Credibility What is the best policy rule to deal with terrorists who take hostages? Should a nation have a policy of negotiating on a case-by-case basis, or should it take a hard-line stance of never negotiating with terrorists? The attraction of the hard-line stance is that, if it is believed, it eliminates any benefit from taking hostages. Hostages are bargaining chips, and if they cannot be used to attain something, they have no value. Most countries realize this fact and announce that they have a policy of no negotiation with terrorists. However, once a hostage is taken, the pressures to abandon the rule and negotiate can be enormous. If the case is publicized, the public will demand that something be done. Yet a decision to open negotiations undercuts the announced policy of no negotiations and by increasing the expectation that taking hostages will be effective, encourages the taking of even more hostages. What looks best in the short-run can be disastrous in the long run, and what looks best in the long run can be extremely painful in the short run. This time inconsistency makes some policy rules very difficult to maintain. The discussion above emphasizes the importance of credibility, which is an aspect of expectations. When a totalitarian regime, which treats life as cheap, announces a no-negotiations policy, is it more or less likely to be believed than a democratic society? Can you think of any totalitarian regimes that have had problems with terrorists taking hostages? Is it just a chance that a large number of hostage-taking situations end with the death of the hostage-takers? When a Muslim faction in Lebanon took US hostages during the 1980s, did having this story constantly in the headlines help resolve it, or did the constant media exposure encourage the faction to continue holding and taking hostages? Kidnapping is a small-scale taking of hostages. It is very rare in the United States, but has been common in some South American countries. In the United States any kidnapping becomes a federal crime and great resources are put into solving it. As a result, it is a very risky crime and one that is not often committed. In contrast, in countries in which kidnapping is common, it usually succeeds, and rarely results in the arrest or death of the kidnappers. The laws may be similar, but the expectations of what will happen if the law is broken are very different. You may be wondering what kidnapping and terrorism have to do with macroeconomic policy. The importance of credibility and expectations are central in both. If a government says that it has a policy of controlling inflation, and that policy is not believed, the way people react to its actual fiscal and monetary policy may be very different from the way they would react to those same policies if they believed that the policy the government. The old idea that people reacted mechanically to policy, and that a tax cut or an increase in money supply had some automatic result on behavior has been undercut. The effects of a particular policy depend not only on that policy, but also on expectations. An unexpected policy change may have a very different effect on people's behavior than an expected policy change. The emphasis on policy rules and expectations has changed attitudes about what government policy can do. The ancient fable of the "Boy Who Cried Wolf" shows that most people have long understood the importance of reputation and credibility. In their new emphasis on the importance of credibility, economists have merely realized that the message of this simple story applies not just to interpersonal relationships but to economic policy as well. Sometimes important insights are based on very simple ideas. Copyright Robert Schenk