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Introduction

During the decades following World War II, it mostly appeared that the problems of managing the U.S. economy had been solved.

There were some relatively minor ups and downs in the economy, but until late 2007 it seemed as if the massive economic failures of the Great Depression were a thing of the past.

The recession that began in December 2007, however, has shaken the confidence of citizens and policymakers alike...

By spring 2009 the gross domestic product of the United States had dropped by more than 6 percent, unemployment had reached 30-year highs, and both sales and investment had plummeted.

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Introduction—Fading Confidence

The concept that government could manage the economy became widely accepted in the later stages of the Great Depression and the post-World War II economic boom...

John Maynard Keynes and other economists provided the government with economic tools to manage the economy and an intellectual justification for using such tools.

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Introduction

Confidence in the government’s ability to manage the economy were bolstered by the economic improvements in the 1950s, 1960s, and early 1970s...

Western nations generally experienced economic growth, low unemployment, and stable prices

President Kennedy’s advisers spoke of the government’s ability to “fine-tune” the economy and manipulate economic outcomes

President Nixon famously proclaimed that “we are all Keynesians now.”

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Introduction

Economic policy became more and more a central concern of government...

as the Clinton campaign reminded itself during the 1992 election, “It's the economy, stupid.”

In others words, focus attention on the economy because that is the issue that concerns the public.

The success of President Obama’s campaign in 2008 was to no small degree a referendum on the Bush administration’s economic policies of large tax cuts and relaxed regulations on the financial sector (some of which started with Clinton) that resulted in massive deficits and destructive business practices that wrecked havoc on the economy.

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The Zero Sum Society Era

Even before the collapse of 2007, the United States was confronting the problems of a so-called zero sum society...

In a zero sum society, the gains achieved by one segment of the society come at the expense of some other segment

Benefits for the growing sector of Americans who are retired increasingly burden a shrinking working class

The need to provide a broader sector of Americans with a high quality education increases government costs.

And, the high costs of dealing with that sector of the population that lacks the education and skills to successfully compete in the market keeps going up.

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How Does the Government Respond?

The government must first create a set of coherent economic policies

These policies consist of many separate decisions, including...

spending for public and defense programs

patterns of taxation

the cost of money (interest rates)

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Goals of Economic Policy

Economic policy has five fundamental goals...

1. economic growth

2. full employment

3. moderate inflation

4. a positive balance of trade

5. manageable debt

There may be trade-offs among these goals, such as the traditional trade-off between unemployment and inflation.

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Instruments of Economic Policy

Policy instruments to influence the economy include...

1. fiscal policy--spending

2. monetary policy—costs and supply of money

3. regulations and control

4. public (i.e. government) support for business and agriculture

5. public ownership

6. incentives

7. moral suasion

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I. Fiscal Policy

Keynesian theory: run a budget deficit to stimulate a lagging economy, and run a surplus to reduce inflation in an “overheated” economy.

A lagging economy would be one with low growth and high unemployment.

An overheated economy would be one growing so fast that prices (inflation) were increasing too fast (scarcity creates inflation).

Keynesian tools have not always been used well

there has been a tendency to run deficits and not to run surpluses, i.e., “one-eyed Keynesianism”

There is also “weaponized Keynesianism” –refusal to cut military spending

from 1950 to 2011, there were 56 budget deficits in 61 years

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Fiscal Policy—Estimating revenues and Spending

It is not easy to estimate appropriate levels of revenues and outlays...

when the economy begins to turn downward, government revenues decline, as workers become unemployed and cease paying income and Social Security taxes, and unemployed workers and their families begin to place demands on a variety of social programs including unemployment compensation and food stamps.

the decline in revenue and the increase in expenditures then automatically push the budget toward a deficit, without political leaders’ making any conscious choices about fiscal policy

unexpected events like 9/11 and Hurricane Katrina also contribute to the final budget balance

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Fiscal Policy

Economic policy can also reflect partisan ideology which overrides thoughtful policy.

The Bush tax cuts of 2003 were justified as a supply-side economic stimulant...

the federal budget quickly went from a surplus of $127 billion in 2001, to a deficit of over $426 billion in 2005

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Making Fiscal Policy

Presidents generally begin the budget process with the goal of balancing the budget, but they are soon overwhelmed by the complexities of the calculations and the political pressures to spend without taxing.

President Bush II did not ask Congress to pass any new taxes to pay for the wars in Iraq or Afghanistan, or to cover his Medicare drug plan (an attempt to close the donut hole).

When asked why he did not have a funding plan for the two wars and the Medicare changes, Bush argued that his tax cuts would expand the economy and bring in more revenue. It did not happen.

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Supply-Side Economics—A version of Fiscal Policy

The fundamental idea of “supply-side” economics is to increase the supply of labor and capital so that economic growth will take place

This basically calls for reducing taxes (especially on top earners and corporations) and reducing regulations on businesses.

The argument is that the tax reductions will result in increased investments, growing the economy and therefore expanding the nation’s tax base.

Taxing a larger economy will bring in more tax dollars even though the rate of taxation has declined.

Reducing regulations will also allow businesses to thrive.

◦ By contrast, Keynesian economics argues for providing people (usually the less affluent) with increased income through government expenditures, with the expectation that they will spend the money and create demand for goods and services.

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Supply-Side Economics

The major instrument of Reagan’s supply-side theory was the Economic Recovery Tax Act of 1981 (ERTA)...

over four years, ERTA reduced the average income tax by 23 percent

the tax cut advantaged those in higher income brackets,

The argument was that lower taxes would encourage the wealthy to invest, expanding the economy and the tax base.

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Supply-Side Economics

What was the impact of ERTA?

There was a massive increase in the federal deficit:

Because federal expenditures were not significantly reduced.

Because the reduction in tax rates did not substantially increase revenues

The Reagan administration stuck with supple-side policies as did the succeeding Bush administrations.

Reagan increased the deficit by 188.6%, Bush by 55.6%, Bush II by 89%.

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Clinton’s Reversal—he raised taxes

By the end of the Clinton administration, large deficits seemed to be at an end

There was a lot of celebration of the positive benefits...

less foreign capital would be required to fund debts

less borrowing from foreign sources would stabilize domestic interest rates

the reduced burden of debt repayment would free up money for other purposes

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Bush II—Back to Supply-Side Economics

But Bush Jr. returned to supple-side economics

Bush convinced Congress to cut taxes (mostly on the rich), lead America into two unfunded wars, signed off on unfunded changes in Medicare and further reduced regulation of the banking and Wall Street sectors.

The result was massive deficits and the economic crisis of 2007, 2008 and 2009.

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II. Monetary Policy

Monetary policy stresses the importance of controlling the money supply as a way to influencing the economy

In the United States, the Federal Reserve Board (the Fed) and member Federal Reserve banks are the primary makers of monetary policy

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Monetary Policy—Buying or selling securities

The Federal Reserve banks principal tools for influencing the economy are...

1. open market operations...

the most commonly used tool of monetary policy

open market operations involve the Fed entering the money markets to buy or sell securities issued by the federal government...

the Fed sells securities to reduce the supply of money

the Fed buys securities to expand the money supply

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Monetary Policy—Altering the discount rate

The Federal Reserve banks also alters the discount rate and the federal funds rate to influence the economy.

these are the rates of interest at which member banks can borrow money from the Fed or from each other

rate increases make money more costly to borrow and will slow down the economy and inflation

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Monetary Policy—Changing the Reserve Requirement

The Federal Reserve banks can also influence the economy by

changing the reserve requirement...

this is a change in the amount of money that member banks are required to keep in reserve to cover their outstanding loans (normally around 10 percent)

reducing the reserve requirement makes more money available for loans and should increase economic activity

this is a more drastic tool, used to effect quick change

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III. Regulations and Control

Antitrust regulation is an important form of economic control...

the Sherman Act of 1890

1. intended to ensure that a few firms did not control an industry and then extract excessive profits

2. however, the enforcement of sanctions was problematic

the Clayton Act of 1914

1. provided clearer, but still ambiguous, definitions of actions that constituted “combinations in restraint” of trade

2. provided an enforcement mechanism that could act administratively rather than entirely through the courts

Designed to regulate the investment activities of banks—particularly their use of customer money (as opposed to their own money) to finance investments.

Amended in 1999—giving banks a much wider investment latitude, including their use of customer funds.

What is Public Policy? 32

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Regulations and Control

Antitrust regulation has been an important mechanism for fostering competition, but some doubts have been raised recently.

the 1990s concern was with external competitiveness and intellectual property rather than internal competition

the 1998 prosecution of Microsoft provided a glimpse of the complexity of the issues involved...

1. Microsoft had created a virtual monopoly, but would the software market be better served by more competition if there were problems of compatibility?

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Regulations and Control

By the summer of 2002, some Americans were wishing for a more regulated economy given numerous identified abuses...

revelations of malpractice at Enron, WorldCom, and Xerox

the Securities and Exchange Commission was proving to be ineffective

Changes in accounting standards and corporate governance have increased regulation, but some argue for better standards.

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Regulations and Control

The economic “meltdown” of 2007-2009 made it clear to most Americans that the regulation of banks and the financial markets in the United States was inadequate

the banks had been deregulated during the 1990s (by amendments to the Glass-Steagall Act of 1933) and became involved in a range of risky investment activities

further, they and other financial institutions began to provide “subprime” mortgages to potential homeowners who would not normally have had sufficient credit to qualify for the loans

while initially providing lower-income people an opportunity to own their own home, these loans now are associated with massive levels of foreclosures that have caused thousands of people to lose their homes

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IV. Public Support for Business

Governments provide a number of direct subsidies to industry...

research and development—much of University research

subsidizing of credit

provision of economic information and weather information

access to public facilities

In 2011, according to the CBO, the federal government supplied over $160 billion in direct and indirect support for business and industry

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Public Support for Business at the State and Local level

State and local governments provide supports to business and industry in a competitive environment...

state and local governments attract industry with direct services (e.g., water and transportation) and tax credits and subsidies

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Public Support for Business

Solving the problems of American industry or promoting them can be viewed in the context of an “industrial policy debate,” a debate about whether and how government should assist business and industry.

Should Obama have bailed out the auto industry? Should he have saved the banks, Wall Street firms, and AIG?

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Public Support for Business

It is often argued that industrial policy should provide

direct government grants for the modernization and expansion of industry—e.g., the sustainable energy industry

trade policies, such as tariffs and barriers, to get industry “back on its feet”

Deregulation to reduce the costs for certain businesses

research and development

regional policy to redistribute industrial fortunes to failing areas

Programs like the EITC, SNAP and Medicaid provide assistance to workers paid low-salaries by businesses, many of which are huge corporations that make large profits. (California—about $86 million a year to support Walmart employees.)

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V. Government Support for Business

Government has regularly been involved in supporting U.S. industry..

many of the country’s great industrial ventures, including the westward extension of the railroads and Hoover dam, were undertaken with the direct support of government

some argue that there should be even greater need for government support for business and industry than in the past, given the declining industrial position of the United States

however, too much dependence on government to bail out losers – banks, Wall Street, the airline industry and, more recently, automakers – may mean that American industry ceases to be responsible for its own revitalization and simply waits for the public sector to rescue it—moral hazard.

Should we allow banks to be too big to fail?

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VI. Incentives

Government influences economic change by providing incentives for desired behaviors—renewable energy (cheap coal and $3 gasoline make alternative energy policy problematic).

The administrative costs of incentive programs are relatively low, particularly compared with the costs of subsidies that may be considered as alternatives

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Incentives

Incentives for structural change in the U.S. economy have been...

the oil depletion allowance and allowances for nonrenewable resources

the capital gains provision of tax codes to encourage investment

tax credit and depreciation schedules to encourage investment

States and cities provide tax breaks to companies to convince them to open businesses in their community.

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VII. Moral Suasion

Presidents often attempt to use persuasion...

Lyndon Johnson appealed to patriotism in asking industries to restrain price increases

George H. W. Bush sought to manipulate symbols (by buying socks in a shopping mall) to persuade Americans to start buying things again

George W. Bush argued that the economy was better than his critics believed and attempted to use this optimism to produce a more robust economy

Barack Obama spent the first months of his administration attempting to buoy consumer confidence to combat the economic recession