North and Thomas -V-
Credibility
© Randall W. Stone, 2002
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
© Randall W. Stone, 2002
Example
Protect
Invest
G
Confiscate
I
1, 2
-1, x
Payoff to:
I, G
Protect
Don’t
Invest
0, 0
G
Confiscate
0, 1
x<2. Is always protect a credible strategy?
x>2. What is the outcome?
© Randall W. Stone, 2002
Commitment Problems
• Investment
• Slow growth
• Capital flight
• Interest rates
• Crowding out investors
• Drain on government revenues
• Inflation
• Disincentives to save
• Disincentives to invest
© Randall W. Stone, 2002
Excessive taxation in Russia
Revenues per ton
Costs - production
$115
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
© Randall W. Stone, 2002
Inflation - why do we have it?
Keynes
P
Sa
Pb
Pa
Db
Da
Ya
Yb
Y
© Randall W. Stone, 2002
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
© Randall W. Stone, 2002
North and Thomas:
Constraints → credibility
Implications:
• Institutions explain development
• Globalization and convergence
• England & Netherlands vs. Spain & France
© Randall W. Stone, 2002
Spain
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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
© Randall W. Stone, 2002
Spain
• External threat
• No rivals
Absolutism (tax autonomy)
• 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
© Randall W. Stone, 2002
France
• Elimination of rivals
• Crisis of 100 years’ war
• Transaction costs →
• distortionary taxation
• guilds
• monopolies
Absolutism (tax autonomy)
© Randall W. Stone, 2002
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)
© Randall W. Stone, 2002
England
• Low external threat
• Independent nobility and merchants
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•
•
•
Constraints on
Tudors and Stuarts
Enforcement problems (why not in France?)
Common law overturned some royal monopolies
Puritan revolution, Restoration 1688
Constraints → lower interest rates → increase in
royal power
© Randall W. Stone, 2002
How do you critique N&T?
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Assumptions
Hypotheses
Research design
Evidence
Conclusions
© Randall W. Stone, 2002