Chapter 15
Chapter 15:Economic Policy
Chapter Review
Although globalization is a powerful phenomenon with many implications for domestic
economic policy, domestic policy makers still make a number of important economic
decisions in the country.
- Goals of Policy Making
- Full employment (actually around 5 percent unemployment) was first
made an explicit policy goal under the Employment Act of 1946, which was designed
to help avoid a backslide into an economic depression. The act
also created the Council of Economic Advisors (CEA).
- Price stability requires controlling inflation, which can come at the expense of
employment. Generally, Republicans are concerned with controlling inflation, while
Democrats are concerned with achieving higher employment numbers.
- The American economy is a capitalist system, and the government is generally reluctant
to enter the economic arena as the free market is more efficient than alternatives.
- The government will work to enforce property rights, maintain capital market security,
and subsidize infrastructure and research developments.
- The government is often under pressure to maintain a balanced budget
and avoid a budget deficit, as financing deficits reduces domestic
program spending and burden future generations with debt.
- Similarly, the government is under some pressure to reduce the trade deficit
and restore balance to the current account.
- Often, it is difficult to enact all these policy goals simultaneously, and law makers
are forced to grapple with trade-offs.
- Achieving full employment often results in higher levels of inflation.
- Reducing the trade deficit may require imposing tariffs, which violates the ideals
of the free market.
- There are four main actors in economic policy making: Congress, the president, the
bureaucracatic agencies, and to an extent, the courts.
- Constitutionally, Congress holds the “power of the purse,” and Congress has traditionally
controlled budget making, with particular influence from a select
number of committees. Congress lost a majority of this power to the executive branch
during the mid-twentieth century. There have been several revisions of the budget-making
process since that time, generally in an attempt to reduce the budget deficit.
- Congress passed the Budget and Impoundment Control Act of 1974, which establishes
Budget Committees in the House and Senate, creates the Congressional Budget Office,
and instituted the process of budget reconciliation, which forced
committees to meet spending targets and then combine all these changes into one
omnibus spending bill.
- The omnibus bill receives different treatment in the Senate than other bills, and
failure to pass the omnibus bill can lead to a government shutdown.
- Congress instituted the Budget Enforcement Act of 1990, which required many things,
but most importantly that any new tax cut or spending increase had to be offset
by a corresponding spending decrease or tax increase.
- The president has a considerable amount of influence over the economy, and relies
on several groups of economic advisors.
- The Office of Budget and Management creates the budget for the president by coordinating
federal agency budgetary requests with presidential priorities. This budget is subsequently
submitted to the Congress each fiscal year, and serves as the baseline for congressional
deliberation.
- The Council of Economic Advisors provides the president with objective data on the
state of the economy and advice on economic policy.
- The United States Trade Representative (USTR) coordinates international
trade and foreign direct investment, and negotiates trade agreements.
- The National Economic Council (NEC) is a group of economic advisors
who coordinate economic policy and brings together cabinet secretaries from different
departments, including Treasury, Labor, and Commerce.
- There are two bureaucratic agencies which are most influential in setting economic
policy: the Federal Reserve System (an independent agency) and the Treasury Department
(a cabinet-level department).
- The Federal Reserve System was established in 1913, and is responsible
for monetary policy for the nation, which includes setting interest rates, regulating
the money supply and the lending activity of member banks. In addition, the Fed
is largely politically independent.
- Its economic decisions are not reviewed by the president or Congress. Further, Fed
board members serve long terms, which do not coincide with election cycles. Lastly,
because it can create its own money, its budget is not subject to congressional
approval.
- This independence may be good because many believe politics should be kept out of
monetary policy. However, by making the Fed politically isolated, it is difficult
to hold it accountable.
- The Fed chair and vice chair are both appointed by the president, and are subject
to Senate approval. However, it is common for presidents to reappoint a Fed chairman,
even if the chair was originally appointed by a president of the opposite party.
- The Treasury Department is the other bureaucratic agency that has
significant influence in monetary policy. It prints money, manages government accounts,
collects taxes, investigates tax evaders, and advises on domestic and international
economic policy. While some of its obligations overlap with those of the Fed, often
the responsibilities are complimentary rather than competing.
- Though they both share the goal of economic prosperity, generally the Fed prefers
to keep interest rates high enough to avoid inflation, while the Treasury Department
prefers to have low interest rates to spur economic growth.
- Though they do not share the same involvement as other organizations, the Courts
do enjoy a significant amount of indirect influence on the economy. By enforcing
and maintaining contract law, property rights, patent law, and banking laws, the
Courts provide the necessary underpinnings for a properly functioning economy.
- Theories of Economic Policy
- Fiscal policy is the government’s power to tax and spend while influencing the direction
of the economy.
- Keynesian economics argues that the government can soften the blows
of recessions by appropriate tax-and-spend policies. Though counterintuitive, by
issuing tax cuts and ramping up government spending during a recession, the government
can provide a boost to the economy. Similarly, reducing government spending and
increasing taxes can cool off a growing economy that may risk inflation.
- Supply-side economics is an alternative fiscal policy that suggests
that tax cuts will stimulate the economy by encouraging investment and increased
production of goods and services.
- Fiscal policy is generally limited in effectiveness by two factors:
- The business cycle is the normal expansion and contraction of the
economy, which can reduce the influence of fiscal policy.
- It is difficult for incumbent politicians to achieve reelection when they vote to
either increase taxes or cut government spending. Even if they wanted to, there
is only so much that they could cut.
- Several programs, such as Social Security, are considered mandatory spending,
and are legally required and cannot be cut. The majority of government spending
is mandatory.
- Congress could move to cut discretionary spending, which includes
funding for the FBI, State Department, and Justice Department, but nondefense-related
discretionary spending makes up a relatively small proportion of the federal budget.
- Regardless of ability to influence the broader national economy, fiscal policy has
redistributive implications, as it determines how the tax burden will be spread,
and where spending will take place.
- Tax cuts can disproportionately benefit one group over another.
- Payroll and excise taxes are regressive: within a certain range,
everyone pays the same regardless of income level. Increasing regressive taxes can
increase the burden on those at lower income levels because a larger proportion
of their income goes to meeting these demands.
- Individual income taxes are progressive: a person’s tax burden
is proportional to their income. Increasing progressive taxes increase the burden
on the wealthy.
- Monetary policy is policy concerning the amount of money that is in circulation,
and how accessible money is.
- The Fed has three targets: monitoring levels of bank lending, monitoring the amount
of money in circulation, and setting interest rates.
- Bank lending is the first target of monetary policy.
- As the source of new money in the economy, bank lending is crucial for economic
growth. Easy credit allows businesses to grow, add jobs and stimulate the economy.
Tight credit does not allow businesses to grow, and can lead to an economic contraction.
- Regulating the money supply is the second target of the Fed.
- According to the monetarist theory of macroeconomic policy, the
amount of money in circulation is the strongest determinant of economic activity.
The Fed can influence the amount of money in the system by making it easier or harder
for banks to lend money.
- The Fed’s third target of monetary policy is regulating loan interest rates. Making
borrowing money easier or harder has an obvious effect on economic growth.
- To meet the targets on credit availability, the money supply, and interest rates,
the Fed uses three tools: the reserve requirement, establishing
interest rates, and engaging in open market operations.
- The reserve requirement is a rarely used but powerful tool in regulating
monetary policy. The Fed can require that banks maintain a certain amount of money
in reserve to make sure that they are able to cover withdrawals. The higher the
Fed sets the reserve requirement, the less money will be in circulation.
- The Fed also can set interest rates, though these are more difficult to manage than
the reserve requirement.
- The discount rate is directly controlled by the Fed, and is the
interest rate that the Fed charges to member banks on short-term loans.
- The federal funds rate (FFR) is the interest rate
that member banks charge each other on short term loans. The Fed does not have the
ability to directly set this rate, but is able to influence it heavily by adjusting
the discount rate.
- While the Fed is able to have a significant level of influence on short-term loans,
it is unable to dramatically influence long-term loans, which are set by the market.
The interest rates for mortgages and student loans are set by expectation of the
bond market.
- The Fed is also able to engage in open market operations, which is the buying and
selling of securities. This is the most powerful tool, as it allows the Fed to influence
the FFR and the level of bank reserves.
- To increase the money supply and decrease the FFR, the Fed will buy bonds from banks.
- To decrease the money supply and increase the FFR, the Fed will sell government
securities to banks.
- Leading up to the great depression, the Fed largely took an accommodationist approach
to monetary policy, meaning that they provided additional credit to banks that needed
it, and reduced credit when credit was unnecessary. Since 1935, the Fed has adopted
an active, countercyclical approach, cooling off a growing economy and stimulating
a shrinking economy.
- Regulatory policy addresses various market failures such as monopolies, negative
externalities or imperfect information. It does so under two guises: economic regulation
and social regulation:
- Economic regulation, which began in the late nineteenth century, sets prices or
conditions of entry of firms into an industry. It can break up monopolies, or if
a “natural monopoly” is most efficient, it will regulate them.
- Social regulation, which had two spurts of growth (1930s and 1960s–1970s) generally
seek to minimize the damage of negative externalities. As a result, most social
regulation takes place in the form of environmental protection or promoting safety.
- Social regulation has expanded over time, while Congress has pared back economic
regulation over the past three decades.
- The decline of economic regulation has had mixed effects for the consumer. Prices
may drop, but at the cost of decreased service in remote areas.
- In general, Republicans tend to favor a strong role for the free market, are pro-business,
and advocate a smaller role for government regulation, while Democrats generally
favor more regulation to protect the interests of consumers, workers, and the environment.
- There are three theories on the politics of regulation:
- The public interest theory suggests that politicians regulate the economy to serve
the public interest when there are market failures. However, this view ignores the
fact that political parties have different views of what constitutes “public interest,”
or the mechanisms necessary to achieve a goal.
- The regulatory capture theory suggests that Congress creates regulations to serve
the public interest, but that over time the regulators become controlled by the
industries they are supposed to be regulating.
- The economic theory of regulation suggests that Congress does not even intend to
serve the public interest in setting up public agencies, but regulate as an effort
to redistribute income toward certain industries in exchange for political support.
- The main target of trade policy is the trade balance: the difference between the
total values of exports and imports. In recent years, the balances have reached
record deficits.
- Trade deficits are financed by borrowing from overseas. In 2008, over 50 percent
of the country’s total publicly owned debt was foreign owned. While it is unlikely
that foreign governments would start to sell their American assets (as it is likely
to decrease the value of their holdings), this foreign financing does make the U.S.
economic system somewhat more unstable.
- The policies that can be used to reduce the trade deficit are protectionist policies
such as trade sanctions, tariffs, or attempts to reduce the value of the dollar.
In general, Congress and the president have supported free trade far more than protectionism,
but there are a few exceptions:
- Democrats tend to be more protectionist than Republicans, as Democrats often represent
labor, while Republicans represent capital.
- Trade policy is probably the most difficult economic policy to influence, as there
are several factors that shape trade policy beyond the control of policy makers:
the strength of the dollar relative to other currencies; the shifts in consumer
tastes; the cost of labor in developing countries; and the economic conditions around
the world.
- The strength of the dollar is determined by the global market, and policy makers
are hard pressed to influence these shifts. When the dollar is strong, imports are
relatively cheap, exports are relatively expensive, and the United States is likely
to run a trade deficit even if policy makers would prefer a trade surplus.
- If consumers are willing to pay a premium for foreign goods, even a weaker dollar
may not fix the trade deficit, and policy makers are unable to regulate preferences.
- Low labor costs overseas are similarly impossible to regulate, and cheaply produced
foreign goods may flood American markets.
- If foreign economies are weak, consumers will not be able to purchase U.S exports
even if the dollar is weak.