1. © Randall W. Stone, 2002 North and Thomas -V- Credibility

2. © 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

3. © Randall W. Stone, 2002 Example I G G Invest Don’t Invest Protect Confiscate 1, 2 -1, x 0, 0 0, 1 x<2. Is always protect a credible strategy? x>2. What is the outcome? Payoff to: I, G

4. © 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

5. © Randall W. Stone, 2002 Excessive taxation in Russia Revenues per ton $115 Costs - production30 - transport, export costs, currency conversion20 - export taxes26 - excise tax4.50 - royalties9.20 - mineral resources tax11.50 - other taxes7 Total costs -------------------------------------108.20 Profit ------------------------------------------- $6.80 Profit tax --------------------------------------- 2.58 NET Profit ------------------------------------- $4.22 Source: Watson, 1994

6. © Randall W. Stone, 2002 Inflation - why do we have it? Keynes SaSa DaDa Y P PaPa YaYa DbDb YbYb PbPb

7. © Randall W. Stone, 2002 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 Inflation - why do we have it?

8. © Randall W. Stone, 2002 North and Thomas: Constraints → credibility Implications: Institutions explain development Globalization and convergence England & Netherlands vs. Spain & France

9. © Randall W. Stone, 2002 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. © Randall W. Stone, 2002 Spain 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 Absolutism (tax autonomy) External threat No rivals

11. © Randall W. Stone, 2002 France Elimination of rivals Absolutism (tax autonomy) Crisis of 100 years’ war Transaction costs → distortionary taxation guilds monopolies

12. © Randall W. Stone, 2002 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 ) Netherlands

13. © Randall W. Stone, 2002 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 England Low external threat Independent nobility and merchants

14. © Randall W. Stone, 2002 How do you critique N&T? Assumptions Hypotheses Research design Evidence Conclusions