Mankiw_ Five Debates Over Macroeconomic Policy

IN THIS CHAPTERYOU WILL . . .

Cons ider whether the tax laws shou ld

be r e formed toencourage sav ing

Cons ider whether thecent ra l bank shou ld

a im fo r zero in f lat ion

Cons ider whetherpo l icymakers shou ld

t r y to stab i l i ze the economy

Cons ider whethermonetar y po l icy

shou ld be made byru le rather than

by d iscret ion

Cons ider whetherf isca l po l icymakersshou ld r educe thegovernment debt

It is hard to open up the newspaper without finding some politician or editorialwriter advocating a change in economic policy. The president should use the bud-get surplus to reduce government debt, or he should use it to increase governmentspending. The Federal Reserve should cut interest rates to stimulate a flaggingeconomy, or it should avoid such moves in order not to risk higher inflation. Con-gress should reform the tax system to promote faster economic growth, or itshould reform the tax system to achieve a more equal distribution of income. Eco-nomic issues are central to the continuing political debate in the United States andother countries around the world. It is no surprise that when Bill Clinton first ranfor president in 1992, his chief strategist posted a sign to remind the staff of thecentral campaign issue: “The economy, stupid.”

The previous dozen chapters have developed the tools that economists usewhen analyzing the behavior of the economy as a whole and the impact of policies

F I V E D E B A T E S O V E R

M A C R O E C O N O M I C P O L I C Y

503

504 PART NINE FINAL THOUGHTS

on the economy. This final chapter presents both sides in five leading debates overmacroeconomic policy. The knowledge you have accumulated in this course pro-vides the background with which we can discuss these important, unsettled is-sues. It should help you choose a side in these debates or, at least, help you seewhy choosing a side is so difficult.

SHOULD MONETARY AND FISCAL POLICYMAKERSTRY TO STABIL IZE THE ECONOMY?

In Chapters 19, 20, and 21, we saw how changes in aggregate demand and aggre-gate supply can lead to short-run fluctuations in production and employment. Wealso saw how monetary and fiscal policy can shift aggregate demand and, thereby,influence these fluctuations. But even if policymakers can influence short-run eco-nomic fluctuations, does that mean they should? Our first debate concerns whethermonetary and fiscal policymakers should use the tools at their disposal in an at-tempt to smooth the ups and downs of the business cycle.

PRO: POLICYMAKERS SHOULD TRYTO STABIL IZE THE ECONOMY

Left on their own, economies tend to fluctuate. When households and firms be-come pessimistic, for instance, they cut back on spending, and this reduces the ag-gregate demand for goods and services. The fall in aggregate demand, in turn,reduces the production of goods and services. Firms lay off workers, and the un-employment rate rises. Real GDP and other measures of income fall. Rising unem-ployment and falling income help confirm the pessimism that initially generatedthe economic downturn.

Such a recession has no benefit for society—it represents a sheer waste of re-sources. Workers who become unemployed because of inadequate aggregate de-mand would rather be working. Business owners whose factories are left idleduring a recession would rather be producing valuable goods and services andselling them at a profit.

There is no reason for society to suffer through the booms and busts of thebusiness cycle. The development of macroeconomic theory has shown policy-makers how to reduce the severity of economic fluctuations. By “leaning againstthe wind” of economic change, monetary and fiscal policy can stabilize aggregatedemand and, thereby, production and employment. When aggregate demand isinadequate to ensure full employment, policymakers should boost governmentspending, cut taxes, and expand the money supply. When aggregate demand is excessive, risking higher inflation, policymakers should cut government spending, raise taxes, and reduce the money supply. Such policy actions putmacroeconomic theory to its best use by leading to a more stable economy, whichbenefits everyone.

CHAPTER 22 FIVE DEBATES OVER MACROECONOMIC POLICY 505

CON: POLICYMAKERS SHOULD NOT TRYTO STABIL IZE THE ECONOMY

Although monetary and fiscal policy can be used to stabilize the economy in the-ory, there are substantial obstacles to the use of such policies in practice.

One problem is that monetary and fiscal policy do not affect the economy im-mediately but instead work with a long lag. Monetary policy affects aggregate de-mand by changing interest rates, which in turn affect spending, especiallyresidential and business investment. But many households and firms set theirspending plans in advance. As a result, it takes time for changes in interest rates toalter the aggregate demand for goods and services. Many studies indicate thatchanges in monetary policy have little effect on aggregate demand until about sixmonths after the change is made.

Fiscal policy works with a lag because of the long political process that gov-erns changes in spending and taxes. To make any change in fiscal policy, a billmust go through congressional committees, pass both the House and the Senate,and be signed by the president. It can take years to propose, pass, and implementa major change in fiscal policy.

Because of these long lags, policymakers who want to stabilize the economyneed to look ahead to economic conditions that are likely to prevail when their ac-tions will take effect. Unfortunately, economic forecasting is highly imprecise, inpart because macroeconomics is such a primitive science and in part because theshocks that cause economic fluctuations are intrinsically unpredictable. Thus,when policymakers change monetary or fiscal policy, they must rely on educatedguesses about future economic conditions.

All too often, policymakers trying to stabilize the economy do just the oppo-site. Economic conditions can easily change between the time when a policy actionbegins and when it takes effect. Because of this, policymakers can inadvertently


exacerbate rather than mitigate the magnitude of economic fluctuations. Someeconomists have claimed that many of the major economic fluctuations in history,including the Great Depression of the 1930s, can be traced to destabilizing policyactions.

One of the first rules taught to physicians is “do no harm.” The human bodyhas natural restorative powers. Confronted with a sick patient and an uncertaindiagnosis, often a doctor should do nothing but leave the patient’s body to its owndevices. Intervening in the absence of reliable knowledge merely risks makingmatters worse.

The same can be said about treating an ailing economy. It might be desirable ifpolicymakers could eliminate all economic fluctuations, but that is not a realisticgoal given the limits of macroeconomic knowledge and the inherent un-predictability of world events. Economic policymakers should refrain from inter-vening often with monetary and fiscal policy and be content if they do no harm.

QUICK QUIZ: Explain why monetary and fiscal policy work with a lag.Why do these lags matter in the choice between active and passive policy?

SHOULD MONETARY POLICY BE MADE BY RULERATHER THAN BY DISCRETION?

As we first discussed in Chapter 15, the Federal Open Market Committee setsmonetary policy in the United States. The committee meets about every six weeks to evaluate the state of the economy. Based on this evaluation and fore-casts of future economic conditions, it chooses whether to raise, lower, or leave un-changed the level of short-term interest rates. The Fed then adjusts the money supply to reach that interest-rate target until the next meeting, when the target isreevaluated.

The Federal Open Market Committee operates with almost complete discre-tion over how to conduct monetary policy. The laws that created the Fed give theinstitution only vague recommendations about what goals it should pursue. Andthey do not tell the Fed how to pursue whatever goals it might choose. Once mem-bers are appointed to the Federal Open Market Committee, they have little man-date but to “do the right thing.”

Some economists are critical of this institutional design. Our second debateover macroeconomic policy, therefore, focuses on whether the Federal Reserveshould have its discretionary powers reduced and, instead, be committed to fol-lowing a rule for how it conducts monetary policy.

PRO: MONETARY POLICY SHOULD BE MADE BY RULE

Discretion in the conduct of monetary policy has two problems. The first is that itdoes not limit incompetence and abuse of power. When the government sends


police into a community to maintain civic order, it gives them strict guidelinesabout how to carry out their job. Because police have great power, allowing themto exercise that power in whatever way they want would be dangerous. Yet whenthe government gives central bankers the authority to maintain economic order,it gives them no guidelines. Monetary policymakers are allowed undisciplineddiscretion.

As an example of abuse of power, central bankers are sometimes tempted touse monetary policy to affect the outcome of elections. Suppose that the vote forthe incumbent president is based on economic conditions at the time he is up forreelection. A central banker sympathetic to the incumbent might be tempted topursue expansionary policies just before the election to stimulate production andemployment, knowing that the resulting inflation will not show up until after theelection. Thus, to the extent that central bankers ally themselves with politicians,discretionary policy can lead to economic fluctuations that reflect the electoral cal-endar. Economists call such fluctuations the political business cycle.

The second, more subtle, problem with discretionary monetary policy is thatit might lead to more inflation than is desirable. Central bankers, knowing thatthere is no long-run tradeoff between inflation and unemployment, often an-nounce that their goal is zero inflation. Yet they rarely achieve price stability.Why? Perhaps it is because, once the public forms expectations of inflation,policymakers face a short-run tradeoff between inflation and unemployment.They are tempted to renege on their announcement of price stability in order toachieve lower unemployment. This discrepancy between announcements (whatpolicymakers say they are going to do) and actions (what they subsequently infact do) is called the time inconsistency of policy. Because policymakers are so oftentime inconsistent, people are skeptical when central bankers announce their in-tentions to reduce the rate of inflation. As a result, people always expect moreinflation than monetary policymakers claim they are trying to achieve. Higher ex-pectations of inflation, in turn, shift the short-run Phillips curve upward, makingthe short-run tradeoff between inflation and unemployment less favorable than itotherwise might be.

One way to avoid these two problems with discretionary policy is to committhe central bank to a policy rule. For example, suppose that Congress passed a lawrequiring the Fed to increase the money supply by exactly 3 percent per year. (Why3 percent? Because real GDP grows on average about 3 percent per year and be-cause money demand grows with real GDP, 3 percent growth in the money supplyis roughly the rate necessary to produce long-run price stability.) Such a law wouldeliminate incompetence and abuse of power on the part of the Fed, and it wouldmake the political business cycle impossible. In addition, policy could no longer betime inconsistent. People would now believe the Fed’s announcement of low in-flation because the Fed would be legally required to pursue a low-inflation mone-tary policy. With low expected inflation, the economy would face a more favorableshort-run tradeoff between inflation and unemployment.

Other rules for monetary policy are also possible. A more active rule might al-low some feedback from the state of the economy to changes in monetary policy.For example, a more active rule might require the Fed to increase monetary growthby 1 percentage point for every percentage point that unemployment rises aboveits natural rate. Regardless of the precise form of the rule, committing the Fed tosome rule would yield advantages by limiting incompetence, abuse of power, andtime inconsistency in the conduct of monetary policy.


CON: MONETARY POLICY SHOULD NOT BE MADE BY RULE

Although there may be pitfalls with discretionary monetary policy, there is also animportant advantage to it: flexibility. The Fed has to confront various circum-stances, not all of which can be foreseen. In the 1930s banks failed in record num-bers. In the 1970s the price of oil skyrocketed around the world. In October 1987the stock market fell by 22 percent in a single day. The Fed must decide how to re-spond to these shocks to the economy. A designer of a policy rule could not possi-bly consider all the contingencies and specify in advance the right policy response.It is better to appoint good people to conduct monetary policy and then give themthe freedom to do the best they can.

Moreover, the alleged problems with discretion are largely hypothetical. Thepractical importance of the political business cycle, for instance, is far from clear.In some cases, just the opposite seems to occur. For example, President JimmyCarter appointed Paul Volcker to head the Federal Reserve in 1979. Nonetheless, in

DURING THE 1990S, MANY CENTRAL BANKS

around the world adopted inflationtargeting as a rule—or at least as arough guide—for setting monetarypolicy. Brazil is a recent example.

B r a z i l t o U s e I n f l a t i o n D a t a f o rM a n a g i n g I n t e r e s t R a t e s

BY PETER FRITSCH

RIO DE JANEIRO—Brazil’s Central Bankwill adopt in late June a formal processfor managing interest rates based onpredefined inflation targets for the fol-lowing 30 months, according to thebank’s president, Arminio Fraga.

In an interview, Mr. Fraga said theCentral Bank is in the process of work-ing out the details of an “inflation target-ing” regime for managing interest ratesand the economy. Inflation targeting—a system used by other countries withfree-floating currencies such as Britain,Canada, and New Zealand—is fairly sim-ple: If prices are rising faster than expec-tations, interest rates are lifted to cooloff the economy. If prices are falling orsteady, rates are cut. . . .

Once in place, Brazil’s new policywill look like the Bank of England’s.Britain’s central bank hitched interest-rate policy to a more visible price anchorafter the inflationary shock of thepound’s severe weakening in 1992. To-day, the United Kingdom targets annualinflation at 2.5% over a two-year horizonand adjusts short-term interest rateswhen its price forecasts wander fromthat goal by more than a percentagepoint.

In general, outside observers likethe simplicity of this policy. “The ad-vantage of targeting inflation is thatthe Central Bank is less likely to

micromanage than if it is trying to targetthe level of interest rates or the cur-rency,” says Morgan Stanley Dean Wit-ter & Co. economist Ernest W. Brown.The downside of setting explicit targetsis that a hard-to-predict economy withoutprice controls like Brazil’s is apt to missits inflation targets from time to time, andmiss them publicly.

That causes some to worry aboutthe Brazilian Central Bank’s lack of inde-pendence. Brazil’s Central Bank reportsto the Finance Ministry, and thus to thepresident. What if missing—or hitting—an inflation target clashes with other ad-ministration goals, such as reducingunemployment? “Inflation targeting goesin the right direction of trying to insulatethe Central Bank from politics,” saysJ. P. Morgan & Co. economist MarceloCarvalho. “Still, introducing inflation tar-geting without proper formal CentralBank independence risks just pouringold wine into new bottles.”

SOURCE: The Wall Street Journal, May 22, 1999,p. A8.

IN THE NEWS

Inflation Targeting


October of that year Volcker moved to contract monetary policy to combat thehigh rate of inflation that he had inherited from his predecessor. The predictableresult of Volcker’s decision was a recession, and the predictable result of the reces-sion was a decline in Carter’s popularity. Rather than using monetary policy tohelp the president who had appointed him, Volcker helped to ensure Carter’s de-feat by Ronald Reagan in the November 1980 election.

The practical importance of time inconsistency is also far from clear. Althoughmost people are skeptical of central-bank announcements, central bankers canachieve credibility over time by backing up their words with actions. In the 1990s,the Fed achieved and maintained a low rate of inflation, despite the ever presenttemptation to take advantage of the short-run tradeoff between inflation and un-employment. This experience shows that low inflation does not require that theFed be committed to a policy rule.

Any attempt to replace discretion with a rule must confront the difficult taskof specifying a precise rule. Despite much research examining the costs and bene-fits of alternative rules, economists have not reached a consensus about what agood rule would be. Until there is a consensus, society has little choice but to givecentral bankers discretion to conduct monetary policy as they see fit.

QUICK QUIZ: Give an example of a monetary policy rule. Why mightyour rule be better than discretionary policy? Why might it be worse?

SHOULD THE CENTRAL BANKAIM FOR ZERO INFLATION?

One of the Ten Principles of Economics discussed in Chapter 1, and developed morefully in Chapter 16, is that prices rise when the government prints too muchmoney. Another of the Ten Principles of Economics discussed in Chapter 1, and de-veloped more fully in Chapter 21, is that society faces a short-run tradeoff betweeninflation and unemployment. Put together, these two principles raise a questionfor policymakers: How much inflation should the central bank be willing to toler-ate? Our third debate is whether zero is the right target for the inflation rate.

PRO: THE CENTRAL BANK SHOULDAIM FOR ZERO INFLATION

Inflation confers no benefit on society, but it imposes several real costs. As we dis-cussed in Chapter 16, economists have identified six costs of inflation:

� Shoeleather costs associated with reduced money holdings� Menu costs associated with more frequent adjustment of prices� Increased variability of relative prices� Unintended changes in tax liabilities due to nonindexation of the tax code


� Confusion and inconvenience resulting from a changing unit of account� Arbitrary redistributions of wealth associated with dollar-denominated debts

Some economists argue that these costs are small, at least for moderate rates of in-flation, such as the 3 percent inflation experienced in the United States during the1990s. But other economists claim these costs can be substantial, even for moder-ate inflation. Moreover, there is no doubt that the public dislikes inflation. Wheninflation heats up, opinion polls identify inflation as one of the nation’s leadingproblems.

Of course, the benefits of zero inflation have to be weighed against the costs ofachieving it. Reducing inflation usually requires a period of high unemploymentand low output, as illustrated by the short-run Phillips curve. But this disinfla-tionary recession is only temporary. Once people come to understand that policy-makers are aiming for zero inflation, expectations of inflation will fall, and theshort-run tradeoff will improve. Because expectations adjust, there is no tradeoffbetween inflation and unemployment in the long run.

Reducing inflation is, therefore, a policy with temporary costs and permanentbenefits. That is, once the disinflationary recession is over, the benefits of zero in-flation would persist into the future. If policymakers are farsighted, they should bewilling to incur the temporary costs for the permanent benefits. This is preciselythe calculation made by Paul Volcker in the early 1980s, when he tightened mone-tary policy and reduced inflation from about 10 percent in 1980 to about 4 percentin 1983. Although in 1982 unemployment reached its highest level since the GreatDepression, the economy eventually recovered from the recession, leaving a legacyof low inflation. Today Volcker is considered a hero among central bankers.

Moreover, the costs of reducing inflation need not be as large as some econo-mists claim. If the Fed announces a credible commitment to zero inflation, it candirectly influence expectations of inflation. Such a change in expectations can im-prove the short-run tradeoff between inflation and unemployment, allowing theeconomy to reach lower inflation at a reduced cost. The key to this strategy is cred-ibility: People must believe that the Fed is actually going to carry through on itsannounced policy. Congress could help in this regard by passing legislation thatmade price stability the Fed’s primary goal. Such a law would make it less costlyto achieve zero inflation without reducing any of the resulting benefits.

One advantage of a zero-inflation target is that zero provides a more naturalfocal point for policymakers than any other number. Suppose, for instance, that theFed were to announce that it would keep inflation at 3 percent—the rate experi-enced during the 1990s. Would the Fed really stick to that 3 percent target? Ifevents inadvertently pushed inflation up to 4 or 5 percent, why wouldn’t they justraise the target? There is, after all, nothing special about the number 3. By contrast,zero is the only number for the inflation rate at which the Fed can claim that itachieved price stability and fully eliminated the costs of inflation.

CON: THE CENTRAL BANK SHOULD NOTAIM FOR ZERO INFLATION

Although price stability may be desirable, the benefits of zero inflation comparedto moderate inflation are small, whereas the costs of reaching zero inflation are


large. Estimates of the sacrifice ratio suggest that reducing inflation by 1 percent-age point requires giving up about 5 percent of one year’s output. Reducing infla-tion from, say, 4 percent to zero requires a loss of 20 percent of a year’s output. Atthe current level of gross domestic product of about $9 trillion, this cost translatesinto $1.8 trillion of lost output, which is about $6,500 per person. Although peoplemight dislike inflation, it is not at all clear that they would (or should) be willingto pay this much to get rid of it.

The social costs of disinflation are even larger than this $6,500 figure suggests,for the lost income is not spread equitably over the population. When the econ-omy goes into recession, all incomes do not fall proportionately. Instead, thefall in aggregate income is concentrated on those workers who lose their jobs.The vulnerable workers are often those with the least skills and experience.Hence, much of the cost of reducing inflation is borne by those who can least af-ford to pay it.

Although economists can list several costs of inflation, there is no professionalconsensus that these costs are substantial. The shoeleather costs, menu costs, andothers that economists have identified do not seem great, at least for moderaterates of inflation. It is true that the public dislikes inflation, but the public may bemisled into believing the inflation fallacy—the view that inflation erodes livingstandards. Economists understand that living standards depend on productivity,not monetary policy. Because inflation in nominal incomes goes hand in hand withinflation in prices, reducing inflation would not cause real incomes to rise morerapidly.

Moreover, policymakers can reduce many of the costs of inflation without ac-tually reducing inflation. They can eliminate the problems associated with thenonindexed tax system by rewriting the tax laws to take account of the effects ofinflation. They can also reduce the arbitrary redistributions of wealth betweencreditors and debtors caused by unexpected inflation by issuing indexed govern-ment bonds, as in fact the Clinton administration did in 1997. Such an act insulatesholders of government debt from inflation. In addition, by setting an example, itmight encourage private borrowers and lenders to write debt contracts indexed forinflation.

Reducing inflation might be desirable if it could be done at no cost, as someeconomists argue is possible. Yet this trick seems hard to carry out in practice.When economies reduce their rate of inflation, they almost always experience a pe-riod of high unemployment and low output. It is risky to believe that the centralbank could achieve credibility so quickly as to make disinflation painless.

Indeed, a disinflationary recession can potentially leave permanent scars onthe economy. Firms in all industries reduce their spending on new plants andequipment substantially during recessions, making investment the most volatilecomponent of GDP. Even after the recession is over, the smaller stock of capital re-duces productivity, incomes, and living standards below the levels they otherwisewould have achieved. In addition, when workers become unemployed in reces-sions, they lose valuable job skills. Even after the economy has recovered, theirvalue as workers is diminished. Some economists have argued that the high un-employment in many European economies during the past decade is the aftermathof the disinflations of the 1980s.

Why should policymakers put the economy through a costly, inequitable dis-inflationary recession to achieve zero inflation, which may have only modest ben-efits? Economist Alan Blinder, whom Bill Clinton appointed to be vice chairman of


the Federal Reserve, argued forcefully in his book Hard Heads, Soft Hearts thatpolicymakers should not make this choice:

The costs that attend the low and moderate inflation rates experienced in theUnited States and in other industrial countries appear to be quite modest—morelike a bad cold than a cancer on society. . . . As rational individuals, we do notvolunteer for a lobotomy to cure a head cold. Yet, as a collectivity, we routinelyprescribe the economic equivalent of lobotomy (high unemployment) as a curefor the inflationary cold.

Blinder concludes that it is better to learn to live with moderate inflation.

QUICK QUIZ: Explain the costs and benefits of reducing inflation to zero.Which are temporary and which are permanent?

SHOULD F ISCAL POLICYMAKERSREDUCE THE GOVERNMENT DEBT?

Perhaps the most persistent macroeconomic debate in recent years has been overthe finances of the federal government. Throughout most of the 1980s and 1990s,the U.S. federal government spent more than it collected in tax revenue and fi-nanced this budget deficit by issuing government debt. When we studied financialmarkets in Chapter 13, we saw how budget deficits affect saving, investment, andinterest rates.

This situation reversed itself in the late 1990s, when a combination of tax hikes,spending cuts, and strong economic growth eliminated the government’s budgetdeficit and even produced a small budget surplus. Our fourth debate concernswhether fiscal policymakers should use this budget surplus to reduce the govern-ment debt. The alternative is to eliminate the budget surplus by cutting taxes orincreasing spending.

PRO: POLICYMAKERS SHOULDREDUCE THE GOVERNMENT DEBT

The U.S. federal government is far more indebted today than it was two decadesago. In 1980, the federal debt was $710 billion; in 1999, it was $3.7 trillion. If we di-vide today’s debt by the size of the population, we learn that each person’s shareof the government debt is about $14,000.

The most direct effect of the government debt is to place a burden on futuregenerations of taxpayers. When these debts and accumulated interest come due,future taxpayers will face a difficult choice. They can pay higher taxes, enjoy lessgovernment spending, or both, in order to make resources available to pay off thedebt and accumulated interest. Or they can delay the day of reckoning and put thegovernment into even deeper debt by borrowing once again to pay off the old debtand interest. In essence, when the government runs a budget deficit and issuesgovernment debt, it allows current taxpayers to pass the bill for some of their

“MY SHARE OF THE GOVERNMENT DEBT

IS $14,000.”


government spending on to future taxpayers. Inheriting such a large debt cannothelp but lower the living standard of future generations.

In addition to this direct effect, budget deficits also have various macroeco-nomic effects. Because budget deficits represent negative public saving, they lowernational saving (the sum of private and public saving). Reduced national savingcauses real interest rates to rise and investment to fall. Reduced investment leadsover time to a smaller stock of capital. A lower capital stock reduces labor produc-tivity, real wages, and the economy’s production of goods and services. Thus,when the government increases its debt, future generations are born into an econ-omy with lower incomes as well as higher taxes.

There are, nevertheless, situations in which running a budget deficit is justifi-able. Throughout history, the most common cause of increased government debt iswar. When a military conflict raises government spending temporarily, it is rea-sonable to finance this extra spending by borrowing. Otherwise, taxes duringwartime would have to rise precipitously. Such high tax rates would greatly dis-tort the incentives faced by those who are taxed, leading to large deadweightlosses. In addition, such high tax rates would be unfair to current generations oftaxpayers, who already have to make the sacrifice of fighting the war.

Similarly, it is reasonable to allow a rise in government debt during a tempo-rary downturn in economic activity. When the economy goes into a recession, taxrevenue falls automatically, because the income tax and the payroll tax are leviedon measures of income. If the government tried to balance its budget during a re-cession, it would have to raise taxes or cut spending at a time of high unemploy-ment. Such a policy would tend to depress aggregate demand at precisely the timeit needed to be stimulated and, therefore, would tend to increase the magnitude ofeconomic fluctuations.

The rise in government debt during the 1980s and 1990s, however, cannot bejustified by appealing to war or recession. During this period, the United Statesavoided major military conflict and major economic downturn. Nonetheless, thegovernment consistently ran a budget deficit, largely because the president andCongress found it easier to increase government spending than to increase taxes.As a result, government debt as a percentage of annual gross domestic product in-creased from 26 percent in 1980 to 50 percent in 1995, before falling back a bit to44 percent in 1999. It is hard to see any rationale for this rise in government debt.If the U.S. government had been operating with a balanced budget since 1980,today’s college graduates would be entering an economy that promised themgreater economic prosperity.

It’s now time to reverse the effects of this policy mistake. A combination offiscal prudence and good luck left the U.S. government with a budget surplus inthe late 1990s and projected surpluses for subsequent years. We should use thesesurpluses to repay some of the debt that the government has accumulated. Com-pared to the alternative of cutting taxes or increasing spending, repaying the debtwould mean greater national saving, investment, and economic growth.

CON: POLICYMAKERS SHOULD NOTREDUCE THE GOVERNMENT DEBT

The problem of government debt is often exaggerated. Although the governmentdebt does represent a tax burden on younger generations, it is not large comparedto the average person’s lifetime income. The debt of the U.S. federal government is


about $14,000 per person. A person who works 40 years for $25,000 a year will earn$1 million over his lifetime. His share of the government debt represents less than2 percent of his lifetime resources.

Moreover, it is misleading to view the effects of government debt in isolation.The government debt is just one piece of a large picture of how the governmentchooses to raise and spend money. In making these decisions over fiscal policy,policymakers affect different generations of taxpayers in many ways. The govern-ment’s budget deficit or surplus should be considered together with these otherpolicies.

For example, suppose the government uses the budget surplus to pay off thegovernment debt instead of using it to pay for increased spending on education.Does this policy make young generations better off? The government debt will besmaller when they enter the labor force, which means a smaller tax burden. Yet ifthey are less well educated than they could be, their productivity and incomes willbe lower. Many estimates of the return to schooling (the increase in a worker’swage that results from an additional year in school) find that it is quite large. Re-ducing the government debt rather than funding more education spending could,all things considered, make future generations worse off.

Single-minded concern about the government debt is also dangerous becauseit draws attention away from various other policies that redistribute income acrossgenerations. For example, in the 1960s and 1970s, the U.S. federal governmentraised Social Security benefits for the elderly. It financed this higher spending byincreasing the payroll tax on the working-age population. This policy redistributedincome away from younger generations toward older generations, even thoughit did not affect the government debt. Thus, government debt is only a smallpiece of the larger issue of how government policy affects the welfare of differentgenerations.

To some extent, the adverse effects of government debt can be reversed byforward-looking parents. Suppose a parent is worried about the impact of thegovernment debt on his children. The parent can offset the impact simply by sav-ing and leaving a larger bequest. The bequest would enhance the children’s abilityto bear the burden of future taxes. Some economists claim that people do in factbehave this way. If this were true, higher private saving by parents would offsetthe public dissaving of budget deficits, and deficits would not affect the economy.Most economists doubt that parents are so farsighted, but some people probablydo act this way, and anyone could. Deficits give people the opportunity to con-sume at the expense of their children, but deficits do not require them to do so. Ifthe government debt actually represented a great problem facing future genera-tions, some parents would help to solve it.

Critics of budget deficits sometimes assert that the government debt cannotcontinue to rise forever, but in fact it can. Just as a bank officer evaluating a loanapplication would compare a person’s debts to his income, we should judge theburden of the government debt relative to the size of the nation’s income. Popula-tion growth and technological progress cause the total income of the U.S. economyto grow over time. As a result, the nation’s ability to pay the interest on the gov-ernment debt grows over time as well. As long as the government debt growsmore slowly than the nation’s income, there is nothing to prevent the governmentdebt from growing forever.

Some numbers can put this into perspective. The real output of the U.S. econ-omy grows on average about 3 percent per year. If the inflation rate is 2 percent per


WHEN POLICYMAKERS FACE GOVERNMENT

budget surpluses, they have three op-tions: cutting taxes, increasing spend-ing, or reducing the government debt.Choosing is not easy.

L a w m a k e r s D i s c o v e rT h a t S u r p l u s e s

C a n B e a s Ve x i n g a s D e f i c i t s

BY DAVID WESSEL AND GREG HITT

WASHINGTON—It took politicians 15 con-tentious years to eliminate the biggestfederal budget deficits since WorldWar II. Now, they are having nearly asmuch difficulty deciding what to do withthe roughly $3 trillion in surpluses pro-jected over the next 10 years.

The sudden emergence of a budgetwindfall larger than anticipated just sixmonths ago is forcing into fast-forwarda longstanding debate over fiscal policyand the role of government.

On the surface, lawmakers face asimple multiple-choice question: Shouldthe surplus be saved, spent, or devotedto tax cuts? But at its core, the debateis about profound issues that werelong suppressed by the deficit-reductionimperative:

How big should government be?Do Americans prefer to pay less intaxes or have government do more?How much should younger workers sac-rifice to support baby-boomer parentsand grandparents in retirement, and howmuch should baby-boomers set aside inadvance? How much should governmentinterfere with the workings of the marketto spread the benefits of today’s pros-perity? Is paying off debt incurred in the1980s and 1990s more or less importantthan raising spending on education andhealth or lowering taxes?

With something less than unanimity,Republicans make the case for biggertax cuts and smaller government. “Re-publicans believe it’s a matter of principleto return excess tax money in Wash-ington to the families and workers whosent it here,” House Ways and MeansChairman Bill Archer, a Texas Republi-can, said on the floor of the House ofRepresentatives during last week’s tax-cut debate. “Republicans believe thatAmericans have the right to keep moreof what they earn.”

Where Republicans see an over-taxed populace, however, liberal Democ-rats in Congress see “unmet needs.”

“The question,” says Rep. BarneyFrank, a Massachusetts Democrat, “isnot whether the surplus should be spentaccording to people’s wishes. Of courseit should. The question is whether itshould be spent on private goods orpublic goods.” . . .

The public is split, but a new WallStreet Journal/NBC News poll suggeststhat the GOP is having trouble sellingits call for tax cuts. . . . Asked to pickjust one option for using the surplus, 46

percent of the 1,007 respondents optedfor spending on social programs such aseducation or a prescription-drug benefitfor Medicare recipients, 22 percentpicked paying down the federal debt, andonly 20 percent picked tax cuts. (Therest picked defense or didn’t make achoice.)

“We are not in a period like thelate 1970s when people really despisedgovernment,” says Republican pollsterRobert Teeter, who conducted the pollwith Democrat Peter Hart. “The elec-torate is saying there are serious le-gitimate issues that the governmentshould address, and they are willing touse some of their money to do it,” Mr.Teeter adds. . . .

Fed Chairman Greenspan continuesto preach the virtues of debt reduction.Although he doesn’t admit to as much,he sees virtue in gridlock. If Congressand Mr. Clinton can get appropriationsbills enacted this year, but agree onnothing else, then the surplus will auto-matically go to reducing the governmentdebt.

SOURCE: The Wall Street Journal, July 29, 1999,p. A1.

IN THE NEWS

The Budget Surplus


year, then nominal income grows at a rate of 5 percent per year. The governmentdebt, therefore, can rise by 5 percent per year without increasing the ratio of debtto income. In 1999 the federal government debt was $3.7 trillion; 5 percent of thisfigure is $165 billion. As long as the federal budget deficit is smaller than $165 bil-lion, the policy is sustainable. There will never be any day of reckoning that forcesthe budget deficits to end or the economy to collapse.

If moderate budget deficits are sustainable, there is no need for the govern-ment to maintain budget surpluses. Let’s put this excess of revenue over spendingto better use. The government could use these funds to pay for valuable govern-ment programs, such as increased funding for education. Or it could use them tofinance a tax cut. In the late 1990s taxes reached an historic high as a percentage ofGDP, so there is every reason to suppose that the deadweight losses of taxationreached an historic high as well. If all these taxes aren’t needed for current spend-ing, the government should return the money to the people who earned it.

QUICK QUIZ: Explain how reducing the government debt makes futuregenerations better off. What fiscal policy might improve the lives of futuregenerations more than reducing the government debt?

SHOULD THE TAX LAWS BE REFORMED TOENCOURAGE SAVING?

A nation’s standard of living depends on its ability to produce goods and services.This was one of the Ten Principles of Economics in Chapter 1. As we saw in Chapter12, a nation’s productive capability, in turn, is determined largely by how much itsaves and invests for the future. Our fifth debate is whether policymakers shouldreform the tax laws to encourage greater saving and investment.

PRO: THE TAX LAWS SHOULD BEREFORMED TO ENCOURAGE SAVING

A nation’s saving rate is a key determinant of its long-run economic prosperity.When the saving rate is higher, more resources are available for investment in newplant and equipment. A larger stock of plant and equipment, in turn, raises laborproductivity, wages, and incomes. It is, therefore, no surprise that internationaldata show a strong correlation between national saving rates and measures of eco-nomic well-being.

Another of the Ten Principles of Economics presented in Chapter 1 is that peoplerespond to incentives. This lesson should apply to people’s decisions about howmuch to save. If a nation’s laws make saving attractive, people will save a higherfraction of their incomes, and this higher saving will lead to a more prosperousfuture.

Unfortunately, the U.S. tax system discourages saving by taxing the return tosaving quite heavily. For example, consider a 25-year-old worker who saves $1,000


of her income to have a more comfortable retirement at the age of 70. If she buys abond that pays an interest rate of 10 percent, the $1,000 will accumulate at the endof 45 years to $72,900 in the absence of taxes on interest. But suppose she faces amarginal tax rate on interest income of 40 percent, which is typical of many work-ers once federal and state income taxes are added together. In this case, her after-tax interest rate is only 6 percent, and the $1,000 will accumulate at the end of 45years to only $13,800. That is, accumulated over this long span of time, the tax rateon interest income reduces the benefit of saving $1,000 from $72,900 to $13,800—or by about 80 percent.

The tax code further discourages saving by taxing some forms of capital in-come twice. Suppose a person uses some of his saving to buy stock in a corpora-tion. When the corporation earns a profit from its capital investments, it first paystax on this profit in the form of the corporate income tax. If the corporation paysout the rest of the profit to the stockholder in the form of dividends, the stock-holder pays tax on this income a second time in the form of the individual incometax. This double taxation substantially reduces the return to the stockholder,thereby reducing the incentive to save.

The tax laws again discourage saving if a person wants to leave his accumu-lated wealth to his children (or anyone else) rather than consuming it during hislifetime. Parents can bequeath some money to their children without tax, but if thebequest becomes large, the inheritance tax rate can be as high as 55 percent. To alarge extent, concern about national saving is motivated by a desire to ensure eco-nomic prosperity for future generations. It is odd, therefore, that the tax laws dis-courage the most direct way in which one generation can help the next.

In addition to the tax code, many other policies and institutions in our societyreduce the incentive for households to save. Some government benefits, such aswelfare and Medicaid, are means-tested; that is, the benefits are reduced for thosewho in the past have been prudent enough to save some of their income. Collegesand universities grant financial aid as a function of the wealth of the students andtheir parents. Such a policy is like a tax on wealth and, as such, discourages stu-dents and parents from saving.

There are various ways in which the tax code could provide an incentive tosave, or at least reduce the disincentive that households now face. Already the taxlaws give preferential treatment to some types of retirement saving. When a tax-payer puts income into an Individual Retirement Account (IRA), for instance, thatincome and the interest it earns are not taxed until the funds are withdrawn at re-tirement. The tax code gives a similar tax advantage to retirement accounts that goby other names, such as 401(k), 403(b), Keogh, and profit-sharing plans. There are,however, limits to who is eligible to use these plans and, for those who are eligible,limits on the amount that can be put in them. Moreover, because there are penal-ties for withdrawal before retirement age, these retirement plans provide little in-centive for other types of saving, such as saving to buy a house or pay for college.A small step to encourage greater saving would be to expand the ability of house-holds to use such tax-advantaged savings accounts.

A more comprehensive approach would be to reconsider the entire basis bywhich the government collects revenue. The centerpiece of the U.S. tax system isthe income tax. A dollar earned is taxed the same whether it is spent or saved.An alternative advocated by many economists is a consumption tax. Under aconsumption tax, a household pays taxes only on the basis of what it spends.Income that is saved is exempt from taxation until the saving is later withdrawn


and spent on consumption goods. In essence, a consumption tax puts all sav-ing automatically into a tax-advantaged savings account, much like an IRA. Aswitch from income to consumption taxation would greatly increase the incentiveto save.

CON: THE TAX LAWS SHOULDNOT BE REFORMED TO ENCOURAGE SAVING

Increasing saving may be desirable, but it is not the only goal of tax policy. Policy-makers also must be sure to distribute the tax burden fairly. The problem with pro-posals to increase the incentive to save is that they increase the tax burden on thosewho can least afford it.

It is an undeniable fact that high-income households save a greater fraction oftheir income than low-income households. As a result, any tax change that favorspeople who save will also tend to favor people with high income. Policies suchas tax-advantaged retirement accounts may seem appealing, but they lead to aless egalitarian society. By reducing the tax burden on the wealthy who can takeadvantage of these accounts, they force the government to raise the tax burden onthe poor.

Moreover, tax policies designed to encourage saving may not be effective atachieving that goal. Many studies have found that saving is relatively inelastic—that is, the amount of saving is not very sensitive to the rate of return on saving.If this is indeed the case, then tax provisions that raise the effective return byreducing the taxation of capital income will further enrich the wealthy withoutinducing them to save more than they otherwise would.

Economic theory does not give a clear prediction about whether a higherrate of return would increase saving. The outcome depends on the relative sizeof two conflicting effects, called the substitution effect and the income effect. Onthe one hand, a higher rate of return raises the benefit of saving: Each dollarsaved today produces more consumption in the future. This substitution effecttends to raise saving. On the other hand, a higher rate of return lowers the needfor saving: A household has to save less to achieve any target level of consumptionin the future. This income effect tends to reduce saving. If the substitution andincome effects approximately cancel each other, as some studies suggest, thensaving will not change when lower taxation of capital income raises the rate ofreturn.

There are other ways to raise national saving than by giving tax breaks to therich. National saving is the sum of private and public saving. Instead of trying toalter the tax code to encourage greater private saving, policymakers can simplyraise public saving by increasing the budget surplus, perhaps by raising taxes onthe wealthy. This offers a direct way of raising national saving and increasing pros-perity for future generations.

Indeed, once public saving is taken into account, tax provisions to encouragesaving might backfire. Tax changes that reduce the taxation of capital incomereduce government revenue and, thereby, lead to a budget deficit. To increase na-tional saving, such a change in the tax code must stimulate private saving by morethan it reduces public saving. If this is not the case, so-called saving incentives canpotentially make matters worse.


QUICK QUIZ: Give three examples of how our society discourages saving.What are the drawbacks of eliminating these disincentives?

CONCLUSION

This chapter has considered five debates over macroeconomic policy. For each, itbegan with a controversial proposition and then offered the arguments pro andcon. If you find it hard to choose a side in these debates, you may find some com-fort in the fact that you are not alone. The study of economics does not alwaysmake it easy to choose among alternative policies. Indeed, by clarifying the in-evitable tradeoffs that policymakers face, it can make the choice more difficult.

Difficult choices, however, have no right to seem easy. When you hear politi-cians or commentators proposing something that sounds too good to be true, itprobably is. If they sound like they are offering you a free lunch, you should lookfor the hidden price tag. Few if any policies come with benefits but no costs. Byhelping you see through the fog of rhetoric so common in political discourse, thestudy of economics should make you a better participant in our national debates.

� Advocates of active monetary and fiscal policy view theeconomy as inherently unstable and believe that policycan manage aggregate demand to offset the inherentinstability. Critics of active monetary and fiscal policyemphasize that policy affects the economy with a lagand that our ability to forecast future economicconditions is poor. As a result, attempts to stabilize theeconomy can end up being destabilizing.

� Advocates of rules for monetary policy argue thatdiscretionary policy can suffer from incompetence,abuse of power, and time inconsistency. Critics of rulesfor monetary policy argue that discretionary policy ismore flexible in responding to changing economiccircumstances.

� Advocates of a zero-inflation target emphasize thatinflation has many costs and few if any benefits.Moreover, the cost of eliminating inflation—depressedoutput and employment—is only temporary. Even thiscost can be reduced if the central bank announces acredible plan to reduce inflation, thereby directlylowering expectations of inflation. Critics of a zero-inflation target claim that moderate inflation imposesonly small costs on society, whereas the recessionnecessary to reduce inflation is quite costly.

� Advocates of reducing the government debt argue thatthe debt imposes a burden on future generations byraising their taxes and lowering their incomes. Critics ofreducing the government debt argue that the debt isonly one small piece of fiscal policy. Single-mindedconcern about the debt can obscure the many ways inwhich the government’s tax and spending decisionsaffect different generations.

� Advocates of tax incentives for saving point out that oursociety discourages saving in many ways, such as byheavily taxing the income from capital and by reducingbenefits for those who have accumulated wealth. Theyendorse reforming the tax laws to encourage saving,perhaps by switching from an income tax to aconsumption tax. Critics of tax incentives for savingargue that many proposed changes to stimulate savingwould primarily benefit the wealthy, who do not need atax break. They also argue that such changes might haveonly a small effect on private saving. Raising publicsaving by increasing the government’s budget surpluswould provide a more direct and equitable way toincrease national saving.

Summar y


1. What causes the lags in the effect of monetary and fiscalpolicy on aggregate demand? What are the implicationsof these lags for the debate over active versus passivepolicy?

2. What might motivate a central banker to cause apolitical business cycle? What does the political businesscycle imply for the debate over policy rules?

3. Explain how credibility might affect the cost of reducinginflation.

4. Why are some economists against a target of zeroinflation?

5. Explain two ways in which a government budget deficithurts a future worker.

6. What are two situations in which most economists viewa budget deficit as justifiable?

7. Give an example of how the government might hurtyoung generations, even while reducing thegovernment debt they inherit.

8. Some economists say that the government can continuerunning a budget deficit forever. How is that possible?

9. Some income from capital is taxed twice. Explain.

10. Give an example, other than tax policy, of how oursociety discourages saving.

11. What adverse effect might be caused by tax incentivesto raise saving?

Quest ions fo r Rev iew

1. The chapter suggests that the economy, like the humanbody, has “natural restorative powers.”a. Illustrate the short-run effect of a fall in aggregate

demand using an aggregate-demand/aggregate-supply diagram. What happens to total output,income, and employment?

b. If the government does not use stabilization policy,what happens to the economy over time? Illustrateon your diagram. Does this adjustment generallyoccur in a matter of months or a matter of years?

c. Do you think the “natural restorative powers” ofthe economy mean that policymakers should bepassive in response to the business cycle?

2. Policymakers who want to stabilize the economy mustdecide how much to change the money supply,government spending, or taxes. Why is it difficult forpolicymakers to choose the appropriate strength of theiractions?

3. Suppose that people suddenly wanted to hold moremoney balances.a. What would be the effect of this change on the

economy if the Federal Reserve followed a rule ofincreasing the money supply by 3 percent per year?Illustrate your answer with a money-marketdiagram and an aggregate-demand/aggregate-supply diagram.

b. What would be the effect of this change on theeconomy if the Fed followed a rule of increasing

the money supply by 3 percent per year plus1 percentage point for every percentage pointthat unemployment rises above its normal level?Illustrate your answer.

c. Which of the foregoing rules better stabilizesthe economy? Would it help to allow the Fed torespond to predicted unemployment instead ofcurrent unemployment? Explain.

4. Some economists have proposed that the Fed use thefollowing rule for choosing its target for the federalfunds interest rate (r):

r � 2% � π � 1/2 (y � y*)/y* � 1/2 (π � π*),

where π is the average of the inflation rate over thepast year, y is real GDP as recently measured, y* is anestimate of the natural rate of output, and π* is the Fed’sgoal for inflation.a. Explain the logic that might lie behind this rule for

setting interest rates. Would you support the Fed’suse of this rule?

b. Some economists advocate such a rule for monetarypolicy but believe π and y should be the forecasts offuture values of inflation and output. What are theadvantages of using forecasts instead of actualvalues? What are the disadvantages?

5. The problem of time inconsistency applies to fiscalpolicy as well as to monetary policy. Suppose the

Prob lems and App l icat ions


government announced a reduction in taxes on incomefrom capital investments, like new factories.a. If investors believed that capital taxes would

remain low, how would the government’s actionaffect the level of investment?

b. After investors have responded to the announcedtax reduction, does the government have anincentive to renege on its policy? Explain.

c. Given your answer to part (b), would investorsbelieve the government’s announcement? Whatcan the government do to increase the credibilityof announced policy changes?

d. Explain why this situation is similar to the timeinconsistency problem faced by monetarypolicymakers.

6. Chapter 2 explains the difference between positiveanalysis and normative analysis. In the debate aboutwhether the central bank should aim for zero inflation,which areas of disagreement involve positive statementsand which involve normative judgments?

7. Why are the benefits of reducing inflation permanentand the costs temporary? Why are the costs ofincreasing inflation permanent and the benefitstemporary? Use Phillips-curve diagrams in youranswer.

8. Suppose the federal government cuts taxes andincreases spending, raising the budget deficit to12 percent of GDP. If nominal GDP is rising 7 percentper year, are such budget deficits sustainable forever?Explain. If budget deficits of this size are maintained for20 years, what is likely to happen to your taxes and your

children’s taxes in the future? Can you do somethingtoday to offset this future effect?

9. Explain how each of the following policies redistributesincome across generations. Is the redistribution fromyoung to old, or from old to young?a. an increase in the budget deficitb. more generous subsidies for education loansc. greater investments in highways and bridgesd. indexation of Social Security benefits to inflation

10. Surveys suggest that most people are opposed to budgetdeficits, but these same people elected representativeswho in the 1980s and 1990s passed budgets withsignificant deficits. Why might the opposition to budgetdeficits be stronger in principle than in practice?

11. The chapter says that budget deficits reduce the incomeof future generations, but can boost output and incomeduring a recession. Explain how both of thesestatements can be true.

12. What is the fundamental tradeoff that society faces if itchooses to save more?

13. Suppose the government reduced the tax rate on incomefrom savings.a. Who would benefit from this tax reduction most

directly?b. What would happen to the capital stock over time?

What would happen to the capital available to eachworker? What would happen to productivity?What would happen to wages?

c. In light of your answer to part (b), who mightbenefit from this tax reduction in the long run?

Documents

Mankiw_ Five Debates Over Macroeconomic Policy