It takes resources to define and protect property rights and to enforce agreements. Institutions together with the technology employed determine those transaction costs. It takes resources to transform inputs of land, labor, and capital into the output of goods and services and that transformation is a function not only of the technology employed, but of institutions as well. Therefore, institutions play a key role in the costs of production.

In previous chapters I specified why it is costly to transact and examined the variety of forms that institutional constraints take in constraining human interaction. Still ahead (in Chapter 9), I shall explore the way by which learning and organizations can modify and alter the relationship between institutions and transaction costs (and transformation costs as well). But first, I simply wish to pull together the threads of the argument so far.

A hierarchy of rules – constitutional, statute law, common law (and even bylaws) – together will define the formal structure of rights in a specific exchange. Moreover, a contract will be written with enforcement characteristics of exchange in mind. Because of the costliness of measurement, most contracts will be incomplete; hence informal constraints will play a major roles in the actual agreement. These will include reputation, broadly accepted standards of conduct (effective to the extent that the conduct of the other parties is readily observable), and conventions that emerge from repetitive interactions.

In this chapter the theory of social situations is applied to the simplest of the three types of games – games in characteristic function form (known also as cooperative games). Several possible ways to represent such games as situations will be suggested. As in the procedural voting-by-veto model (Example 3.6), this demonstrates that the description of a social environment as a cooperative game is incomplete. It omits some essential information. I shall argue that a cooperative game specifies the power coalitions have if and when they form, but it is totally silent on the crucial issue of how exactly this power can be used. (As every card player knows, the distribution of the cards does not, in itself, suffice to determine the course of the game; it is important to know how the “hands” are played.)

The representation of a cooperative game as a situation forces us to address, among other issues, the following two fundamental questions in the theory of coalition formation:

1. C.1. What, in fact, is the meaning of forming a coalition – is it a binding commitment of the players to remain and never leave a coalition once it forms, or is it merely a “declaration of intentions” which can be revised?

2. C.2. Do players first form a coalition and only then discuss their payoff there, or are the two decisions made simultaneously?

We shall see that two of the most important game-theoretic solution concepts for cooperative games – the core and the vN&M solution – can be regarded as stemming from the way (C.I) and (C.2) are answered.

In all societies from the most primitive to the most advanced, people impose constraints upon themselves to give a structure to their relations with others. Under conditions of limited information and limited computational ability, constraints reduce the costs of human interaction as compared to a world of no institutions. However, it is much easier to describe and be precise about the formal rules that societies devise than to describe and be precise about the informal ways by which human beings have structured human interaction. But although they defy, for the most part, neat specification and it is extremely difficult to develop unambiguous tests of their significance, they are important.

In the modern Western world, we think of life and the economy as being ordered by formal laws and property rights. Yet formal rules, in even the most developed economy, make up a small (although very important) part of the sum of constraints that shape choices; a moment's reflection should suggest to us the pervasiveness of informal constraints. In our daily interaction with others, whether within the family, in external social relations, or in business activities, the governing structure is overwhelmingly defined by codes of conduct, norms of behavior, and conventions. Underlying these informal constraints are formal rules, but these are seldom the obvious and immediate source of choice in daily interactions.

All theorizing in the social sciences builds, implicitly or explicitly, upon conceptions of human behavior. Some of the approaches rest on the expected-utility assumption in economic theory or the extension of that behavioral assumption into other social science disciplines, loosely termed rational choice theory. Other approaches raise some quite fundamental questions about the traditional economic approach. Although I know of very few economists who really believe that the behavioral assumptions of economics accurately reflect human behavior, they do (mostly) believe that such assumptions are useful for building models of market behavior in economics and, though less useful, are still the best game in town for studying politics and the other social sciences.

I believe that these traditional behavioral assumptions have prevented economists from coming to grips with some very fundamental issues and that a modification of these assumptions is essential to further progress in the social sciences. The motivation of the actors is more complicated (and their preferences less stable) than assumed in received theory. More controversial (and less understood) among the behavioral assumptions, usually, is the implicit one that the actors possess cognitive systems that provide true models of the worlds about which they make choices or, at the very least, that the actors receive information that leads to convergence of divergent initial models. This is patently wrong for most of the interesting problems with which we are concerned.

This chapter establishes existence and uniqueness results that will be used extensively in the applications of the theory of social situations in Chapters 6–10. Thus, this chapter is rather technical. The reader may proceed directly to the next chapters and accept statements that refer to this chapter. Alternatively, the reader may wish to familiarize himself (at least in the first reading) only with the definitions and results of this chapter but skip the proofs.

Hierarchical situations

Interesting social environments are frequently represented by situations said to be “hierarchical,” which have a relatively simple structure. For example, the situation in Example 2.1.2, the voting by veto model in Example 3.6, and games in characteristic function, normal, and extensive form (see Chapters 6–10) are naturally associated with hierarchical situations.

An important property of many hierarchical situations is that they admit a unique OSSB and a unique CSSB. Moreover, these two notions can be derived explicitly by the (recursive) formulas that fully characterize them (see Theorems 5.2.1 and 5.4.1).

A situation (γ,Γ) is hierarchical if there exists a finite “hierarchy” of the positions in Γ such that a position can be induced either from positions of a higher hierarchy than it or else from itself. Moreover, for every G∈Γ, there is at most one coalition, denoted S(G), that can induce G from itself.

Before stating the formal definition, it should be stressed that the hierarchical structure is only a technical construct that carries no other meaning or interpretation whatsoever.

This work was originated during my two-year stay at the economics department of Stanford University in the academic years 1984–6 and my visit to CORE, Belgium, in September 1985. Since then I have had the opportunity (and often the pleasure) of discussing the contents of this research monograph with a number of individuals. I benefited not only from insightful comments made by some scholars, but also from the dogmatic thinking of others, which forced me to be more precise and explicit in my writing. I thank members of both groups.

Special thanks are due to Geir Asheim, Giacomo Bonanno, Edi Kami, Amnon Rapoport, Howard Rosenthal, and Zvi Winer for their very useful and thoughtful comments.

One person, to whom I owe the most for (almost) always being willing to listen, read, discuss, and criticize my ideas, is my friend and colleague Benyamin Shitovitz. His many suggestions concerning both contents and exposition have been extremely helpful.

I have also profited from teaching parts of this book at the following institutions: Haifa University, Israel; California Institute of Technology; G.R.E.Q.E., Marseilles; GSIA, Carnegie Mellon University; University of California at Davis; and the University of Notre Dame de la Paix, Namur, Belgium, where I held the Chaire Francqui Internationale, 1987.

The theory of social situations has two main ingredients. First, it offers a unified way to represent social environments, namely, by means of “situations.” Second, it offers a unified criterion for the recommendations, namely, that the “standard of behavior” (for the given situation) be “stable.”

Situations

The notion of a “situation” defined below provides a complete description of the social environment. It specifies in an explicit and detailed manner the opportunities that are available to the agents.

To motivate and facilitate the definition of a situation, consider the game of chess. The set of players consists of two individuals: Black and White. There is a collection, say, C, of “admissible” configurations of the pieces on the board. For example, every configuration in C must be such that both kings are present on the board and occupy nonadjacent squares. For each pair (c,i), where c is a particular configuration in C and i is one of the two players, there is a set of configurations in C that player i can “induce” from c, if it is i's turn to make a move once c was reached. When this set is empty player i is checkmated. Clearly, all induced configurations must themselves be admissible, that is, belong to C, since the rules of the game apply to such and only such configurations.

There are rhythms in American political life. There is the regular fouryear electoral rhythm, as well as the more irregular rhythm of party alternation in control of the White House. It would be surprising if economic policy and outcomes did not resonate with these rhythms. Much empirical research has been done on this question. As is typical, there are contradictory findings, but it seems quite clear that economic policy and outcomes do vary with control of the White House, and it is likely that policy and outcomes vary with the electoral calendar. Are there similar rhythms in monetary policy? The answer is less clear. The Fed, after all, was set up to be insulated from these political rhythms. In this chapter I shall look at some arguments and some evidence for electoral or partisan rhythms in the making of monetary policy.

I take as uncontroversial that presidents wish to be reelected; if one is not eligible for reelection, one prefers that the White House remain with one's party. Presidents may have other goals, and they may even rank those other goals more highly, but no one achieves the presidency without some interest in being elected. It follows from this that presidents will prefer policies that will help them get reelected, at least insofar as those policies do not conflict with other goals. We need not view the president as being willing to do anything to get elected in order to believe that he evaluates policies at least partially in terms of their effects on the next election.

Knowledge of actual Federal Reserve behavior is important in studies of monetary policy and financial markets for at least two reasons. First, the interpretation of variables chosen to represent the monetary policy process may be marred if they do not correspond to variables actually used by the Federal Reserve to implement monetary policy or to gauge its performance. Accordingly, the Federal Reserve's choices regarding targets, intermediate targets,-and instruments may play a key role in research design. Unfortunately, information regarding these choices is not always easy to obtain. Relevant Federal Reserve policy statements, such as an FOMC policy directive, are released after substantial delays and often are ambiguous. Thus, additional knowledge regarding actual Federal Reserve behavior may have a methodological payoff.

Second, the recurrent issue of policy credibility requires an assessment of the extent to which Federal Reserve statements find a reflection in the beliefs and behavior of economic agents. Although credibility potentially has a variety of interpretations, all would seem to require that a shift in stated policy objectives and instruments be associated with at least some change in market behavior. Thus, additional knowledge regarding Federal Reserve behavior, and the financial market's reaction to it, may help illuminate the credibility issue.

This chapter examines actual Federal Reserve behavior from a financial-market perspective. Movements in interest rates are used as the metric in this exercise. The underlying presumption is that financialmarket participants fully understand Federal Reserve behavior. This position is sensible for two reasons. First, many financial-market participants are former Federal Reserve officials and economists.

The first time I saw Milton Friedman was at a public debate on free enterprise versus socialism at the University of Chicago. He based his entire lecture on what a benevolent dictator would do. Admittedly, he intended this simply as a rhetorical device to argue for a free economy. Of course, Friedman himself was not in favor of a dictatorship. He was, however, using a benevolent dictator as a means of avoiding all discussion of politics.

In this, he was typical of the economists of that time. They investigated optimal policies and considered what well-intentioned people would do if they had control of the government. Insofar as they had an argument for this approach, it was based on the division of labor. They would have said that politics was best left to political scientists. As a matter of fact, political scientists were not doing very well with politics, essentially because they lacked the tools that economists had. Public choice is, in the real sense, the use of economic and economiclike tools developed for special application in a field that political scientists traditionally taught.

Let us turn to the more scientific aspect of public choice. I am going to give an example of the kind of work we do. This example is particularly interesting because it is a case in which for some two hundred years economists were simply wrong.

Current debates over international coordination of macroeconomic policy pose interesting conundrums for our understanding of domestic monetary policy. For a number of years the United States has been exerting pressure on Japan and West Germany to pursue an easier monetary policy, and particularly in the case of the West Germans the United States has been unsuccessful. German officials cite fear of inflation as their rationale for a restrictive policy. Yet, last year, consumer prices fell in West Germany, casting suspicion on either the sincerity or wisdom of the German government's stance.

An alternative explanation, now recognized by economists and other observers, is that macroeconomic expansion is thought by the German government to be incompatible with maintenance of corporate profitability in West Germany (Llewellyn 1983). The German case suggests the need to rethink traditional approaches to understanding macroeconomic policy in general and monetary policy in particular.

This chapter attempts such a rethinking. Using the case of the United States, we investigate the hypothesis that the Federal Reserve's monetary policy is motivated by a concern for corporate profitability. We reinterpret the standard evidence on the determinants of monetary policy in light of this hypothesis. The results are consistent with the view that the Federal Reserve is acting so as to maximize the (weighted) profitability of finanical and nonfinancial corporations. Furthermore, there is no evidence that the Fed independently attempts to promote labor's interests.

Theories of monetary policy

It is well established that the Federal Reserve responds to inflation and the growth of output by leaning against the wind. Reaction-function studies such as that of McNees (1986) support this proposition.

Academic research on the behavior of the Federal Reserve System has accelerated rapidly in recent years. The spread of public-choice analysis has strongly challenged the traditional public-interest view of economic policy-making, opening up exciting new areas of research. In addition, the distinction between the effects of anticipated and unanticipated policy actions emphasized by rational-expectations theory has stimulated additional interest in estimating policy reaction functions. Likewise, the politics of economic policies, both domestic and international, has become a popular topic of research for political scientists. The small band of monetary economists who have long engaged in Fed-watching now has considerable company. This has been a very healthy development.

Monetary policy is determined by the interactions of the preferences and personalities of key government officials with formal and informal institutional structures and the pressures of interest groups and market behavior. This is a highly complex process, and as Tom Mayer emphasizes in his Introduction, its study requires institutional as well as formal mathematical and econometric analysis.

We can learn a great deal from the formal modeling of limited aspects of even very complex situations, but it is essential to keep in mind the distinction between the argument that a particular factor has significant explanatory power and the treatment of that factor as if it were the only important consideration. Both rational-expectations and public-choice theorists have at times failed to be clear on this, dismissing as irrelevant considerations that may have considerable explanatory power.

That political and economic processes cannot be separated seems self-evident. Markets are regulated by the coercive institutions of the state, and the state dictates the supply of that most efficient accounting of exchange – money. Simultaneously, regardless of a state's form, as long as two people perceive mutual advantages from exchange, markets, however primitive, will persist. Thus, the hard-learned lesson of political conservatives is that the state establishes the context in which markets operate and stands ready at any time to upset any particular market outcome. People are not merely consumers and producers, they are also citizens in a variety of polities that can not only regulate markets but can also expropriate directly the resources markets allocate. Correspondingly, it is impossible to predict market outcomes without also predicting the political responses that alternative outcomes engender. On the other hand, the hard-learned lesson of the left, and of cruder forms of Marxism in particular, is that whatever institutional structure the state takes, the laws governing market forces cannot be abrogated – the forces of supply and demand operate regardless of culture, ethnic identity, socialization pattern, ideology, and political system.

From this view, it is surprising to find economics and politics divided into distinct disciplines, with their joint study impeded by bureaucratic divisions at universities, by the specialization of scholarly journals, and by the prevalent use of modes of inquiry in political science that are seemingly at odds with those used in economics.