In the previous chapters we've covered many policy choices made by the President, Congress, and the Federal Reserve. In theory these policies are used to combat recessions, inflation, and stagflation, along with ensuring stable long-run growth. However, even as we look back 30 years, U.S. economic history is filled with recessions, growth recessions and inflation. With all of the policy levers available, why can't we prevent these macro failures? This chapter examines how and why theory and reality don't always mesh.
I. A Summary and Recent Examples of Policy Choices
First, let's review our choices. Our policy options are summarized on table 19.1, page 370.
A. Fiscal Policy
Recall that fiscal policy involves changing taxes or spending:
Fiscal policy refers only to deliberate changes in taxes and spending
not automatic stabilizers. Fiscal policy is up to the President and Congress.
A major tax cut in 1981 under President Reagan help usher in the economic expansion of the 1980s, but caused big deficits as well.
In 1993 Clinton and the Democrats pushed through tax increases in an effort to balance the budget. The vote fell EXACTLY along party lines. Republicans called it the "largest tax increase in history," but it was actually the second largest. The largest was in 1983 when Congress voted huge increases in Social Security taxes. As of March 2001, a tax cut proposed by George W. Bush is being debated in the Senate, having easily pased the House.
B. Monetary Policy
Recall that monetary policy involves change the money supply and interest rates to achieve economic goals, again by shifting the AD curve. There are three potential tools of monetary policy: the reserve requirement, discount lending, and open market operations. In reality, monetary policy is almost exclusively conducted using open market operations. Monetary policy is conducted by the Federal Reserve System, in particular, by the Federal Open Market Committee (FOMC).
There is substantial disagreement between Keynesians and Monetarist
about targeting money supply versus targeting interest rates and about
whether the FOMC should be active in monetary policy at all.
One of the more controversial periods of monetary policy in recent history was the period from 1979-82. Inflation at the time was very high (over 10%). The Fed Chair, Paul Volcker drastically slowed down the growth of the money supply, and interest rates skyrocketed. By 1982, inflation fell to 4%. Unfortunately these high interest rates led to a very severe recession in 1981-82, sometimes called the "Volcker Recession." Some economists (including me) credit Volcker for ushering in an era of relatively low inflation and long economic expansions in the 1980s and 1990s.
Today the Fed targets interest rates when conducting monetary policy. The Fed under Alan Greenspan has made price stability their top priority. In 1999 and the first part of 2000 the Fed has increased interest rates in an effort to slow down the economy and keep inflation low. It may have worked a little too well. In the middle of 2000 and into the first half of 2001 the FOMC reversed course, decreasing the federal funds rate target in an effort to prevent a slowdown from turning into a recession.
C. Supply-Side Policy
Recall that the focus of supply-side theory is to increase aggregate supply by offering incentives to work and invest, and by limiting the regulatory burden on firms and households. Working and investment incentives typically take the form of lower income tax rates and capital gains tax rates, as well as tax deductions for certain types of savings and investments.
Supply-side policies are made by the President and Congress. President Reagan, an economics major himself, was a big believer in supply-side economics. In the 1980s we saw huge decreases in regulation with the banking, airline, telecommunications and trucking industries. We also saw huge decreases in the top marginal tax rates.
The 1990s continued with the deregulation of the telecommunications and utility industries, but also added regulation with tougher pollution laws and laws to protect worker rights, such as the Americans with Disabilities Act (ADA) and the Family Leave Act. The 1990s also saw supply-side policy in the form of increased infrastructure spending and investment in education and worker training. With a Republican president and congress in 2001, it will be interesting to see what new deregulation initiatives are undertaken.
II. The Ideal Scenarios
In theory, fiscal, monetary, and supply-side policies can "cure" the problems of the business cycle. Assuming we actually lived in happy, perfect La-La Land, let's review how they would work.
Case 1: Recession
A recession is characterized by a real GDP that falls well below the level of full employment GDP, so that unemployment is too high.
Keynesians advocate shifting the AD curve to the right through fiscal policy (a tax cut and or spending increase) or using monetary policy to lower interest rates and increase investment.
Monetarists would oppose any intervention at this point, instead waiting for interest rates to fall, stimulating new investment.
Supply-siders would favor a cut in marginal tax rates or government spending specifically targeted to infrastructure or human capital development. Note that Keynesians would support this too, but for different reasons. Keynesians would support ANY tax cut or spending increase, while supply-siders want a specific type.
Case 2: Inflation
An overheated economy where AD is too high relative to productive capacity can lead to sustained increases in the price level, or inflation.
Keynesians would advocate the use of fiscal or monetary policy to shift the AD curve left. This includes raising taxes, cutting spending, or increasing interest rates.
Monetarists would cut the money supply, since they view inflation as a monetary phenomenon with "too many dollars chasing too few goods."
Supply-siders would focus not on the "too many dollars" part, but instead the "too few goods" part. Increasing AS through tax rate cuts and favorable tax treatment for investment would increase productive capacity.
Case 3: Stagflation
An economy suffering from stagflation is characterized by both high inflation and high unemployment. As discussed in chapter 16, shifting AD will solve only one problem while making the other worse. Supply-side policies are the only ones that can address this problem. When stagflation is caused by an external shock, like high oil prices or natural disasters, there may be no complete "cure."
Fine Tuning
During the 1960s, Keynesian economists suggested that fiscal and monetary policies could be constantly adjusted to make small improvements in the economy and guarantee continued, uninterrupted prosperity. These constant small adjustments are known as "fine tuning" the economy.
III. The Economic Record
Clearly the business cycle has not been defeated. At least one recession has occurred within the lifetimes of everyone in this class. But let's start our discussion of the economic record on a positive note: One of the strongest cases for government efforts to achieve macro stability is the change in the severity and duration of business cycles. The graph below demonstrates how the U.S. economy has spent much less time in recession since 1960:
Or alternatively, if we look at the average length of recessions and expansions we see a pattern of shorter recessions and longer expansions:
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Now for the bad news. Consider the goals for the 3 main macroeconomic variables discussed in chapters 5-7, which were established in 1978:
It is clear from the graphs in figure 19.1 (page 377) that we consistently
and frequently fail to meet these goals. In fact, in the 5 years following
1978 we did not meet any of these goals!
Consider just the track record of the 1990s.
With all of these policy tools at our disposal how could we fail?
IV. Why Do Policies Fail?
Your textbook places the sources of policy failures into 3 categories:
A. Goal Conflicts
Fiscal and monetary policy are done by different institutions. Fiscal policy is done by Congress and the President, both of which are accountable to voters. Monetary policy is carried out by the FOMC which once appointed is accountable to almost no one. Thus fiscal and monetary policy may be working in different directions. Congress may cut taxes to spur job growth while the Fed is raising interest rates to combat inflation.
Sometimes cooperation does occur. In 1993, Alan Greenspan promised President Clinton to keep interest rates low while Clinton and Congress raised taxes to address the budget deficit. Low interest rates helped offset the impact of tax hikes on an economy that was already growing very slowly.
Also, even within fiscal and monetary policy, there are conflicting goals. Clinton wanted a national health care plan and a middle class tax cut, but in choosing to balance the budget he gave up both (actually, health care was rejected).
All policy decisions have opportunity costs. If Congress wants a big tax cut, they may have to scale back a Medicare prescription drug benefit.
B. Measurement and Design Problems
We cannot hope to achieve any of our economic goals if we do not accurately measure the extent of our economic problems. Way back in modules 2 and 3 we discussed measurement issues with unemployment rates, GDP, and the CPI.
Even if our measures of output, employment, and inflation are accurate enough to be useful, they are measure with a lag. In other words, we measure GDP AFTER output has occurred, we measure price increases AFTER they have happened. This means that we will not truly know the state of today's economy until early next year in January 2001.
Given this, forecasts of all of these variables are very important, but any forecast is subject to some margin of error. This margin of error makes it almost impossible to fine tune the economy.
The government and private industries use large complicated macroeconomic models to predict GDP growth, inflation, consumer spending, etc. However, the predictions are only as good as the model itself, and Keynesians, Monetarists, and others disagree about what the models should look like--for example, the transmission mechanism of monetary policy. If models incorrectly predict the reaction of consumer or firms, then the desired policy result will not materialize.
C. Implementation Problems
Monetary and fiscal policy are subject to long and variable time lags. This is the chief criticism of monetarists of those who would attempt to use policy to fine tune the economy. Figure 19.3 (page 385) demonstrates the time lags associated with policy decisions. The policy takes time to decide, to implement, and to start working. By the time a policy starts working, the state of the economy may have changed. This problem is related to the problem of formulating an accurate forecast.
Take, for example, the 1990-91 recession. Both the Fed and Congress were late in recognizing that a recession was underway. The Fed then acted by reducing interest rates, but this took time to increase AD. Congress debated a tax cut throughout 1991-92. By the time Clinton (who promised a middle class tax cut) was elected, the economy was in recovery and the tax cut was scrapped.
Monetary policy has a shorter implementation lag than fiscal policy because it is easier for 12 FOMC members to agree than for 535 senators and representatives. Both types of policy can easily take a year to work once they are enacted.
Also, keep in mind that most politicians formulate laws and policies that maximize their re-election probabilities rather than the long-run best interest of the United States economy. Cynical, but true.
V. Hands On or Hands Off?
Among macroeconomists and politicians alike their continues to be substantial disagreement about the appropriate role of government in fine-tuning the economy, also known as the "rules vs. discretion" debate. Table 19.6 (page 389) summarizes the positions of various schools of economic thought.
Milton Friedman, leader of the modern-day monetarists, advocates fixed policy rules that do not change with the condition of the economy. The rule might be a function of economic conditions, but the rule itself would be fixed. The "hands off" arguments are based on the reality of trying to implement policy. Inaccurate forecasts and policy lags make fine-tuning the economy almost impossible. Under these conditions, intervention may do more harm than good. For example, the persistent inflation problems of the 1970s are as much the fault of bad monetary policy as high oil prices.
New Classical economists also advocate a "hands off" policy. These economists believe that consumers and firms form rational expectations about the economy. That is, they make decisions based on all available information, included expectations about government policies. By anticipating government policies, consumers and firms can render them ineffective. Only unanticipated policies would work, but you can only surprise people so often. For example, if people expect the Fed to increase the money supply, then they expect inflation and demand higher wages today. This negates the impact of higher money supply on output.
The New Classicals still believe in a role for government in addressing market failures and providing a stable legal environment. Some even advocate a strong government role in investing in infrastructure and education.
Advocates of a "hands on" approach, namely NeoKeynesians, note that since government has taken a larger role in the economy, recessions are shorter and less severe, while expansions are longer. They argue for discretionary policy that allows the Fed and Congress to alter the policy to specific economic circumstances. They contend that a fixed rule is impractical and impossible to maintain. Monetary and fiscal policy today are very much discretionary, so these folks appear to be winning, at least for now.
FYI: Related Links
Policy Debate: Should the Fed pursue a fixed policy Rule? Arguments for and against using monetary policy to fine tune the economy. Monetarists advocate a fixed policy rule.
Index of Leading Economic Indicators A measure that combines 10 different economic variables in an effort to forecast where the economy is headed over the next 3 to 6 months.
CBO
Economic Forecasts for 2000 and 2001 Get the latest economic
forecasts from the Congressional Budget Office (which tend to be too optimistic).