indirect link results in a free-rider problem. With commitment by the monetary authority, there is no free rider problem even if the model has forward-looking private agents.